CIA Part 3 Textbook

CIA Part 3
Business Knowledge
For Internal Auditing
Version 20.01
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2020 Edition
CIA
Preparatory Program
Part 3
Business Knowledge
For Internal Auditing
Brian Hock, CIA, CMA

and
Lynn Roden, CMA
with
Kevin Hock
HOCK international, LLC
P.O. Box 6553
Columbus, Ohio 43206
(866) 807-HOCK or (866) 807-4625

(281) 652-5768
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cia@hockinternational.com
Published June 2020
Acknowledgements
Acknowledgement is due to the Institute of Internal Auditors for permission to use

copyrighted questions and problems from the Certified Internal Auditor Examinations by
The Institute of Internal Auditors, Inc., 247 Maitland Avenue, Altamonte Springs, Florida
32701 USA. Reprinted with permission.
The authors would also like to thank the Institute of Certified Management Accountants
for permission to use questions and problems from past CMA Exams. The questions and
unofficial answers are copyrighted by the Certified Institute of Management Accountants
and have been used here with their permission.
The authors also wish to thank the IT Governance Institute for permission to make use
of concepts from the publication Control Objectives for Information and related
Technology (COBIT) 3rd Edition, © 2000, IT Governance Institute, www.itgi.org.
Reproduction without permission is not permitted.
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ISBN: 978-1-934494-12-7
This textbook is for personal use only by Leonardo Jr Del Carmen (leonardoonline101@gmail.com).
Thanks
The authors would like to thank the following people for their assistance in the
production of this material:
§ Carl Burch, CIA, CMA for his assistance in the technical elements of the material,
§ All of the staff of HOCK Training and HOCK international for their patience in the
multiple revisions of the material,
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international in our Distance Learning Program who have made suggestions,
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§ Most importantly, to our families and spouses, for their patience in the long hours
and travel that have gone into these materials.
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CIA Part 3 Table of Contents
Table of Contents
Exam Introduction ............................................................................................................. 1

Section I – Business Acumen ........................................................................................... 2
1. Organizational Objectives, Behavior, and Performance ............................................ 2
1 A. Strategic Planning 2
1 B. Common Performance Measures 9
1 C. Organizational Behavior 26
1 D. Management Skills and Leadership Styles 35
2. Organizational Structure and Business Processes .................................................. 42
2 A. Risk and Control Implications of Different Organizational Structures 42
2 B. Risk and Control Implications of Common Business Processes 49
2 C. Project Management Techniques 65
2 D. Contracts 69
3. Data Analytics .............................................................................................................. 74
Big Data and the Four (or Five) V’s of Data 74
Data Analytics Process 75
Types of Data Analytics 76
Implementing Data Analytics in the Internal Audit Activity 76
The Future of Data Analytics 78
Section II – Information Security .................................................................................... 79
A. Physical Security Controls ......................................................................................... 80
B. User Authentication and Authorization Controls ..................................................... 81
C. Information Security Controls.................................................................................... 82
General Controls 82
Application Controls 83
Firewalls 85
Intrusion Detection Systems 85
Encryption 86
Antivirus Software: Protection against Viruses, Trojan Horses, and Worms 87
D. Privacy ......................................................................................................................... 88
E. Emerging Technology Practices and Their Impact on Security .............................. 91
Auditing Smart Devices 92
F. Cybersecurity Risks .................................................................................................... 97
G. Cybersecurity and Information Security-Related Policies ...................................... 99
Section III – Information Technology ........................................................................... 101
Introduction to Information Technology ...................................................................... 101
1. Application and System Software ............................................................................ 102
Systems Development Lifecycle 102
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Table of Contents CIA Part 3
System and Program Change Controls 105

Databases 106
The Internet and Internet Terms 108
Software Systems 110
Introduction to MRP, MRPII, and ERP 111
2. IT Infrastructure and IT Control Frameworks .......................................................... 114
Networking Concepts 114
Operational Roles with IT 116
IT Control Frameworks 117
3. Business Continuity and Contingency Planning .................................................... 124
Disaster Recovery 125
Section IV – Financial Management ............................................................................. 127
1. Financial Accounting and Finance ....................................................................... 127
1 A 1. Financial Accounting Concepts and Principles 127
1 A 2. External Financial Statements 134
1 A 3. Intermediate Concepts of Financial Accounting 152
1 B. Advanced Concepts of Financial Accounting 160
1 C. Financial Analysis 170
1 D. The Revenue Cycle and Working Capital Management 191
1 E 1. Capital Structure 223
Cost of Capital 231
1 E 2. Capital Budgeting 243
1 E 3. Basic Taxation 258
1 E 4. Transfer Pricing 262
2. Managerial Accounting .......................................................................................... 270
2 A 1. Budgeting Concepts 270
2 A 2. Cost-Volume-Profit Analysis 282
2 A 3. Responsibility Centers and Responsibility Accounting 294
2 A 4. Shared Services Cost Allocation 301
2 B. Cost Management Systems 311
2 B 1. Cost Classifications 311
2 B 2. Cost of Goods Sold (COGS) and Cost of Goods Manufactured (COGM) 320
2 B 3. Costing Systems 322
2 B 4. Variable and Absorption Costing for Manufacturing Costs 343
2 C. Decision Making 349
Appendix A – Time Value of Money Concepts (Present/Future Value) ..................... 362

Simple Interest 362
Compound Interest 363
Present Value 364
Future Value 370
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CIA Part 3 Introduction
Exam Introduction
The CIA Part 3 exam, Business Knowledge for Internal Auditing, is 120 minutes (2 hours) long and
consists of 100 multiple-choice questions. For more information about the exams, visit the IIA’s website
(www.theiia.org).
The Part 3 exam has four sections:
• Section I: Business Acumen (35%)
• Section II: Information Security (25%)
• Section III: Information Technology (20%)
• Section IV: Financial Management (20%)
Additionally, the IIA syllabus refers to proficient and basic cognitive levels:
• Proficient: Candidates must exhibit thorough understanding and ability to apply concepts, pro-
cesses, or procedures; analyze, evaluate, and make judgments based on criteria; and/or put
elements or material together to formulate conclusions and recommendations.
• Basic: Candidates must retrieve relevant knowledge from memory and/or demonstrate basic com-
prehension of concepts or processes.
Note: All information in Part 3 is tested at the basic level unless otherwise indicated.
In preparing for the exam, candidates need to read the textbook and use the ExamSuccess software with
questions from past exams. Many of the exam topics are very large; therefore, by studying past exam
questions candidates can get a feeling for the manner and depth to which a topic is tested.
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Section I – Business Acumen CIA Part 3
Section I – Business Acumen

1. Organizational Objectives, Behavior, and Performance
1 A. Strategic Planning
Planning in general refers to the process that provides guidance and direction regarding what an organiza-
tion needs to do throughout its operations. It determines the answers to the “who, what, when, where, and
how” questions of a business operation. Planning is the first activity management must undertake when
creating yearly budgets and making other critical decisions that will affect the company’s future. A com-
pany’s plan serves as its guide or compass for the activities and decisions made by individuals throughout
the entire organization. The planning process not only defines the company’s objectives and goals, it sets
the stage for prioritizing how to develop, communicate and carry out accomplishing them.
Planning in Order to Achieve Superior Performance

For most companies, if not all, the ultimate objective is to achieve superior performance in comparison
with the performance of their competitors. When superior performance is achieved, company profitability
will increase. When profits are growing, shareholder value will grow. A publicly-owned for-profit company
must have maximizing shareholder value as its ultimate goal. The shareholders are the owners. They have
provided risk capital with the expectation that the managers will pursue strategies that will give them a
good return on their investment. Thus, managers have an obligation to invest company profits in such a
way as to maximize shareholder value.
The result of attaining superior performance will be competitive advantage. Competitive advantage is an
advantage a company has over its competitors that it gains by offering consumers greater value than they
can get from its competitors. The greater value may be in lower prices for the same product or service; or
it may be in offering greater benefits and service than its competitors do, thereby justifying higher prices;
or it may be offering greater benefits at the same or even at a lower price than its competitors charge.
Competitive advantage may be derived from attributes that enable an organization to outperform its com-
petitors such as access to natural resources, highly-skilled personnel, a favorable geographic location, high
entry barriers, and so forth.
A company that has competitive advantage will usually be more profitable than the companies it competes
with. The higher its profits are in comparison to its competitors, the greater its competitive advantage will
be. Competitive advantage leads to increased profitability; and greater profitability leads to increased com-
petitive advantage. Competitive advantage makes the difference between a company that succeeds and a
company that fails.
In order to increase profitability and sustain profit growth, managers need to formulate strategies that
will give their companies competitive advantage. Strategic planning is this formulation of strategies. The
strategies that managers pursue create the activities that together can set the company apart from its
competitors and cause it to consistently outperform them.
Strategic planning is neither detailed nor focused on specific financial targets, but instead looks at the
strategies, objectives and goals of the company by examining both the internal and external fac-
tors affecting the company.
• Internal factors include current facilities, current products and market share, corporate goals and
objectives, long-term targets, technology investment, and anything else within the direct control
of the company itself.
• External factors include the economy, labor market, domestic and international competition, envi-
ronmental issues, technological developments, developing new markets, and political risk in other
countries (or the home country).
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Section I 1. Organizational Objectives, Behavior, and Performance
The Strategic Planning Process

The formal strategic planning process consists of five steps, as follows:
1) Defining the company’s mission, vision, values, and goals, or developing its mission statement.
The company’s mission statement provides the context within which its strategies will be formu-
lated.
2) Analyzing the organization’s external competitive environment in order to identify opportunities

and threats.
3) Analyzing the internal operating environment to identify strengths, weaknesses, and limitations
of the organization.
4) Formulating and selecting strategies that, consistent with the organization’s mission and goals, will
optimize the organization’s strengths and correct its weaknesses and limitations for the purpose
of taking advantage of external opportunities while countering external threats.
5) Developing and implementing the chosen strategies.
Developing the Mission Statement
Note: This is the first of five steps in the strategic planning process.
The mission statement includes four components:
1) A statement of the company’s mission, or “reason to be.” A company’s mission is what the
company does. A company’s mission statement should be very broad, because customer demands
can shift quickly, and a given need can be served in more than one way. A company that limits
itself to serving a need in just one way will find itself obsolete when technological change passes
it by. It needs to be flexible and ready to adapt to changing conditions and new ways of serving
its customers’ needs.
2) Its vision, or a statement of a desired future state. The vision is what the company would like to
achieve or become, and it should be challenging. A good vision statement should challenge the
company by stating an ambitious future state that will (1) motivate employees at all levels and (2)
drive the strategies that the company’s management will formulate and implement in order to
achieve the vision. For example, Du Pont’s mission statement says, “Our vision is to be the world's
most dynamic science company, creating sustainable solutions essential to a better, safer and
healthier life for people everywhere.”
3) A statement of the organization’s values. The organization’s values describe how managers and
employees should behave and do business. A company’s values are the foundation of its organi-
zational culture. The organizational culture consists of the values, norms and standards that
govern how the company’s employees work to achieve the company’s mission and goals. These
standards are in turn associated with the company’s performance—either good performance or
poor performance. A deep respect for the interests of customers, employees, suppliers and share-
holders has been associated with high performance in firms. On the other hand, a lack of respect
for the same groups (values not expressed in the company’s mission statement) has been asso-
ciated with poor performance in firms. Thus, the company must not only “talk the talk” but it must
also “walk the walk.”
4) A statement of its major goals. A goal is a precise and measurable future state that the company
wants to achieve. The purpose of goal-setting is to specify what needs to be done in order to attain
the company’s mission and vision. Well-constructed goals provide a means for managers’ perfor-
mance to be evaluated.
1. Organizational Objectives, Behavior, and Performance CIA Part 3
The characteristics of well-constructed goals are:
a. They are precise and measurable.
b. They should be crucial and address important issues.
c. The number of goals should be limited so managers can maintain their focus on them.
d. They should be challenging while at the same time being realistic. A goal that is too unrealistic
may cause employees to either give up or embark upon unethical behavior in an attempt to
meet the goal. On the other hand, a goal that is not challenging enough may not be motivating
enough.
e. They should specify when they should be achieved in order to create a sense of urgency.
f. The goals that are developed must be clearly stated in specific terms to prevent “interpre-
tation” of the objectives by employees.
g. The goals must be communicated to all individuals who will be impacted by them, and
everyone in the organization must accept the goals and work toward accomplishing them.
Analyzing the External Environment
Note: This is the second of the five steps in the strategic planning process.
The second step in the strategic planning process is to analyze the forces that shape the industry in which
the company operates and the competition within that industry in order to understand the opportunities
available to the firm and any threats confronting the firm that can affect it in the pursuit of its mission.
Understanding its opportunities and threats will enable the company to outperform the competition.
• Opportunities arise when companies can leverage1 external conditions to develop and implement
strategies that will make them more profitable.
• Threats include conditions in the external environment that pose a danger to profitability.
Three environments should be examined, and the three environments are interrelated.
1) Examine the industry in which the company operates, as other companies in the same industry
are a company’s closest competitors.
2) Analyze the country or the national environment in which the company operates as well as the
international environment, including domestic and international political risk and the impact of
globalization on competition within the industry.
3) Assess the macroenvironment in which the company operates, including macroeconomic factors
such as economic growth and recession that will affect the industry or the economy as a whole,
interest rates, currency exchange rates, and social factors such as laws and regulations and tech-
nological factors.
Competitive Analysis
Competitive analysis involves analyzing the competitive environment in which a business operates or is
considering operating in to determine the following:
• Defining the competitors and analyzing their strengths and weaknesses.
• Demographics and needs of the market in which the business operates, including customer needs
and wants.
1
“Leverage” as it is used here means “to gain advantage through the use of something.”
• Analyzing the company’s own internal strengths and weaknesses and strategies to improve the
company’s position in the marketplace.
• Studying impediments to the market for both the company and its competitors, such as patents,
high start-up costs, or a high level of knowledge required for success.
• Studying impediments to the company’s entering new markets.
• Barriers the company can erect to limit competitors’ ability to erode the company’s place in the
market.
Analyzing the Internal Environment
Note: This is the third of the five steps in the strategic planning process.
The purpose of internal analysis is to identify strengths, weaknesses, and limitations within the organ-
ization. The company’s resources and capabilities need to be assessed. Strengths lead to superior
performance. Weaknesses and limitations lead to inferior performance.
The primary objective of strategy is to create a sustained competitive advantage, because that
will lead to superior profitability and profit growth.
A firm creates competitive advantage when it is able to use its resources and its capabilities to achieve
either a differentiation advantage or a cost advantage (or both) to create superior value for its cus-
tomers and superior profits for the company.
1) A differentiation advantage creates value for a firm’s customers because it provides its custom-
ers with benefits that exceed those provided by the firm’s competitors. A differentiation advantage
gives the firm more flexibility in pricing because it can price its product or service higher than the
prices of its competitors, leading to greater profits than the competition.
2) A cost advantage creates the same value and benefits for the firm’s customers as its competitors
but at a lower cost, also leading to greater profits than the competition.
Distinctive competencies are strengths a company has that enable it to have either a differentiation
advantage or a cost advantage, or both, leading to competitive advantage. Distinctive competencies come
from a company’s resources and capabilities.
Four generic distinctive competencies create competitive advantage. These four factors are called “generic”
distinctive competences because any company can pursue them. The four generic distinctive competencies
are:
• Superior efficiency. Efficiency is the relationship between inputs and outputs. The more efficient
the company is, the fewer inputs will be required to produce a given output. Therefore, superior
efficiency leads to lower costs, which in turn lead to higher profitability and competitive advantage.
• Superior quality. A product has superior quality when customers consider that its attributes give
them higher utility than the attributes of competing products. Offering superior quality enables the
company to charge a higher price than competitors for its product, leading to higher profits.
• Superior innovation. Innovation is the creation of new products or new processes. Product
innovation creates value by developing products that customers perceive as having more utility,
and thus the company’s pricing options for the products are increased. Process innovation can
create value by decreasing costs.
• Superior customer responsiveness. Superior customer responsiveness occurs when a company

is able to do a better job than its competitors of identifying customer needs and satisfying them.
Customers attribute more utility to the product, and this greater utility differentiates the product
from that of the competition. Customer response time, or the time required to deliver a product or
perform a service, is also an important aspect of customer responsiveness.
An important part of the internal analysis is analysis of the company’s financial performance to identify how
its strategies contribute or do not contribute to its profitability. Comparing, or benchmarking, the com-
pany’s current financial performance against that of its competitors as well as against the company’s own
historical performance using financial statement analysis can help management to understand what is going
on in the company and identify its strengths and weaknesses.
By analyzing its financial performance, management can see whether the company is more or less profitable
than its competitors and whether its profitability has been improving or deteriorating. Analysis of financial
performance will also help management to see whether the strategies the company is pursuing are max-
imizing value creation, whether the company’s costs are in line with those of its competitors, and whether
the company’s resources are being used effectively.
Formulating Strategies (SWOT Analysis)
Note: This is the fourth of the five steps in the strategic planning process.
Once the company’s external opportunities and threats and internal strengths and weaknesses have been
identified, the next step is to perform SWOT analysis.
SWOT stands for Strengths, Weaknesses, Opportunities, and Threats. The purpose of SWOT analysis is to
optimize the organization’s strengths and correct or minimize its weaknesses in order to take advantage of
external opportunities while countering external threats.
SWOT analysis consists of generating a series of strategic alternatives that could be pursued given the
company’s strengths, weaknesses, opportunities and threats. The strategic alternatives are used to select
the strategies that will do the most to align the company’s resources and capabilities to the demands of its
environment.
Management selects a set of strategies that will create and sustain a competitive advantage for the com-
pany. It considers a range of strategies. The general classifications of strategies considered are:
• Functional-level strategy, for the purpose of improving operations inside the company. These
operations include areas such as manufacturing, marketing, materials management, product de-
velopment, and customer service.
• Business-level strategy, which includes the position of the business in the marketplace as well
as different positioning strategies that could be used. Some examples are (1) cost leadership, (2)
differentiation, (3) focusing on a particular marketing niche or segment, or (4) a combination of
more than one of these.
• Global strategy, or considering how to expand operations outside the home country.
• Corporate-level strategy, considering what business or businesses the company should be in so

as to maximize its long-run profitability and profit growth.
The strategies that emerge from SWOT analysis should be compatible with each other. Functional-level
strategies should support the company’s business-level and global strategies. Corporate-level strategies
should also support business-level strategies.
The strategies selected by the company will constitute its business model. A company’s business model
is its managers’ idea of how the set of strategies and capital investments the company makes should fit
together to generate above-average profitability and, at the same time, profit growth.
SWOT analysis enables management to choose among possible business models and to fine-tune the
business model selected.
Developing and Implementing the Chosen Strategies
Note: This is the fifth of the five steps in the strategic planning process.
Once a set of strategies has been chosen to achieve competitive advantage and increase performance, the
strategies must be translated into action. Translating strategy into action is strategy implementation, or
taking the actions necessary to execute the strategic plan.
Strategy implementation takes place in the context of the organization’s organizational design. Analysis
of a company’s organizational design can lead top management to devise ways to restructure the company’s
culture, organizational structure, and control systems in order to improve coordination and motivation
among its people. Effective organizational design can give a company the means to obtain competitive
advantage and above-average profitability. Therefore, the next priority after formulation of the business
model and strategies is organizational design.
Organizational design involves determining how a company should create, combine, and use three ele-
ments to pursue its business model successfully:
1) Its organizational structure
2) Its control systems
3) Its organizational culture
The above three elements of organizational design are the means by which the organization motivates and
coordinates its members to work toward achieving competitive advantage through its distinctive compe-
tencies. Remember that those distinctive competencies are superior efficiency, superior quality,
superior innovation, and superior responsiveness to customers.
• Organizational structure specifies who should do what, how it should be done, and how the
various people and groups should work together to increase efficiency, quality, innovation, and
responsiveness to customers so that employees work together to achieve the strategies spec-
ified by the business model.
• Control systems provide managers with incentives to motivate their employees to work to in-
crease efficiency, quality, innovation, and responsiveness to customers. Control systems
also provide feedback to managers on how well the company and its employees are succeeding in
increasing these building blocks of competitive advantage. Feedback from control systems enables
management to take action when needed to strengthen the business model.
• Organizational culture includes all of the norms, values, beliefs and attitudes that people in an
organization share. It is the company’s way of doing things, and it controls the way its members
interact with one another and also with outside stakeholders. Furthermore, the structure of an
organization affects its culture. In order to change the culture, it may be necessary to change the
structure.
Characteristics of Successful Strategic Plans

• Strategic planning should be an ongoing process, not just a one-time or even a once-a-year or
once-every-five-years activity. It should be integrated into the organization as a core business
practice that keeps the company focused on its strategic direction.
• A successful strategic plan is integrated throughout the organization. Strategies should be

balanced across all of the dimensions that will drive growth in the organization. All of the different
areas of the business need to be in alignment and operating together. The plan should not focus
only on specific areas such as financial results or marketing programs. Instead, it should address
the whole company’s strategy. For example, the marketing program should support the strategic
initiatives of the organization.
• In developing a strategic plan, all former assumptions should be challenged. The strategy
should be based on a clear understanding of the current direction of the business environment and
the company’s markets, not just a reiteration of the previous plan.
• Strategies should be long-term in nature. However, if an idea or a discovery that could lead to
a new product or a new market is brought forth or if a disruptive change occurs in the market after
the plan has been formalized, the plan should be flexible enough to enable the company to respond
to the change or the new opportunity. If the plan cannot be changed and if the company cannot
change its direction when necessary, the company’s actual results may diverge more and more
from the strategic plan, and the plan may become irrelevant.
• Employees at all levels should have input into the strategic planning process. Although top
management must take the lead and make the final decisions, input should not be limited to top
management. Sometimes the best ideas for change come from lower level managers, engineers,
or customer service employees because those people are closest to what is going on. Furthermore,
inclusion of lower-level managers and employees in the planning process promotes their under-
standing and ownership of the plan, motivates them to participate in its implementation, and helps
them to perceive that the decision-making process is fair and inclusive.
• Everyone in the organization needs to know what the firm is trying to achieve. The strategy should
be communicated clearly and often to everyone in the organization. The strategy should be
viewed as a roadmap to take the firm from vision to reality.
• The success of the strategy lies in its execution. The organization and its people need to have
the tools to properly execute the strategy. Performance objectives should be developed, and em-
ployees at all levels should have performance incentives linked to the company’s strategy.
• The strategic planning process should be viewed as an opportunity to develop a shared vision,
increase the sense of joint-ownership among the staff, and build a leadership team that is
focused on moving the business in the right direction.
Benefits of Planning
• Objectives are formally expressed and the methods of attaining the objectives are clearly defined.
The plan focuses employees’ attention on the company’s stated objectives and facilitates coordina-
tion of efforts.
• If the plans are communicated properly throughout the organization, employees may feel more
motivated to take part in carrying them out.
• When planning is done in advance, risk and uncertainty can be minimized, backup plans can be
prepared, and decisions can be made in a measured, disciplined manner rather than spontaneously.
• Planning can improve a company’s competitive advantage. The company can plan ahead and find
the best prices for resources it needs and it can use those resources more effectively, leading to
reduced costs and higher profitability.
• Planning helps the company to efficiently effect changes in its procedures, product line, and facilities.
• Planning provides the objectives against which actual performance can be measured, facilitating
controlling.
Limitations of Planning
• Planning is time-consuming and costly. The services of outside professionals such as accountants
and marketing experts may be needed, and the planning process itself takes managers’ time away
from other responsibilities. The costs versus the benefits need to be weighed before embarking upon
a complex planning process.
• Following a plan too rigidly can cause the business to be unable to adapt to new threats or to take
advantage of new opportunities. Plans can hinder managers’ creativity and innovation if they are
not flexible enough to accommodate changes that may be suggested by new ideas.
• Planning is based on forecasts that may be inaccurate. A large variance between actual circum-
stances and planned circumstances, such as an unplanned recession, natural disaster, labor strike,
or technological change may cause the plan to become ineffective or unworkable. Excessive reliance
on a plan in the face of obviously changed circumstances can cause severe problems.
1 B. Common Performance Measures

Note: CIA exam candidates are expected to demonstrate knowledge of common performance
measures at the proficient level. They must be able to apply concepts, processes, or procedures;
analyze, evaluate, and make judgments based on criteria; and/or put elements or material together to
formulate conclusions and recommendations.
Strategic Issues in Performance Measurement

A company needs to measure performance and reward outstanding performance in a way that motivates
its managers to achieve the company’s strategic objectives and operational goals. If the performance
measurement system rewards managers for achieving only their own units’ goals, managers may maximize
their own units’ performance without necessarily maximizing the company’s performance. Therefore, per-
formance evaluation measures should be directly related to the company’s strategic objectives and
operational goals. The company’s specific performance targets (such as increasing market share in key
customer segments, reducing costs, or providing innovative products and services) need to be reinforced
by the management reward system so that managers’ rewards are dependent on their achieving the target
performance.
“Goal congruence” is defined as “aligning of goals of the individual managers with the goals of the organ-
ization as a whole.” “Goal congruence” means that individuals and organization segments are all working
toward achieving the organization’s goals. It also means that managers who are working on behalf of their
own best interests are taking actions that accomplish the overall goals of the company’s senior manage-
ment. It is important to evaluate managers on their achievement of goals that benefit the company, not
on goals that benefit only their own departments or divisions.
Another strategic issue in performance measurement is the balance between short-term versus long-term
focus. Too much emphasis on the current quarter’s results will nearly always cause managers to eliminate
or postpone activities that are vital for the firm’s long-term success in order to improve short-term profits.
If the long-term focus is lost, the business’s future success will be endangered. For example, a pharmaceu-
tical company could improve its current results by cutting back on new drug R&D, but eventually its existing
drug patents will expire, and without enough new drugs in the pipeline as new sources of revenue the
company will be exposed to competition from generic drugs.
Timing of Feedback
An important part of any performance measurement system is the feedback it generates. The timing of the
feedback is important because feedback that is not received in a timely manner is not useful. The proper
timing of the feedback depends on who should receive the information, the importance of the information,
and the content of the feedback.
For example, managers of profit centers need information about their sales volumes quickly, usually on a
daily or a weekly basis, particularly in a business with high fixed costs. When a manager is responsible for
generating adequate sales to cover high fixed expenses, he or she needs to know immediately if sales
decline so that actions can be taken to reverse the decline. However, daily or weekly sales information
would probably be too frequent for top management. Top management may need sales information on a
monthly basis only, although if top management has any cause for concern, it may need information more
frequently.
Performance Measures Should be Related to Cost and Revenue Drivers

A cost driver is anything (such as an activity, an event, or a volume of something) that causes costs to be
incurred each time the driver occurs. If a performance measure involves costs, then the company needs to
evaluate its processes that cause those costs, not just the costs themselves.
Example: Packaging for shipping of items sold is an example. If the company’s goal is to minimize
packaging costs, then it needs to have standards for the amount it should pay for boxes, bubble wrap,
tape, and other packaging materials. The actual costs should be compared against those standards, and
the causes of variances should be investigated as part of the performance measurement system. The
cause of an unfavorable variance in packaging costs may be that too much bubble wrap was used for
the items that were shipped, and the reason for the excess bubble wrap used may be that in an attempt
to save money, the shipping boxes purchased were too flimsy and so required extra bubble wrap to
prevent damage to the contents. If the cost for the additional bubble wrap was greater than the amount
saved by buying the flimsy boxes, then the decision to purchase cheaper boxes was not a good one and
should be changed. Just looking at “packaging costs” without considering the causes, or drivers, of
packaging costs will not identify the cause of an unfavorable variance.
Anything that creates revenue is a revenue driver. Units of output sold, selling prices, and marketing ac-
tivities are all examples of revenue drivers. Therefore, revenue performance measurements need to focus
on things like units of output, sales volume, selling prices, and marketing activities. The performance meas-
urement system needs to compare actual activities with planned levels of activities, not simply measure
actual revenue in comparison with planned revenue. Focusing on the revenue drivers will help the company
identify the causes of unfavorable variances. Perhaps sales were down because of an economic recession,
or perhaps a competitor introduced a new product that directly competed with one of the company’s own
products.
If the cause (or driver) of the lower revenue is not identified, then the decreased revenue cannot be ad-
dressed.
Financial Performance Measurement

Return on Investment (ROI) and Residual Income (RI) are the primary means of segment financial perfor-
mance measurement. Candidates should know what each one is, how each is calculated, how each one is
interpreted, and how they compare and contrast with each other.
Each of these methods by itself measures only one thing, and therefore one method by itself does not
provide a complete evaluation of a manager or a department.
Note: In addition to these numerical and financial-based measures, it is also critical for the evaluation
process to include non-financial measures such as customer satisfaction, innovation, operational effi-
ciency, and capabilities in human capital, information capital, and organizational capital. Evaluation of a
manager’s overall contributions can be accomplished by means of the balanced scorecard, which is dis-
cussed later in this section.
Return on Investment (ROI)

Return on Investment (ROI) can be used to evaluate the performance of the entire firm, but it can also be
used to evaluate the performance of single divisions and their division managers.
ROI is the key performance measure for an investment center. It measures the percentage of return
that was earned on the amount of the investment (that is, assets). The formula for ROI is:
Income of Business Unit

ROI =
Assets of Business Unit
Note: For performance measurement, “Income” means operating income unless otherwise stated.
Example: A company has four regional divisions. A summary of financial results for the company is
shown below.
North East South West
Operating income 1,000 5,000 4,000 7,500
Assets 2,500 15,000 8,000 25,000
Total equity 2,000 8,000 7,000 20,000
Liabilities 500 7,000 1,000 5,000
North division’s ROI is: 1,000

= 0.40 or 40%
2,500
5,000
East division’s ROI is: = 0.333 or 33.3%
15,000
4,000
South division’s ROI is: = 0.50 or 50%
8,000
West division’s ROI is: 7,500

= 0.30 or 30%
25,000
South division’s return on investment is the highest of the four.
If ROI is used as an evaluation tool, management must be certain that it is the correct measurement for
the company’s goals and that the ROI goals are representative of that individual segment’s market and
business.
A manager can use ROI to determine if the division should accept a capital investment or project. If the
ROI of the project is higher than the target or required rate of return or hurdle rate (see next topic), the
manager will accept the project. Conversely, if the ROI is lower than the required rate of return, the man-
ager will reject the project, even if the project itself is profitable.
The Required Rate of Return

The required rate of return is the minimum rate of return that a segment or project must earn in order
to justify the investment of resources. Senior management of the company determines what the
company’s required rate of return should be. Generally, a company’s weighted average cost of capital
is its minimum required rate of return. However, the required rate of return set by management may be
higher than the firm’s weighted average cost of capital, depending on the risk inherent in the segment or
project. If the level of business risk for a particular segment or project is judged to be higher than the
overall firm’s level of business risk, the required rate of return for that segment or project will be increased
above the firm’s weighted average cost of capital.
The Weighted Average Cost of Capital (WACC)

Capital is long-term debt and equity. The weighted average cost of capital is expressed as a percentage
rate, roughly equivalent to the total cost of long-term funds (debt and equity) divided by the fair value of
the long-term funds.
The following formula gives a general idea of what WACC represents. However, be aware that the formula
below is not the way the weighted average cost of capital is calculated but is only a general idea
of what the WACC represents.
(Interest Paid on Debt – Effect of Taxes) + Dividends Paid on Shares

WACC =
Average Fair Value of Debt Outstanding + Fair Value of Shares Outstanding
Note that the fair values (market values) of outstanding debt and stock are used to calculate the WACC,
in contrast to the book value of balance sheet accounts used in other ratios.
Calculation of the weighted-average cost of capital is covered in this volume in Section IV, Financial Man-
agement, in the topic Capital Structure.
Note: The total interest cost must take into account the effect of taxes. Because interest is a deductible
expense, the true cost of interest (the after-tax cost of interest) is the amount of interest expense
minus (the tax rate × the interest expense amount). The after-tax cost of interest can also be calculated
as the amount of interest × (1 – the tax rate). The after-tax cost of interest is lower than the actual
interest expensed by the company.
Disadvantages of Using ROI for Performance Measurement

The problem with ROI as a performance measurement tool is that it measures return as a per-
centage rather than as a monetary amount. If the expected ROI of a new project under consideration
is lower than the division’s present ROI but higher than the target rate, the manager may reject a profitable
project because it would lower the division’s overall ROI, even though the project would be beneficial for
the company. While it is good to have a higher rate of return, the company is ultimately interested in the
amount of the return. Any project with a return higher than the company’s required rate of return
will increase the company’s net income. However, a project with a return higher than the company’s
required rate of return may reduce the division’s ROI if the division’s current ROI is higher than the expected
ROI of the new project. The outcome may be that a division manager will reject a project that would have
been beneficial to the company as a whole because it would have lowered that division’s ROI. As a result
of this shortcoming of ROI, ROI is often used together with other performance measurement tools.
Another disadvantage of using ROI for performance measurement is that when a manager is evaluated
using current ROI, the pressure to meet the current period’s ROI target may cause short-term profits to
take priority over long-term profits. Prioritizing short-term profits can lead to reduced performance in the
long term, because managers may reduce R&D spending, advertising, employee training, or productivity
improvements in order to make current ROI look better.
Benefits of Return on Investment as a Performance Measure
• ROI can be used to determine if a division should accept a capital investment or project.
• ROI is easily understood and is widely used.
• The ROI on an investment being considered can be compared to the company’s cost of capital and
to rates of return on other potential investments as part of the decision process.
Limitations of Return on Investment as a Performance Measure
• ROI measures return as a percentage rather than as a monetary amount.

• When a manager is evaluated using current ROI, the pressure to meet the current period’s ROI target
may cause short-term profits to take priority over long-term profits.
• ROI has problems with respect to distortion caused by the accounting policies selected by the com-
pany. ROI must be interpreted carefully because of the various effects of different accounting policies
on units’ operating incomes and on their amounts of investment.
Residual Income (RI)

Residual Income (RI) attempts to overcome the weakness in ROI by measuring the amount of monetary
return that is provided to the company by a department or division. RI for a division is calculated as the
amount of return (operating income before taxes) that is in excess of a targeted amount of return
on the division’s assets. Residual income is the operating income earned after the division has covered the
required charge for the funds that have been invested by the company in its operations.
When evaluating a potential project for investment, any project that has a positive RI will be accepted,
even if it will reduce the overall company’s or unit’s ROI.
Note: If the expected rate of return on a new investment is greater than the required rate of return
(usually the cost of capital), residual income will increase as a result of the new investment, even if the
expected return on investment (ROI) for the new project is lower than the current return on investment.
An investment that may have been rejected on the basis that its ROI was lower than the unit’s existing
ROI would instead be accepted, and the company would benefit from the new investment.
The following items are very important to know in regard to the calculation of RI.
1) The targeted amount of return is usually an annual percentage of, or annual rate of return on,
the total employed assets of the division, or the invested capital in the division, and
2) The percentage used in the calculation is the required rate of return set by management.
The required rate of return may be the company’s weighted average cost of capital, or it may not be. The
required rate of return is whatever rate management sets. Management sets the required rate of re-
turn.
If the required rate of return is not given in a question but the company’s weighted average cost of capital
is given, use the company’s weighted average cost of capital as the required rate of return.
The formula for RI is:
Operating income of business unit

– (Assets of business unit × required rate of return)
= Residual Income
Assets of the business unit multiplied by the required rate of return is the business unit’s target return.
Thus, Residual Income is the business unit’s actual operating income minus its target operating income
(target return).
Note: In the calculation of Residual Income, the target return (assets of the business unit × required
rate of return) is an imputed cost of the investment. This imputed cost is the opportunity cost of
other potential returns that have been forgone in order to make the investment in the business unit’s
assets. The required rate of return is determined by senior management. It might be equal to the firm’s
weighted average cost of capital or the marginal cost of capital for a given project, but it is the required
rate of return because it is the rate management has selected as the required rate.
Example: Medina Division of Erie Company has total assets of 4,000,000 and operating income of
600,000. Its required rate of return is 10%. How much residual income does Medina Division earn?
The target return = 4,000,000 × 0.10 = 400,000
Operating income of 600,000 less 400,000 target return = 200,000 of residual income.
Note: Residual Income may be a negative amount. Negative Residual Income occurs when the
profits that the division or project actually achieved are less than the target income that was set for the
division or project.
Benefits of Residual Income as a Performance Measure
• When RI is used in preference to ROI, a project that would be beneficial to the company is more
likely to be selected, even if its ROI is lower than the unit’s existing ROI.
• A firm can adjust its required rates of return for differences in risk. A unit with higher business risk
can be evaluated using a higher required rate of return than that which is used for a unit with lower
business risk.
• RI enables a company to use a different investment charge for different classes of assets. For exam-
ple, the company could use a higher required rate of return for long-lived assets, especially if their
resale values are expected to be low, and a lower required rate of return for shorter-term assets
(such as inventory).
Limitations of Residual Income as a Performance Measure
• RI focuses on the monetary amount of the return. Although just one currency unit of residual income
might be beneficial for a company, the amount of the return may be so small in comparison to the
amount invested that the return is not worth the effort. Therefore, RI is often used together with
another evaluation measure.
• It is difficult to compare the performance of units of different sizes. A large unit would probably have
a larger residual income than a small unit, but the smaller unit might have a higher rate of return on
its employed assets despite its lower RI.
• A small change in the required rate of return would have a greater absolute effect on the amount of
a large unit’s RI than it would on the RI of a small unit.
• RI has the same issues as ROI with respect to distortion caused by the accounting policies selected
by the company. Residual income must be interpreted carefully because of the various effects of
different accounting policies on units’ operating incomes and on their amounts of investment.
Using ROI and RI

The key differences between Return on Investment (ROI) and Residual Income (RI) are:
• ROI is focused on the rate of the return, whereas
• RI is focused on the absolute amount of the return.
This basic difference between ROI and RI means that the use of one or the other of these for performance
measurement may cause division managers to make different decisions regarding which investments to
accept or reject.
Balanced Scorecard
As discussed in the topic of Strategic Planning, developing a strategic plan includes stating the company’s
goals, formulating strategies to attain the goals, and implementing the strategies. The balanced scorecard
is a widely-used strategic performance management tool designed to manage strategic performance. The
balanced scorecard transforms an organization’s strategic plan from a passive document into the "marching
orders" for the organization in its day-to-day activities. It provides a framework that not only provides
performance measurements but also helps management to identify what needs to be done and how its
achievement can be measured. The balanced scorecard enables execution of strategies.
Drs. Robert Kaplan and David Norton introduced the concept of the balanced scorecard in a Harvard Busi-
ness Review article in 1992. Since then, the concept has evolved and changed rather substantially. The
balanced scorecard has evolved from an initial measurement and evaluation tool to a means of managing
the organization’s progress toward achieving its strategic plan. The changes have been documented in a
series of books published by Kaplan and Norton beginning in 1996. Though the changes have been beneficial
to the concept, they have caused some confusion because the understanding of what a balanced scorecard
is varies widely depending on when an individual first read about the concept and whether that individual
has kept up with the advancements.
The balanced scorecard initially developed as a response to problems caused by evaluating managers only
on the quarterly or annual financial performance of their business units. If managers are evaluated and
rewarded on only their units’ short-term financial performance, then that is what managers will primarily
focus on. This focus on short-term financial performance often takes place to the detriment of other dimen-
sions that may be equally or more important for improved long-term financial performance. For example,
a focus on cost containment to improve quarterly results can result in a loss of quality due to the use of
low-priced but inferior manufacturing components. The long-term result of loss of quality is loss of custom-
ers and, ultimately, loss of business.
The balanced scorecard includes both financial and nonfinancial measures in evaluating the overall con-
tribution made by each unit to the achievement of company goals. Financial measures that focus on short-
term financial performance are in fact lagging indicators of how the company is doing.
While the balanced scorecard does use financial measurements, it also uses non-financial and operational
indicators that measure the basic performance of the company and improvements it is making in those
indicators. Improvements in the non-financial measures provide the prospect of increased future economic
value for shareholders. Nonfinancial measures focus on performance that should ultimately result in im-
proved long-term financial performance. Thus, nonfinancial measures are leading indicators of
performance.
Each company needs to develop its own set of metrics and means to assess its progress toward meeting
its goals, and both the goals and the metrics should be linked to the company’s vision and strategy devel-
oped in its strategic plan. Divisional and individual goals must be congruent with the goals of the corporation
and contribute toward their achievement. Thus, the balanced scorecard used by each division and individual
will be inextricably linked with the corporation’s strategy. The balanced scorecard used by each division will
probably be unique, based on that division’s goals and objectives. However, the balanced-scorecard ap-
proach promotes goal congruence by encouraging everyone in the organization to work toward the same
goals.
The Four Perspectives

The metrics used in the balanced scorecard fall into four broad categories of performance indicators, also
known as perspectives. The perspectives are hierarchical, meaning that achievement of the objectives of
each perspective supports achievement of the objectives of the perspective on the next level above it.
Achievement of learning and growth and internal process objectives leads to achievement of customer
satisfaction and financial measures objectives.
The perspectives and their content have changed since the first article was written by Kaplan and Norton.
The current perspectives are as follows.
1) Financial. The Financial perspective focuses on the organization’s financial objectives and enables
tracking of financial success and shareholder value. Some of the more common measures of fi-
nancial performance are: operating income, revenue growth, revenue from new products, gross
margin percentage, cost reductions, Residual Income, and Return on Investment. Financial per-
formance is a priority, but good long-term financial performance will not be achieved if goals in
other non-financial categories are not attained.
2) Customer. The Customer perspective involves identifying the market segment or segments the
company wants to target and then measuring its success in those segments. A common method
of measuring this success is the trend in the company’s share of the market over time and the
degree to which its market share increases in line with management goals. Customer satisfac-
tion is another vital part of the customer perspective, because if customers are not satisfied they
will take their business elsewhere. Customer satisfaction goals relate to the manner in which the
company’s management wants the company to be viewed by its customers. Management may
want to become the lowest cost supplier, in which case pricing goals will be part of the customer
perspective.
Other management goals with respect to the customer perspective may be meeting customer
needs better than the competition or being known for high quality and excellent customer service.
Being the lowest cost supplier can be measured by the customer’s total cost of using the company’s
product relative to the customer’s total cost to use competitors’ products. The number of repeat
customers and the percentage of deliveries that are made as promised and when promised can
measure the degree to which customers’ needs are being met. The number of defective products
returned and the level of product reliability over time can measure achievement of quality goals.
Customer surveys can be used to measure the level of customer service provided after the sale.
3) Internal Process. The Internal Process perspective includes innovations and improvements in
products and services, operations, and customer service/support needed to create value for cus-
tomers (the Customer perspective), which in turn furthers the Financial perspective.
If one of the company’s customer goals is to be the lowest cost supplier, that goal will need to be
supported operationally by maintaining efficient, low-cost production, which can be measured by
metrics such as the cost of raw materials, the number of employee hours needed to manufacture
a unit of product, and plant utilization. Efficient cycle times also keep costs low.
If high quality is a customer satisfaction goal, the support for that objective will also be required
within the internal processes that create high quality, such as good manufacturing practices. Meet-
ing customers’ needs better than the competition is supported by innovations in products and
services, which can be measured by the number of new product introductions. Technological ca-
pability for customer service personnel is necessary to provide excellent customer service, and it
is also needed in manufacturing in order to produce high quality products efficiently.
Internal surveys of customer service employees could be used to determine whether or not those
employees have the information they need immediately available to them, or if they frequently
need to put callers on hold to search for information. Percentage of manufacturing processes with
advanced controls would be a way of measuring manufacturing technology.
4) Learning and Growth. The Learning and Growth perspective originally focused on employee
learning, but it now covers not only human capital but also organizational capital and information
capital. Initially innovation was part of this perspective, but users of the balanced scorecard system
concluded that innovation properly belonged in the Internal Process category.
The Learning and Growth perspective includes the capabilities that the organization must have in
order to achieve its objectives in the Internal Process perspective. Currently, the components of
the Learning and Growth perspective include
• Human capital, or the skills, talents, and knowledge of employees;
• Information capital, or the information systems, networks, and technology infrastructure of the
company; and
• Organizational capital, or the company’s culture, leadership, degree of teamwork, and

knowledge management.
Financial Perspective
Customer Perspective
Internal Process Perspective
Learning and Growth Perspective
Vision and Strategy
Key Performance Indicators

It is important for the business to select only a few critical metrics that are most relevant to its specific
business strategy and then to track these measures rigorously rather than using many different measure-
ments. These critical measures are called key performance indicators (KPIs). Key performance
indicators are measures of the aspects of the company’s performance that are essential to its competitive
advantage and therefore its success.
Different business strategies call for different scorecards, and quality is more important than quantity in
balanced scorecard measures. Management’s attention should be focused on the few key measures that
are the most vital for implementing the company’s chosen strategies and should not be distracted by less
important measures.
In a business where customer service is critical, important measurements to track include telephone wait
time, the level of knowledge and empowerment of customer service personnel, and the availability to cus-
tomer service personnel of needed information. For example, a company that provides 3D printing (additive
manufacturing) services using 3D design files prepared and uploaded by the customer to its website needs
service personnel knowledgeable enough to provide technical advice to customers in order to achieve sat-
isfactory results; it needs adequate numbers of customer service representatives; and it must have
sufficient telephone lines to keep customers’ wait times to a minimum.
Strategy Map
A strategy map links the four balanced scorecard perspectives together, beginning with Learning and
Growth.
• The goals of the Learning and Growth perspective contribute to the Internal Process perspec-
tive because the company’s culture of empowering staff members and providing them with the
technological support they need makes innovation and improvements in products and services
possible.
• The innovations and improvements in products and services in the Internal Process perspective
support the goals of the Customer perspective, such as increasing market share.
• Increased market share from the Customer perspective leads to increased profits, thereby sup-
porting the goals of the Financial perspective.
When the company’s financial and non-financial measures are linked in the strategy map, the non-financial
measures serve as leading indicators of the firm’s future financial performance. The strategy map provides
a way for all employees to see how their work is linked to the corporation’s goals.
An example of a strategy map appears on the following page.
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Balanced Scorecard Strategy Map
Financial Perspective
Increase Sales Revenue Increase Job Profitability
Customer Perspective
Increase No. of Customers Increase No. of Sales
Internal Process Perspective
Increase Choice Reduce Cost of Improve Quote Improve Order

of Materials Materials Turnaround Time Turnaround Time
Reduce Direct Increase Maxi- Website/Online

Reduce Defects
Labor Cost mum Object Size Ordering
Learning and Growth Perspective
Increase Customer Ser- Improve Information

Improve Customer Tel-
vice Personnel’s Available to Customer
ephone Access
Knowledge Service Personnel
Implementing a Balanced Scorecard

Implementation of a balanced scorecard system of performance measurement is most successful when the
entire organization is aware of it and supports it. The manner in which the organization’s management
communicates the role, the use, and the benefits of the balanced scorecard to its employees is one of the
most important factors in successful implementation of a balanced scorecard. The balanced scorecard needs
to be introduced by illustrating the sequence of cause-and-effect relationships, the way the perspectives
are linked, and the reasons why meeting the goals at the bottom level make it possible to meet the goals
at the next level up, which in turn make the next level of goals possible, and so forth.
It is important for senior management, even up to the level of the board of directors, to support the pro-
gram. The board of directors can also have balanced scorecard goals. Having balanced scorecard goals for
the board of directors creates support at the very top of the organization, and the support filters down.
Each business unit and division should be involved in developing its own customized scorecard
based on the company’s overall objectives and the action items that the unit needs to achieve in order to
contribute to those objectives. Involvement of the scorecard users builds their support. However, the score-
cards as developed by middle managers need to be reviewed and approved with input from senior
management to make sure they are congruent with the company’s goals.
The actual scorecard report for a business unit should be organized according to the four perspectives, with
each selected scorecard measure on a line and classified within its perspective. The target can be in one
column followed by the actual results in the next column. Results that are in line and out of line can be
identified, perhaps by color. Each manager should be accountable for specific lines on each report, and a
division head is accountable for all the lines on the divisional report. A good, balanced scorecard report can
also identify tradeoffs that managers might make, for instance by reducing R&D spending to achieve short-
run financial goals, or making other tradeoffs that could hurt future financial performance. The decline of
R&D spending or other problems would be signaled.
The balanced scorecard needs to be marketed to both management and staff to garner support. Internal
promotion of the program should take place through various media, such as print, verbal, and electronic
means.
• A brochure can be used to explain how the balanced scorecard will help achieve the company’s
long-term goals in a way that merely tracking financial performance cannot. Employee newsletters
can be utilized to feature the balanced scorecard program and report on results. If improvement
in market share is one of the metrics and market share in fact improves, an article can be written
to highlight the factors that contributed to the positive results. On the other hand, if a metric is
not met, an article can explain the reasons and outline a plan to correct the situation.
• Verbal communication can occur in regular employee meetings where management reviews the
results and gives employees the opportunity to ask questions. One-on-one conversations between
supervisors and employees can provide opportunities for the employees who are closest to the
work to point out ways in which the program can be improved. Suggestion systems, programs
inviting employee comments, and employee training programs can also be used to enlist employee
support, and managers must be willing to listen to criticism and to make changes. It is essential
that employees get the sense that management takes their ideas seriously, responds to them, and
rewards useful ideas, because if employees feel that their input is ignored they may conclude that
the program is a wasted initiative.
• General results of the balanced scorecard program can be posted on the company’s intranet (in-
ternal network) with links to the overall corporate goals that each balanced scorecard result
supports. In addition, the company can give senior managers password access to detailed results
on the company’s intranet for their use in decision-making. Linking employees’ bonuses to their
goal attainment can align employee interests with the goals. Aligning compensation with balanced
scorecard results maximizes the balanced scorecard’s use and effectiveness.
Balanced Scorecard Reporting

Software can be used to provide balanced scorecard performance information to interested parties. How-
ever, installing dedicated balanced scorecard software does not mean that the balanced scorecard has been
implemented. Specialized software merely tracks the results of a balanced scorecard program. A business
must develop its own balanced scorecard for each unit, undertake the implementation project, and follow
up on the results.
Benefits of Using a Balanced Scorecard for Performance Measurement
• The balanced scorecard encourages managers to focus on elements that tend to lead to long-term
success instead of on short-term financial performance by rewarding them for improvements in
those elements that tend to lead to long-term success.
• Evaluating and rewarding managers based on these non-financial indicators should lead to long-term
financial performance improvements, if the proper non-financial indicators have been selected.
Limitations of Using a Balanced Scorecard for Performance Measurement
• It is difficult to use scorecards for comparisons across business units because each business unit has
its individualized scorecard. Scorecard evaluation is more effective when it is used to judge the
progress of an individual business unit relative to the prior year or relative to its goals rather than
when used to compare a manager’s performance with that of other managers or a segment’s per-
formance with that of other segments.
• In order to implement balanced scorecard performance measurement, a firm must have extensive
enterprise resource planning2 systems to capture the required information.
• Non-financial data are not subject to control or audit and thus the data’s reliability could be ques-
tionable.
• The efficacy of the balanced scorecard in achieving the organization’s strategic goals must be moni-
tored closely. If all of the non-financial targets are achieved but the financial targets are not achieved,
then probably a strong causal relationship does not exist between the non-financial indicators chosen
for monitoring and the financial goals. The non-financial indicators may need to be re-evaluated and
changed.
• If the balanced scorecard is used as a “command and control” document that is used to control
behavior, employees may “make the numbers” but not be committed to achieving the organization’s
goals. Instead, the balanced scorecard should be used to create an environment in which everyone
can learn and grow.
If developed and used properly, the balanced scorecard is an effective method of developing strategies and
evaluating progress toward meeting goals.
Quality Management
Quality is the measure of how well a company’s product or service satisfies customers’ expectations given
the price. The key to understanding quality is to first understand the expectations. Even if a company seeks
to differentiate its products with lower prices, it must still satisfy customer expectations or else they may
not purchase the product again.
Quality Management and Productivity

Productivity is the level of output given an amount of input. It might seem that, by allocating resources
to quality and spending resources in the quality process, a company will produce fewer outputs for the level
of inputs. This, however, is not the case. In fact, as a company’s commitment to quality increases, produc-
tivity also increases. Therefore, the relationship between quality and productivity is a positive one: the
more attention paid to quality, the higher the levels of production.
2
Enterprise resource planning (ERP) is a suite of integrated business software applications that a company can use to
collect, store, manage and interpret data from multiple business activities.
There are a number of reasons for this effect:
• Fewer defective units. Producing fewer defective units reduces the time, material, and effort
wasted on unusable output as well as time spent fixing salvageable defective units. (The hidden
factory is a term that refers to the time and effort spent on reworking and repairing damaged
units.)
• A more efficient manufacturing process. The company may remove or change inefficient, un-
productive or non-value adding activities.
• A commitment to “doing it right the first time.” By focusing energy on increasing quality
products or services, the employees are encouraged to take a more conscientious approach to
their work, which may lead to improved productivity.
Total Quality Management (TQM)

Total Quality Management describes a management approach that is committed to customer satisfaction
and continuous improvement of products or services. The basic premise of Total Quality Management (TQM)
is that quality improvement increases revenues and decreases costs. According to TQM, a product must be
made correctly the first time, and to achieve this result errors must be caught and corrected at the
source.
At the root of TQM is an understanding of the many ways that “quality” is defined. For a customer, it is a
product that meets expectations and performs as expected for a reasonable price. For a production man-
ager, it is a product that is manufactured within the required specifications. The TQM process requires
companies to appreciate and take into account these different perspectives of quality as it strives to improve
its products and its processes.
The objectives of TQM include:
• Enhanced and consistent quality of the product or service.
• Timely and consistent responses to customer needs.
• Elimination of non-value-adding work or processes, which leads to lower costs.
• Quick adaptation and flexibility in response to the shifting requirements of customers.
Certain critical factors are common to all TQM systems:
• The support and active involvement of top management.

• Clear and measurable objectives.
• Quality achievements are recognized in a timely manner.
• Ongoing TQM training. Part of this pursuit of excellence is a focus on continuing education. Em-
ployees at all levels participate regularly in continuing education and training in order to
promote and maintain a culture of quality.
• Striving for continuous improvement. Kaizen is a popular business philosophy that encourages
companies to strive toward ideal standard. Even though an ideal is never achieved, the work
toward the ideal is beneficial to the company.
• A focus on satisfying customers’ expectations and requirements. In a TQM system, people
within the organization are also considered customers. Every department, process, or per-
son is at some point a customer and is at some point also a supplier.
• All employees participate in order to promote and maintain a culture of quality.
Another feature of TQM is quality circles. A quality circle is a small group of employees or teams who
work together and meet regularly to discuss and resolve work-related problems and monitor solutions to
problems.
TQM is an organizational action and the entire organization must strive for quality improvement and
pursue excellence throughout the organization. In TQM, the role of quality manager is not limited to a
special department. Instead, every person in the organization is responsible for finding errors and cor-
recting any problems as soon as possible.
Cost of Quality
The costs of quality can be divided into two categories: the costs of conformance and the costs of
nonconformance. Furthermore, these two categories each have two subcategories.
Note: For the exam, you need to make certain that you know the four subcategories of the costs of
quality and which individual items go into each one of them.
Costs of Conformance
The costs of conformance are incurred to decrease the probability that defective products will reach the
consumer. The two costs of conformance are as follows:
1) Prevention Costs are incurred to prevent defects. Total Quality Management is an example of a
prevention cost. Prevention costs include:
• Design engineering so the product design is not defective and process engineering costs so the
manufacturing process produces a quality product
• Quality training to teach employees proper procedures
• Preventive equipment maintenance
• Supplier selection and evaluation costs to ensure that materials and services received meet
established quality standards and costs to train suppliers to conform to the firm’s requirements
• Evaluation and testing of materials received from a new supplier to confirm their conformance
to the company’s standards
• Information systems costs to develop systems for measuring, auditing, and reporting of data
on quality
• Planning and execution costs of quality improvement programs
2) Appraisal Costs are incurred to monitor production processes and individual products and ser-
vices before delivery in order to determine whether all units of the product or service meet
customer requirements. Appraisal costs include:
• Costs to test and inspect manufacturing equipment, raw materials received, work-in-process,
and finished goods inventories
• Cost for equipment and instruments to be used in testing and inspecting manufacturing equip-
ment, raw materials, work-in-process, and finished goods inventories
• Costs for quality audits
Costs of Nonconformance
Nonconformance costs are incurred after a defective product has already been produced. The two costs of
nonconformance are as follows:
1) Internal failure occurs when problems are detected before shipment to the customer. Internal
failure costs include:
• Rework costs (materials, labor, overhead, and reinspection)
• Costs of spoilage and scrap
• Tooling changes and downtime required to correct a defective product
• Machine repairs due to breakdowns

• Engineering costs to redesign a product or process to correct quality and process problems
• Lost contribution margin due to reduction of output caused by spending time correcting defec-
tive units
• Expediting costs, that is, the cost of rushing to re-perform and complete an order in time
because of a failure to complete it correctly the first time
2) External failure occurs when a defective product reaches a consumer. External failure costs in-
clude:
• Customer service costs of handling customer complaints and returns
• Warranty costs to repair or replace failed products that are returned
• Product recall and product liability costs
• Lost contribution margin on sales lost because of the loss of customer goodwill
• Environmental costs such as fines and unplanned cleanup fees caused by a failure to comply
with environmental regulations
The costs of prevention are normally lower than the costs of appraisal, internal failure, and external failure.
The costs of quality can be summarized in a cost-of-quality report such as the one shown below:
Prevention costs 11,000

Appraisal costs 13,000
Internal failure costs 14,000
External failure costs 16,000
Total quality costs 54,000
Measuring the Cost of Quality

There are a number of ways to measure the costs of quality. A quality cost index, which measures the
cost of maintaining a certain level of quality, is expressed in the following equation:
Total Quality Costs

Quality Cost Index = × 100%
Direct Labor Costs (or some other measure of activity)
Using the preceding cost of quality report showing 38,000 in total quality costs, if direct labor costs are
120,000, the quality cost index for direct labor is 45%:
54,000
Quality Cost Index = × 100 = 45%
120,000
To understand whether a calculated Quality Cost Index is favorable or unfavorable, it must be compared to
another quality cost index, such as one that measures a prior period or the industry average.
Customer Response Time and Manufacturing Cycle Time

Customer response time is the time from the receipt of a customer’s order by the company until the
order is delivered to the customer.
Manufacturing cycle time is the amount of time from the receipt of the order by the manufacturing
area and the time the finished good is produced. Manufacturing cycle time includes activities (and non-
activities) such as waiting time (the time after the order is received by the manufacturing department and
before manufacturing begins, or time spent waiting for parts for the next process); time spent inspecting
products and correcting defects; and time spent moving the parts, the work-in-process, and the finished
goods from one place to another.
Receipt Manufacturing Delivery

Time Cycle Time Time
Waiting Manufacturing
Time Time
Order Received Order Received Manufacturing Finished Goods Order Delivered

From Customer By Manufacturing Begins Complete To Customer
Customer-Response Time
Manufacturing cycle efficiency, or MCE, is the ratio of the actual value-adding time spent on production
to the total manufacturing cycle time.
Value-Adding Manufacturing Time

Manufacturing Cycle Efficiency (MCE) = × 100
Total Manufacturing Cycle Time
Only actual manufacturing time—time when value is being added to the product—is included in the numer-
ator of the MCE calculation. Waiting time, time spent on equipment maintenance, and other non-value-
adding times are not included in the numerator (though they are included in the denominator).
For example, if the actual time spent on manufacturing is 3 days while the total manufacturing cycle time
is 10 days (because the waiting time is 7 days), the MCE is
3
Manufacturing Cycle Efficiency (MCE) = × 100 = 30%
10
Companies would like their MCE to be as close to 100% as possible, because that means very little time is
being spent on non-value-adding activities.
Other useful ratios are those that measure good output to total output, the percentage of defective goods
shipped, customer satisfaction, customer complaints, on-time deliveries and so on.
Six Sigma
Six Sigma is an approach to quality that strives to eliminate defects. The goal of Six Sigma is to improve
customer satisfaction by reducing and eliminating defects, which should lead to greater profitability. To
achieve Six Sigma, a process must produce no more than 3.4 defects per million opportunities.
“Opportunities” refers to the number of instances where nonconformance might occur. It can be expressed
as the total number of parts, components, and designs in a product, any of which could be defective. For
example, if a product has 10,000 parts, components, and designs, 3.4 defects per million would amount to
34 products out of every 1,000 that would have some defect.
1 C. Organizational Behavior
Organizational behavior covers several topics, including motivation theories, group dynamics, human re-
source processes, the implications of different leadership styles, organizational politics, performance, and
organizational theory.
1 C 1. Motivation Theories
Motivation drives people to accomplish objectives. The following section discusses major theories about
how people are motivated and to what ends.
Needs-based Theories of Motivation

Motivation is the desire and commitment that a person has to achieve a specific goal. Ideally, management
motivates its employees and subordinates by creating situations and requiring behaviors that satisfy both
the needs of the organization and the needs of the employees. If the required behavior does not satisfy the
employees’ needs, the employees will be less motivated.
The level of motivation that people have is determined by the opportunity to satisfy their needs. Therefore,
the things that the organization offers to the employees as motivation should match the benefits that the
organization will receive from the work of those employees. It is the task of the manager to make sure that
the motivators achieve the necessary level of production.
Maslow’s Hierarchy of Needs

Abraham Maslow’s hierarchy of needs is a well-known theory that illustrates how people are motivated.
Maslow identified five basic needs that a person strives to fulfill; furthermore, he suggested that the most
basic needs must be satisfied first. As each level of needs is satisfied, the next need up the hierarchy
becomes dominant. However, if a lower-level need becomes deficient, the person will abandon a higher
need to address it.
The following chart lists Maslow’s five levels of needs from the lowest to the highest:
The basic requirements of life: water, food, and shelter. In or-

Physiological
ganizations, means adequate pay, toilet facilities, and
Needs
Lower Order comfortable working conditions.
Needs The freedom from physical or emotional harm: security against
Security and
the loss of a job, medical insurance, savings, and an adequate
Safety Needs
retirement program.
Belonging to a group and being accepted by others. Family,

Social Needs
friends and co-workers usually satisfy this need.
Factors that promote the individual’s worth in the eyes of other

people: self-respect, achievement, status, and recognition. Job
Esteem
Higher Order titles, choice offices, bonuses, and other rewards can meet
Needs these needs.
Factors that promote the individual’s worth in the eyes of the

Self- individual himself or herself. At this highest level, the person is
Actualization “self-actualized”; that is, experiences personal growth and ful-
fillment.
Maslow’s hierarchy of needs was the earliest motivational theory to become popular and is still one of the
best known. But more recent research has shown that need structures are not so invariable and people do
not always move from one level to the next quite as smoothly as the theory claims. Furthermore, this need
hierarchy is not applicable to all cultures.
McClelland’s Theory of Needs: Achievement, Power, Affiliation

According to David McClelland, personal motivation is based upon the need for achievement, power, and
affiliation.
Some people have the need for achievement, which is to do things better than they have ever done it
before. High achievers thrive when a job calls for personal responsibility because they seek feedback on
their performance to gauge their improvement. They may find it difficult to delegate. These people fre-
quently go into sales because they can get immediate feedback in the form of sales results. High achievers
avoid goals that are too easy, but they also avoid goals that are too difficult. They do better with moderately
difficult tasks. High-need achievers are also preoccupied with their work and they hate to stop in the middle
of a job. These individuals do well as entrepreneurs but less well as senior executives, because an executive
must be able to delegate and seldom receives immediate feedback.
The need for power is the desire to be able to control one’s environment, which includes influencing other
people as well as one’s own financial, material, and information resources. Good managers have a high
need for power. Managers must have a low need for affiliation because their power may alienate them from
others. Further, a manager’s need for power must be combined with self-control so that the need for power
will not interfere with effective interpersonal relationships.
The need for affiliation is a drive for human companionship and close interpersonal relationships. People
with a high need for affiliation desire approval from others and are concerned about others’ feelings. They
strongly identify with other people and tend to think and act the way they think other people want them
to. People with a high need for affiliation go into jobs that provide them with interpersonal contact, such as
sales and teaching.
ERG Theory
According to the ERG Theory, people’s core needs are, from most basic to most complex, existence (E),
relatedness (R), and growth (G).
• Existence needs are related to survival; they are similar to Maslow’s physiological and safety
needs.
• Relatedness needs include the desire for interpersonal relationships; they are similar to Maslow’s
social and external esteem needs.
• Growth needs focus on personal development; they are similar to Maslow’s self-esteem and self-
actualization needs.
Like Maslow’s hierarchy, ERG theory suggests that satisfaction of lower-order needs leads to the desire to
satisfy high-order needs. However, Maslow claims that only one need is dominant at a time, whereas ERG
theory asserts that more than one need can motivate a person at the same time. Furthermore, if a higher-
level need is not gratified, the desire to satisfy a lower-level need increases. In addition, ERG theory says
a person can work on growth needs even though the needs for existence and relatedness have not been
satisfied.
ERG theory is more adaptable to cultural differences than Maslow because people in various cultures rank
their needs differently. ERG theory is widely considered to be a more valid system of the need hierarchy.
Process-Based Motivational Theories

Process-based motivational theories explain why employees behave the way they do in order to help man-
agers develop compensation programs and other rewards to enhance motivation and performance.
Equity Theory
Equity theory says the amount of motivation employees receive from rewards is affected by their percep-
tion of the equity, or fairness, of the rewards. Employees compare the ratio of what they have received
(outcomes) with what they perceive they have given in effort (inputs), and compare that to similar ratios
for other jobs they have had or to those of other people who work either inside or outside the same organ-
ization. For most employees, their motivation is influenced by relative rewards as much as by absolute
rewards.
If an employee perceives inequity, he or she will be motivated to reduce the inequity, which may be man-
ifested as reduced effort on the job or a request for a raise. Employees may adjust perceptions of either
their own outcomes or inputs or of the outcomes or inputs of the person with whom they are comparing
themselves. Alternatively, they may seek additional avenues for growth and development; some may even
resort to stealing from the employer. Finally, the employee may look for another position and leave.
Research has confirmed this theory, at least where piecework and hourly workers are concerned. Piecework
workers who perceive inequity will decrease quality to increase quantity. Hourly workers who perceive
inequity will decrease the quality and quantity of their work.
Expectancy Theory
The basic premise of expectancy theory is that people’s motivation depends on the intensity of desire for
a certain objective and how likely they believe it is they will get it. As applied to the workplace, employees
will put in maximum effort if they expect that their efforts will lead to rewards that will satisfy their personal
goals.
Expectancy theory says that objectives need to be clear and there needs to be specific criteria for measuring
progress toward the objectives. Furthermore, employees need to have confidence that their efforts will
result in a satisfactory reward if their objectives are achieved. Expectancy theory also recognizes that
different objectives satisfy different people.
Research has failed to support the general premise of the theory. Critics feel it has limited use because few
people perceive any real relationship between their performance and rewards in their jobs. Instead of
rewarding employees for their performance, most organizations reward employees for seniority, effort, skill
level, and job difficulty.
Goal-Setting Theory
According to goal-setting theory, goals tell an employee what needs to be done and can be a major
source of motivation. For this theory to work, goals need to be specific, because generalized goals provide
only vague targets. Specific goals increase performance, and challenging goals (if accepted by the em-
ployee) result in high performance. In addition, feedback is an effective component of goal-setting,
especially when it helps the employee monitor his or her own progress. Four other factors affect the success
of goal setting:
1) The degree to which the employee is committed to the goal and determined not to abandon it.
2) The degree to which the employee believes in his or her own ability to meet the goal (self-
efficacy).
3) The degree to which the employee believes the goal is achievable (that is, simple and well-
known tasks have a more positive effect than difficult tasks) and independent (that is, an individual
goal has a more positive effect than a group goal).
4) The culture, as different cultures prioritize goals in different ways.
Although goals can be a potent motivating force and lead to higher performance, goal-setting theory has
not proved to increase job satisfaction among employees.
Reinforcement Theory
In reinforcement theory, reinforcements and consequences control people’s behavior. Consequences (that
is, actions that occur after a behavior takes place) take the form of positive reinforcement (rewards),
negative reinforcement (the removal of an unpleasant condition as a reward), extinction (ignoring a
bad behavior), and punishment.
Reinforcement theory disregards any internal motivation; rather, it emphasizes the power of external rein-
forcement to motivate actions. For instance, reinforcement theory disregards feelings, expectations, needs,
and attitudes. In addition, positive reinforcement is most effective when rewards are given according to a
variable schedule. In other words, the reward for an encouraged behavior should be given at an irregular
interval, not at the time that the behavior occurs.
Intrinsic Motivation and “Flow”

Flow is a feeling of timelessness that comes from the process of performing an activity. Key to the flow
experience is that it is not related to a specific goal; rather, when the task is completed a sense of satis-
faction comes from the journey, not the destination. The flow experience most often comes from a task
that is challenging and requires a high degree of skill, not one that is monotonous or repetitive. Even so,
the task requires total concentration and creativity and it is so consuming that the person has no thought
for anything else.
The flow concept can be extended to the theory of intrinsic motivation, which suggests that intrinsically
motivated employees are those who care deeply about their work, are always looking for ways to do better,
and are fulfilled by this process. Therefore, the rewards the employee receives come from the work itself,
not external factors such as raises, praise, or other rewards.
The theory further suggests that intrinsic motivation is the factor in people experiencing feelings of choice,
competence, meaningfulness, and progress in their work. However, these results come from studies that
were conducted with professional and managerial employees. It is unclear whether lower-level employees
would have the same reactions.
Impact of Job Design

Job design refers to the way an organization defines and structures its labor requirements. Done correctly
and efficiently, job design improves employee motivation, performance, and job satisfaction. The advent of
job specialization was responsible for the gains in productivity that were achieved through assembly-line
manufacturing. Highly specialized jobs can result in high productivity. However, jobs that are too highly
specialized can create boredom and other dissatisfactions because of the monotony.
Job rotation was introduced to reduce worker dissatisfaction from specialized, monotonous work. Workers
were systematically moved from one task to another (often through cross-training) to maintain interest
and motivation. Rotation proved advantageous because workers had more job skills and thus more flexi-
bility in their assignments. Unfortunately, job rotation did not solve the basic problem of boredom. Instead
of working on just one boring job, workers were working on several boring jobs. In addition, efficiency was
compromised. Job rotation therefore can expand a highly trained workforce but not necessarily inspire
motivation.
Job enlargement was another effort to increase job satisfaction. It involves expanding a job’s responsi-
bilities horizontally. For example, the complexity or intensity of a particular task would be increased. The
expectation was that boredom would decrease because each job entailed multiple specific tasks. However,
experiments with job enlargement proved disappointing. As long as all the tasks are simple and easy to
master, doing more of them did very little to decrease monotony.
Job enrichment, based on Frederick Herzberg’s Dual-Structure (or Two-Factor) Theory, was devel-
oped as an alternative to job rotation and job enlargement. Herzberg proposed that there are certain factors
that can make a person feel dissatisfied; however, when those same factors are improved, the most that
can be said is that the person no longer feels dissatisfied. For example, a pay raise does not necessarily
move a person from job dissatisfaction to job satisfaction. Rather, the person moves from job dissatisfaction
to “not-job-dissatisfaction.” Other factors, such as achievement and recognition, are required to raise a
person from not-job-dissatisfaction to job satisfaction.
Herzberg suggested that salary, job security, relationship with supervisors, and working conditions, if in-
adequate, lead to job dissatisfaction. These “dissatisfiers” are hygiene factors. On the other hand,
achievement and recognition, if present, lead to job satisfaction. When they are not adequate, their absence
can lead to feelings of no satisfaction but not necessarily to dissatisfaction. These “satisfiers” Herzberg
called motivation factors. Herzberg developed the notion of job enrichment as a technique for structur-
ing jobs. Job enrichment attempts to motivate employees both by adding more tasks to their jobs and also
by giving them more control over those tasks, allowing them to make more decisions as well as do more
tasks.
Many companies have used job enrichment with mixed results. Critics of Herzberg point out that related
studies have proved inconclusive and that in his own work he did not take into consideration individual
differences caused by factors such as age.
1 C 2. Group Dynamics
A group is defined as several individuals who come together to accomplish a specific task or goal. Group
dynamics is the study of the nature of groups within an organization: how they function, why they function,
why they fail, and why they succeed.
Traits of Group Dynamics

Generally, there are two types of groups: formal and informal.
Formal Groups
Formal groups have the sanction of the organization, have legitimate power, and are formed to help ac-
complish a goal or task. Formal groups, such as a committee, quality circle, or task force, contribute to the
success of the organization.
A formal group tends to have an explicitly designated leader who has the authority and responsibility
to direct other members. The leader operates according to the hierarchical principle of the organization;
that is, power flows downward from the top.
Informal Groups
Informal groups emerge within an organization for reasons other than completing a specific task. Often
these groups come about spontaneously and may be created around a workplace issue (such as an interest
group) or an activity outside the workplace (such as a friendship group).
The leader of an informal group is not formally designated, at least with respect to the official work chan-
nels; instead, an informal-group leader emerges because of a personal characteristic—the person might be
the most knowledgeable or the most outspoken—or due to the particular group dynamic.
Informal groups share these characteristics:
• They arise as a result of their proximity, personality, and needs of the individual.
• Virtually all employees (including managers) belong to some kind of informal group.
• They are often small and complex. People tend to be more satisfied in smaller groups.
• Most members tend to conform to group pressures.
Even though informal groups are not officially sanctioned by organizations, they do provide benefits to the
organization, such as:
• Reducing tension and stress in the workplace.
• Providing another channel of communication via the grapevine.3
• Improving employee feelings about the workplace.
• Enhancing coordination and reducing required supervision.
• Aiding training, perpetuating cultural values, and providing social satisfaction on and off the job.
Informal groups might also cause problems for the organization, such as:
• Resisting change, becoming protective of the status quo.
• Pressuring other group members into accepting something that may go against company objec-
tives.
• Spreading rumors or distorting information.
• Causing conflict in the formal organization.
• Forming subgroups that may cause problems with group cohesiveness.
• Developing dominant members.
Attraction to Groups
The degree to which members desire to remain in the group depends on the group’s attractiveness and
cohesiveness, as explained below:
• Attractiveness: The group is viewed favorably by outsiders.
• Cohesiveness: Group members adhere to group norms and resist outside pressure.
A group is considered to be both attractive and cohesive when it can recruit members and maintain
membership. Elements that increase the group’s attractiveness and cohesiveness are:
• Prestige and good social standing.
• Cooperation among the members.

• Substantial member interactivity.
• Small size.
• Similarity of the members.
• Good public image.
• Common external threats.
On the other hand, elements that diminish the group’s attractiveness and cohesiveness are:
• Objectionable demands on its members.

• Disagreement among members about the group’s activities and procedures.
• Bad experiences of the group members.
• Conflict between the demands of the group and those of other groups.
• Negative public image.
• The possibility of joining other groups.
3
In a business situation, the “grapevine” is the rumor mill through which gossip and unofficial information is spread.
Roles and Norms

Roles and norms are important concepts of group dynamics theory and are the social building blocks for
groups and organizational behavior.
Roles are the expectations regarding behavior of a group member in specific positions. Roles will determine
what a person must, must not, or may do in a position. The role a person is expected to play or assume
depends on the situation, but people in similar positions should behave in similar fashion.
Role conflict can occur when there is inconsistency between the perceived role and actual role behavior.
For example, an individual can experience role conflict when trying to manage numerous demands coming
from different sectors, and each side has a widely different expectation of that person’s role.
Employees who feel that role conflicts have been poorly managed may experience the following:
• Increased tendency to leave the organization
• Decreased commitment
• Decreased involvement with the job
• Decreased job satisfaction
• Decreased participation in decision-making
Norms tend to be more generalized than roles. Norms are the standards—degrees of acceptability or un-
acceptability—for conduct that help individuals judge what is good or bad in a given social setting. Norms
are culturally derived and vary from one culture to another. In addition, norms are usually unwritten yet
have a strong influence on individual behavior. Norms go beyond formal rules and written policies.
Norms function to:
• Facilitate group survival
• Make behavior more predictable
• Avoid embarrassing situations
• Express the values of the group
In order for behavior to be accepted, a majority of the group must support the norm. However, there could
be instances where members violate group norms. If a majority of the members do not adhere to the
norms, then norms will change and no longer serve as a standard for evaluating behavior. Members who
do not conform to norms are punished by being excluded, ignored, or ostracized.
Conformity and Groupthink

Conformity is another important element of group dynamics. In his book Management, Robert Kreitner
defines conformity as “complying with the role expectations and norms perceived by the majority to be
appropriate in a particular situation.” The majority can influence members either through subconscious
processes or overt peer pressures.
Predictors of the level of conformity within a group include:
• Group size. A group of three to five people will elicit more conformity from its members than a
group of one or two people will. As the group size increases beyond five members, conformity
continues to increase but at a diminishing rate.
• Unanimity. Usually one group member will not take a stand that differs from that of the group, if
all the other members in the group are in agreement. However, if just one person does voice a
different opinion, it is more likely that other members will also voice their differing opinions. There-
fore, if the modeled behavior or belief is not unanimous, conformity is reduced.
• Cohesion. The more cohesive a group is, the more power it has over its members. A minority
opinion from someone within the group will sway group members more than will a minority opinion
from someone outside the group. Conformity is enhanced by group cohesion.
• Status. Higher-status people have more impact on group members than do lower-status people.
The higher the status of those modeling a behavior or belief, the greater is the likelihood of the
group going along with it and conforming.
• Public response. People conform more when they must voice their opinion in front of others than
when they are writing their opinion privately. People conform the most when their responses are
public, that is, in the presence of the group.
• Extent of prior commitment. Having previously made a public commitment, people tend to stay
with it, even if it means they will not conform to the group. Thus, having made a prior commitment
to a certain behavior or belief increases the likelihood that a person will stay with that prior com-
mitment rather than conform, if the group disagrees. On the other hand, people with no prior
commitment will be more likely to conform to the group’s ideas.4
Conformity has both benefits and costs. The primary benefit of conformity is that it provides a basis to
predict behavior. On the other hand, the cost of conformity, in extreme cases, can lead to tolerating
illegal or unethical conduct.
Groupthink is “a mode of thinking [that] people engage in when they are deeply involved in a cohesive
in-group, when the members’ strivings for unanimity override their motivation to realistically appraise al-
ternative courses of action.” Groupthink is a negative term that describes poor decision making that results
from group dynamics that prioritize harmony over critical thinking.
Some of the symptoms of groupthink are:
• Excessive optimism
• Unquestioned belief in the inherent morality of the group
• Collective rationalization of the group’s decisions
• Shared stereotypes of those outside the group, particularly opponents
• Self-censorship where members withhold criticism
• Illusion of unanimity
• Intolerance to dissent
• Self-appointed “mindguards” that protect the group from negative information
Groupthink can be prevented in the following ways:
• Avoid using groups as rubber stamps for decisions already made by senior management
• Urge group members to think independently
• Bring in outside experts and invite the group to meet off-site; changes in settings and surroundings
are a stimulant
• Consider the ramifications of different actions
• Take time to consider possible effects and consequences of alternative courses of action
Stages of Group Development

Most groups exhibit similar stages of development in the beginning. There may be uncertainty about the
group’s objectives and the roles of the members, but with time the group can develop understanding, trust,
and commitment. The final stage of development is the mature group, which is the most effective and
productive of the stages.
4
David G. Myers, Social Psychology, 10th ed. (New York: McGraw-Hill, 2010), 210-215.
According to Jewell and Reitz, the characteristics of a mature group are as follows:
• Members are aware of each other’s assets and liabilities.
• Individual differences are accepted.
• The group’s authority and interpersonal relationships are accepted.
• Group decisions are made through rational discussion with no attempt to force unanimity.
• Conflict is over substantive issues, not emotional issues.
• Members are aware of their roles in the group’s processes.
Several models have been developed to describe the stages of group development, but the Jewell and Reitz
version is the most persuasive. They described these six stages of group development as follows:
1) Orientation stage. The least effective, least mature, and least efficient stage. High uncertainty.
2) Conflict and change stage. Subgroups struggle for control; roles are undefined. If conflicts can-
not be resolved, this is the final stage.
3) Cohesion stage. A consensus on leadership, structure, and procedures is reached.
4) Delusion stage. Members might gain a false sense that all issues have been resolved and that
the group has reached maturity.
5) Disillusion stage. A decrease takes place in the group’s cohesiveness and commitment. Members
realize that their expectations are not being met.
6) Acceptance stage. At this stage, the group is more effective and efficient. In some cases, a
trusted and influential group member steps forward and moves the group from conflict to cohesion,
making the group more effective and efficient.
1 C 3. Organizational Politics
Andrew Dubrin defined organizational politics as “the pursuit of self-interest at work in the face of real or
imagined opposition.” Similar to organizational politics is impression management, which is “the process
by which people attempt to control or manipulate the reactions of others to images of themselves or their
ideas.” Both organizational politics and impression management are tactics to influence—or manipulate—
perception of work-related activities.
Politics is a fact of life in organizations, so managers have to accept that power relations exist and must be
appropriately handled. The manager must find a workable balance between the employees’ self-interest
and the organization’s interest. If a balance can be found, then the pursuit of self-interest may serve the
organization’s interest. On the other hand, if balance is not found, then self-interest can erode or defeat
the organization’s interest.
Organizational culture plays a big part in determining the amount of power plays, or politicking, that occurs
in the organization. Politicking, which is invariably negative, can:
• Hinder organizational and individual effectiveness.
• Be an irritant to employees.
• Have significant ethical implications.
Dubrin identified six common political tactics:
1) Posturing. An employee tries to make a good impression by staying one step ahead of the com-
petition or taking credit for others’ work.
2) Empire building. Gaining control over human and material resources.
3) Making the boss look good. Cultivating recognition by flattering or otherwise giving undue credit
to one’s immediate superiors.
4) Collecting and using social IOUs. Reciprocal political favors are exchanged by enhancing some-
one’s reputation or covering up their mistakes.
5) Creating power and loyalty cliques. A person assembles a group of allies; the bloc can work to
protect the individual and further that person’s objectives.
6) Engaging in destructive competition. An individual sabotages the work of others.
Although management cannot entirely eliminate politicking, it must work to keep it constructive and within
reasonable bounds. To manage organizational politicking, Dubrin suggested the following:
• Strive for a climate of openness and trust.
• Measure results based on performance rather than personality.
• Encourage top management to abstain from politicking.
• Integrate individual and organizational goals through meaningful work and career planning.
• Practice job rotation to encourage broader perspectives and understanding others’ problems.
1 D. Management Skills and Leadership Styles

Through exercising leadership skills, an individual can direct and coordinate a group’s work to achieve a
goal. Although leadership and management are related, they are not the same. A manager may be a leader
as well as a manager, but not all managers are leaders. In fact, a person may be a leader without having
any managerial authority. Leadership can be formal or informal:
• Formal leadership is the process of influencing others to pursue the organization’s objectives.
• Informal leadership is the process of influencing others to pursue unofficial objectives that may
or may not serve the organization.
A leader casts a vision for people and develops strategies to achieve that vision. A manager develops
formal plans and monitors the results compared to those plans. Thus, the manager implements the
leader’s vision and strategy, coordinates the activities and the staffing, and handles day-to-day prob-
lems. A manager brings about order and predictability to the effort to produce results.
Both leaders and managers achieve planned, orderly change. Furthermore, both leaders and managers
establish an ethical and moral climate. Leadership creates and directs change, and it helps an organization
get through difficult times. Management coordinates efforts and produces results during stable times.
Note: By definition, entrepreneurs are individuals who start and manage their own business. While
entrepreneurs are not normally associated with managers within a larger organization, it is becoming
more common for businesses to appreciate some of the traits that entrepreneurs usually have. Among
these are a drive to achieve success and a willingness to do whatever needs to be done to do reach their
goal, without considering job titles and places within an organization. Many of the management and
leadership skills that are discussed in the material can be looked at as having some of the
characteristics of an entrepreneur as well as a manager or leader in a larger organization.
1 D 1 Studies on Leadership
This section discusses four frameworks for leadership studies: the trait approach, the behavioral ap-
proach, the contingency approach, and the transformational leader.
The Trait Approach

Researchers have identified five traits that seem common to effective leaders:
1) Intelligence
2) Scholarship
3) Dependability in exercising responsibilities
4) Activity and social participation
5) Socioeconomic status
Another trait profile is based on leaders with emotional intelligence (EI), which is the ability to monitor
and control one’s emotions and behavior in complex social settings. Daniel Goleman asserts that the
following leadership traits are associated with EI:
• Self-awareness is to know oneself. A person maximizes potential after becoming aware of their
strengths and weaknesses.
• Self-management refers to methods, skills, and strategies by which individuals can effectively
direct their own activities toward the achievement of objectives.
• Social awareness is being able to understand the actions and emotions of others.
• Relationship management is an ability to use one’s own emotions and the emotions of others
to manage relationships for a successful outcome.
In addition, gender, ethnicity, and cultural background can influence leadership styles, both in how leader-
ship is exercised and how it is perceived.
The Behavioral Approach

The behavioral approach differentiates leadership styles according to three categories: autocratic, dem-
ocratic, and laissez-faire. The assumption governing this approach is that these leadership styles are
fixed for an individual, and a particular leader will always govern according to one of these styles.
1) Autocratic. The leader relies on legitimate power or position authority to give detailed instructions
for attainment of goals and to provide praise and criticism. Subordinates depends upon the leader’s
presence to be productive. When the leader is absent, production slacks off.
2) Democratic. The leader gives an overview of the task and encourages the group to participate in
developing appropriate procedures. The leader provides feedback and consultation and also makes
the final decisions. Members grow in self-confidence and in their respect for other members of the
group. There is emphasis on team effort and cooperation, resulting in a high level of satisfaction
among the members. Productivity continues even in the leader’s absence.
3) Laissez-faire. The leader provides information to the group but no feedback unless asked. Group
members enjoy complete freedom. However, group members can experience a lack of clear goals
or clarity about their goals. Unity may suffer and production could lag as a result.
A variation of the behavioral approach defines leadership as being one of two categories: job-centered or
employee-centered. The assumption governing this approach is that a leader cannot be both job-centered
and employee-centered at the same time.
1) The job-centered leader supervises the work of subordinates closely and explains work proce-
dures carefully. The primary concern is job performance.
2) The employee-centered leader emphasizes interpersonal relations and builds effective work
groups. Employee-centered behavior tends to produce higher performance of the group and better
job satisfaction.
Contingency Theories of Leadership

Contingency theories of leadership describe the complex relationship between leaders and their follow-
ers. The core assumption is that the behavior of leaders will vary according to circumstances. Contingency
theories of leadership focus on transactional leaders who motivate followers by clarifying tasks and roles.
Fiedler’s LPC Theory of Leadership

Fred Fiedler developed the earliest contingency model, proposing that effective group performance is a
function of a good match between the leader’s style and the situation. Fiedler’s Least-Preferred Coworker
(LPC) Theory of Leadership proposes that some leaders can be effective in one situation while being
ineffective in a different situation. The theory attempts to identify matches between leadership styles and
the various situations in which each style should result in effective performance.
Fiedler asked a leader to complete a questionnaire describing the employee that he or she had least enjoyed
working with. Fiedler believed that the results reflected differences in the leader’s personality traits and
dictated the person’s leadership style. If the leader described the least-preferred coworker in relatively
favorable terms, then the leader was relationship-oriented. If the leader described the least-preferred
coworker in relatively unfavorable terms, then the leader was task-oriented.
Fiedler assumed that leadership styles are fixed, and he proposed that in some situations a task-oriented
leader is needed and in other situations a relationship-oriented leader is required. Specifically, task-oriented
leaders perform better in situations of either high or low control, while relationship-oriented leaders perform
better in moderate control situations.
Fiedler suggested that if the leader’s style did not match what the situation called for, either the situation
would have to be changed or the leader would have to be replaced in order for good performance to be
achieved. There is evidence to support at least parts of Fiedler’s model. However, his findings with respect
to the LPC theory and the practical use of the model are problematic and controversial.
The Path-Goal Theory of Leadership

A basic principle of the Path-Goal Theory is that the appropriate leadership style depends upon the
subordinates and the situation. The leader has a responsibility to assist followers in attaining their goals
by engaging in behavior that complements the followers’ abilities and compensates for their deficiencies
while also meeting their needs within the environment in which the work is being done. It assumes that the
leader can be flexible and change behaviors in different situations and with different employees to match
the needs of the followers and the environment.
The early versions of the theory focused on a leader’s interaction with individual subordinates. Later revi-
sions to the theory recognized the growing importance of group dynamics and focused more on a leader’s
interaction with a group.
Path-Goal Theory identifies four primary leadership behaviors:
1) A directive leader lets subordinates know what is expected of them, gives specific guidance on
accomplishing tasks, schedules the work, and sets standards of performance. The leader makes
all the decisions and provides close supervision. Directive leadership is most effective with subor-
dinates who have a greater need for role clarity, such as employees that are inexperienced or
unsure about the task. The downside of a directive leadership style is that certain leaders can
abuse their position and be autocratic and abusive. Furthermore, if employees feel competent to
do their work without that much direction, they may feel resentful.
2) A supportive leader is friendly and concerned for the needs of subordinates. A supportive leader
prioritizes a friendly, worker-oriented environment. The leader treats the subordinates with respect
and supports them when necessary. Supportive leadership is most effective when tasks and rela-
tionships are physically or psychologically challenging. For example, in high-stress workplaces the
leader’s attention to the followers’ personal needs can reduce the stress level and lead to higher
performance. Supportive leader behavior is also motivating when subordinates’ jobs are not in-
trinsically satisfying, such as when the work is repetitive. The downside of supportive leadership
is that the leader may be too accommodating.
3) A participative leader consults with subordinates and considers their suggestions before making
a decision that affects them. Participative leadership is most effective when the employees are
self-motivated, highly skilled, require minimal oversight, prefer to work independently, and their
advice is both needed and they expect to be able to give their advice. The downside of participative
leadership is that the leader could get bogged down in too much consultation or allow competing
voices to overwhelm the decision-making process. Furthermore, if the subordinates prefer more
direction, participative leadership would be less effective.
4) An achievement-oriented leader expresses confidence in the followers’ capabilities and encour-

ages them to set high goals and standards of excellence. The achievement-oriented leader is also
supportive and provides adequate resources for workers to accomplish their objectives. Achieve-
ment-oriented leadership is most effective when tasks are unstructured, complex, and ambiguous
and the followers are professionals such as in technical or scientific environments. The result of
achievement-oriented leadership is an overall increase in subordinates’ performance and satisfac-
tion. The downside to achievement-oriented leadership is that a relentless focus on goals—and
recognition—may encourage shortcuts that might undermine the final product.
The Path-Goal Theory highlights two factors that have a strong influence on how subordinates respond to
different leadership behaviors:
1) Personal characteristics. Employees bring to the workplace their skills and their experience. As
a result, they establish a locus of control, which refers to the sense of power (or lack thereof)
over their work environment.
Workers who feel they have control over their work tend to respond most positively to a
participative leader, because that leader makes them feel that their actions can make a difference.
If workers feel that control is not part of their work environment, they may be more satisfied with
a directive leader, since they believe their actions lack consequence. If employees have a high
regard for their own abilities, they will not respond positively to a directive leader; however, if they
have a low regard for their own abilities, they will prefer a directive leader.
2) Environmental characteristics. These are features outside the subordinate’s control, such as
the task structure, the authority system, and the work group.
The Path-Goal Theory says that the leader’s behavior will motivate subordinates if it helps them
deal with the uncertainties related to the things that are outside their control. If the task structure
is high, directive leadership is not necessary and is less effective. If the work group itself gives
each employee sufficient social support, a supportive leader will not have much to offer.
In general, evidence has supported the proposition that an employee’s performance and satisfaction im-
prove if the leader compensates for things that are lacking in either the employee or the work setting. If a
leader over-manages an employee, however, the leader will be ineffective because the employee considers
the directive behavior inappropriate and insulting.
Vroom’s Decision-Tree Approach

Vroom’s Decision-Tree Approach, like the Path-Goal Theory, attempts to determine an appropriate leader-
ship style for various situations and assumes a leader may use different leadership styles. However, it limits
itself to the question of subordinate participation in decision-making and how much participation is appro-
priate under various circumstances. The leader evaluates several characteristics of each decision and
determines the decision style that reflects the proper amount of subordinate participation.
Vroom proposes two decision trees: one to use when the primary consideration is to make an effective
decision as quickly as possible, and the other for when the primary focus of the effort is developing
the decision-making capabilities of others. After choosing the pertinent decision tree, the leader eval-
uates a series of eight factors (which are outside the scope of the exam) to determine how much
participative decision-making is appropriate and decides among five alternatives:
1) Autocratic I. The leader solves the problem alone.
2) Autocratic II. The leader consults group members and then makes the decision alone.
3) Consultative I. The leader consults with group members individually for information and eval-
uation; the leader makes the decision alone.
4) Consultative II. The leader consults with group members collectively then makes the decision
alone. The decision may or may not reflect the group’s opinion.
5) Group. The leader consults with the group. The leader focuses and directs the discussion but does
not impose a decision. The group makes the final decision.
Transformational Leadership
Transformational leaders inspire subordinates to put forth extra effort to achieve group goals. The trans-
formational leader displays the following characteristics:
• Charisma. The leader instills a sense of mission and pride while also earning respect and trust.
• Inspiration. The leader communicates high expectations and important purposes.
• Intellectual stimulation. The leader promotes intellect and rationality for problem solving.
• Individualized consideration. The leader is a coach, giving individual attention to each em-
ployee.
Transformational leadership is not in opposition to transactional leadership, which is the key characteristic
of contingency theories. It extends transactional leadership by getting followers to put forth more effort
and perform at a higher level than a transactional approach alone might produce.
Transformational leaders are overwhelmingly considered to be more effective than transactional leaders.
Transformational leadership generally results in lower turnover rates among employees, higher productiv-
ity, and greater employee satisfaction.
Mentoring
A mentor is a person with knowledge, experience, and connections who cultivates a protégé through tutor-
ing, coaching, and guidance. According to Kathy Kram, mentors provide two primary functions:
1) Mentors serve a career enhancement function, which involves coaching, sponsoring advance-
ment, providing challenging tasks, protecting the protégé from adverse forces, and fostering
positive visibility.
2) Mentors provide psychological support, which may involve personal support, friendship, coun-
seling, acceptance, and role modeling.
Mentoring has many positive effects on the organization as a whole and on career outcomes for the protégé.
Research indicates that mentored individuals have a higher level of mobility on the job, recognition, pro-
motion, and financial compensation. In regards to benefits to the organization, mentoring can be a tool for
socializing new employees, increasing organizational commitment, and reducing turnover.
1 D 2. Team Building and Assessing Team Performance

Team building is the process of establishing and developing trust and collaboration between and among
team members. It is important for organizations to establish team-building methods so that new employees
can adapt to their job requirements and current employees can feel more involved in day-to-day operations.
Participative Management
A common means of motivating individuals is through participative management. Employees can par-
ticipate in decision-making processes such as setting goals and determining work schedules. These methods
treat the ideas and suggestions of the employees with respect and consideration. The primary forms of
participative management are quality circles, self-managed teams, and open-book management.
1) Quality circles are small groups of employees who work together and meet regularly to discuss
problems and recommend solutions. These groups focus on problems relating to quality, such as
reducing rework and defective products. They do not make decisions about how the work should
be done; they can only make recommendations. Quality circles tend to be permanent teams.
2) Self-managed work teams are charged with performing daily tasks. Like quality circles, self-
managed works teams tend to be permanent. They have the authority to decide how work will be
done in terms of planning, scheduling, and assigning tasks to members. They act to solve problems
that develop, make operating decisions, and work directly with suppliers and customers. Some
self-managed teams even select their own members, and members evaluate each other’s
performances and instill discipline. The entire team is responsible for the results of their work. The
efforts of all the team members can produce a level of performance that is greater than the sum
of their individual efforts. Though self-managed work teams can be successful in some situations,
they do not work very well in cultures that emphasize hierarchical authority.
3) In open-book management (OBM), employees are given all relevant financial information about
the company so that they feel more empowered. This information can include, but is not limited
to, revenue, expenses, profit, cost of goods sold, and cash flow.
Raj Aggarwal and Betty Simkins developed an OBM model called STEP, which features the
following components: share, teach, empower, and pay.
• Step One: Share all relevant financial information.
• Step Two: Teach employees to understand the financial information.
• Step Three: Empower employees so they are responsible for the numbers under their control.
• Step Four: Pay employees a fair amount based on performance. Methods of compensation
might include bonuses, stock options, and profit-sharing.
Types of Teams
Some teams are formal, created by management. Others are informal, evolving naturally in organizations
that permit participative management. The major types of teams are as follows:
• Problem-solving teams are temporary groups formed to solve a specific problem in the work-
place. Problem-solving teams are often cross-functional; that is, they consist of members from
different functional areas of the organization and are selected for their expertise. Problem-solving
teams make recommendations, not decisions.
• Cross-functional teams are composed of employees from different work areas who collaborate
together, for example to manage a single client’s account. They may be a permanent team. A team
working together for one client can improve communications and tracking of jobs, leading to higher
client satisfaction.
• Management teams are made up of managers from several areas who work together to support
and coordinate the activities of work teams. These are relatively permanent teams. Their primary
job is to coach and counsel work teams. They also coordinate the activities of work teams that are
dependent upon each other.
• Product development teams are a combination of work teams and problem-solving teams. They
are formed to create new products or services. They are similar to problem-solving teams in that
they may be disbanded when the product has been developed and is in production. Use of a team
to develop a new product can cut product development times.
• Virtual teams are made up of members who work remotely. In some cases, they may be located
all over the world. Therefore, they share files and communicate remotely. A global team can coor-
dinate its work so that as one team ends its workday, a second team can pick up where the first
team left off. For example, a virtual team can act as a non-stop product-development team, dra-
matically cutting the time necessary to bring a new product to market.
Team Effectiveness
Teams are considered effective when they accomplish goals, have innovative ideas, adapt to change, com-
mit to their objectives, and are highly rated by senior management. Accordingly, team effectiveness is
determined by the following interdependent factors:
• Leadership. Effective leadership is necessary in order for teams to function productively. Team
members may fulfill the leadership roles or management may provide the leadership.
• Abilities of members. A productive team is one that has the right mix of skills appropriate for
the task at hand. A team with unbalanced or insufficient abilities will most likely fail.
• Team performance. When a team is initially formed, it can take a while to establish a productive
working relationship and team performance may lag. However, as time passes, leaders take
charge, the work becomes focused, and team members become more competent and more com-
mitted.
• Top management support. Support from top management is essential for team success. Man-
agement can provide support systems and assistance with decision-making. This support is
particularly useful during the early stages of group formation.
Trust, a “reciprocal faith in others’ intentions and behavior,” is a key element to team effectiveness.5
Management is responsible for creating a climate of trust. It establishes productive interpersonal relation-
ships, encourages self-control, reduces the need for direct supervision, and expands managerial control.
Fernando Bartolomė outlines six ways to build trust:
1) Communication
2) Support
3) Respect
4) Fairness
5) Predictability
6) Competence
5
Kreitner and Kinicki, Organizational Behavior, 5th edition, pg. 422.
2. Organizational Structure and Business Processes CIA Part 3
2. Organizational Structure and Business Processes

2 A. Risk and Control Implications of Different Organizational Structures
A company’s organizational structure greatly impacts its risk and control environment and therefore also
influences the success of the company’s controls. No matter what type of organizational structure a com-
pany has, there must be a unity of objectives, which occurs when all of the objectives of individuals and
departments agree with the larger organizational goals. In order to accomplish unity of objectives, man-
agement must clearly communicate organizational goals.
The relationships between the individuals, groups, and departments need to be considered as well, and
they are to varying degrees based upon authority, responsibility, and accountability.
• Authority is the right to direct the performance of others, including the right to describe the
means and methods by which the work will be performed.
• Responsibility is the obligation a person has to perform.
• Accountability is the duty to account for the completion of the responsibility.
Risk and control implications of the assignment of authority and responsibility:
Reporting relationships should be formally established so that all employees know to whom they are
accountable.
Authorities should be formally established, for example, who has authority to make purchases (or re-
quest/requisition supplies), what types of purchases each is authorized to make or requisition (such as
office supplies or raw materials) and the monetary maximum that each one has the authority to commit
the organization to. Adherence to the authorized maximums should be monitored and enforced. Author-
izations should be reviewed periodically.
Policies should be established that describe appropriate business practices.
The resources needed by each employee for fulfilling his or her duties should be provided.
Elements of the Organizational Structure

A structure of an organization may be defined in terms of its:
• Complexity
• Formalization
• Centralization
Complexity
The amount and type of differentiation that exists among the various elements of an organization deter-
mine its complexity:
• Vertical differentiation. The more hierarchical levels there are within an organization, the more
complex it is and also the slower and less effective it will be in adapting to changing conditions.
Vertically differentiated organizations are tall organizations.
• Horizontal differentiation describes the degree to which different functional areas work together
to form cross-functional teams. A horizontally differentiated organization is a complex organization
because a greater diversity and depth of skills are required. Special skills and knowledge are re-
quired to complete the tasks. These are flat organizations because there are many different
skills within the organization but not a lot of hierarchical differentiation among them.
• Spatial differentiation. A spatially differentiated organization entails geographic separation of

the organization’s activities.
Section I 2. Organizational Structure and Business Processes
Formalization
Formalization describes the extent to which jobs are standardized and the clarity of the procedures and
tasks that need to be performed. The lower the level of formalization within a company, the more room
there is for employee decisions. A strong corporate culture reduces the need for the formal expression of
all corporate standards because the standards are disseminated and monitored naturally as part of the
corporate culture.
Centralization and Decentralization

Centralization is the extent to which a company’s authority and freedom of decision-making are concen-
trated in one location or dispersed over many locations.
• When authority and decision-making are concentrated in one location, the organization’s structure
is centralized.
• If authority and decision-making are dispersed over many locations, departments, or individuals,
the organization has a decentralized structure.
Neither centralization nor decentralization is necessarily good or bad in itself; rather, centralization and
decentralization can be considered two polar extremes of corporate organizational structures. Most compa-
nies will find a happy medium for themselves, balancing the need for structure with the need for individual
autonomy. Therefore, management needs to be aware of the advantages and disadvantages of each ap-
proach and then make clear decisions about how centralized or decentralized it wants the company to be.
When deciding how centralized or decentralized the company ought to be, management should consider
the following factors:
• Information flow. Necessary and proper information must be available to the people making the
decisions. Thus, if critical information is available only to the head office, management should
incline toward a more centralized structure. However, if information is gathered and processed
from various locations, a decentralized structure is favorable.
• Location of decision makers. If it is clear that a majority of highly skilled employees, managers,
or decision-makers work outside the home office’s geographic center, management might incline
toward a more decentralized structure. If most of these individuals work close to the center, the
company can afford to be more centralized.
• Timely manner of decisions. Oftentimes, business decisions must be made quickly. A

decentralized structure can make it easier to enact a timely decision, because a highly centralized
corporate structure might unnecessarily prolong decision making.
• Coordination. If a company has large, interconnected operations, streamlined coordination is

essential to maximize efforts and eliminate waste. Decentralization might exacerbate coordination
problems, whereas more centralization could do a better job of keeping track of resources and
managing troubleshooting.
• Critical decisions. Decisions that are critical to the company as a whole are generally made at
the central location and should not be decentralized. Furthermore, centralized organizations can
avoid confusion by ensuring that the organization speaks with “one voice” when it comes time to
make a decision.
In general, companies can incline more towards decentralization when lower levels of management make
many of the decisions, most functions and tasks are influenced by decisions made at lower levels of man-
agement, and the review or approval of a decision is not required before implementation. In addition,
decentralization is most often and easily implemented in organizations that have departments that are
based upon clearly divisible units, functions, or products.
Following are the benefits and limitations of decentralization.
Benefits of Decentralization
• Greater speed in making operational decisions.
• Encourages better communication and initiative among employees.
• Identifies and trains good decision-making at lower levels; builds a pool of managers.
• Gives responsibility and authority to lower level managers.
• Frees top management from operations duties and enables them to focus on strategic goals.
• Enables the financial measurement of a particular unit.
Limitations of Decentralization
• Tendency to focus on short-term local issues rather than long-term success of the larger organ-
ization.
• Increased risk due to the loss of control by top management.
• Coordinating interdependent units is difficult; lower levels of management may make conflicting
decisions.
• Greater danger of satisficing—that is, accepting any option rather than the best option since lower
management may not have the broad operational perspective that upper management has.
• Requires the understanding of company goals throughout the organization.
Delegation
One of the key aspects of decentralization is delegation of authority, which is the process of passing
power to a subordinate. By delegating certain responsibilities, a member of upper management can free
up time to concentrate on other important projects. Without question, there must exist a great deal of trust
between the two parties, in large part because duties carried out by the delegate have the implied stamp
of approval from the delegator. Thus, a careful delegator will put in place safeguards and other controls to
prevent the delegate from overstepping boundaries or committing serious errors.
Delegation has the useful side effect of helping subordinates develop confidence and initiative. By extending
authority to a subordinate for a limited time period, a member of upper management can observe and even
mentor those who seem capable of assuming greater levels of responsibility at a later date. Thus, delegation
can serve as a kind of probationary tool that could lead subordinates to commendation and promotion.
Successful delegation requires the following:
• The necessary skills and a sound knowledge of the organization objectives
• A feedback system that allows assessment of performance
• Faith in the abilities of the subordinate
• A recognition of the need to delegate
• A willingness to accept risk
• The desire to train subordinates
The delegation process involves the following steps:
1) Determine the expected results
2) Recruit responsible subordinates
3) Assign tasks and responsibilities
4) Communicate clearly what is expected
5) Delegate the necessary authority to complete those tasks
6) Follow-up on the process because ultimate authority remains with the manager
Note: Even when responsibility is delegated, the person who did the delegating is still ultimately re-
sponsible for the success or failure of the task. In other words, final responsibility cannot be delegated.
Risk and control implications of delegation:
Delegation should take place only to the extent that it is necessary to achieve the organization’s objec-
tives.
Delegating responsibility must include the delegation of the necessary authority to fulfill the responsibil-
ities delegated.
A flat organizational structure usually leads to increased delegation of authority and responsibility. A
flatter organization and increased delegation require greater competence on the part of employees and
greater accountability by employees for decisions made.
Before delegating responsibility, management must have effective procedures in place to monitor the
results and must be able to overrule decisions, if necessary.
In order to be able to monitor and potentially overrule decisions, management must have a means to
be aware of what is being done at the lower levels in the organization. Thus, good communication is
essential.
Structure of the Organization

The structure of a company’s organization may be either mechanistic or organic:
• A mechanistic structure is a very set and detailed system in which there are tight controls,
extensive division of labor, and high formalization. This type of structure works well for mass
production and any time there is a strong need for operational efficiency.
• An organic structure, on the other hand, has low complexity, a low amount of formalization, and
a highly participative decision-making structure. Organic structures are more flexible and adaptive
to change and function better in more dynamic and complex environments. An organic structure
is better for product development.
Structure and Strategy

The structure that management chooses for the company is a function of its main strategy.
• If the main strategy is one of innovation and development of new products, an organic structure
works better.
• For a cost-minimization strategy, a mechanistic structure is better.
• If the strategy is to imitate others and move into markets only after they are proven, a combi-
nation of organic and mechanistic works best.
The company’s structure is also a function of:
• Organizational size. Though there is no direct relationship between the size of the company and
the structure that is required, larger companies tend to be more mechanistic because of the
need for formalization.
• Technology. An organic environment would work best with non-routine technology where for-
malization is lower.
• Environment. Generally, the more stable the environment, the more mechanistic the company.
A mechanist environment may also be more appropriate when the company has little opportunity
for growth. Organic environments would tend to be more dynamic and complex. These environ-
ments generally require the flexibility and adaptability that is offered by an organic environment.
Components of an Organization
According to Henry Mintzberg, a notable management theorist, an organization has five components6:
Operating Core The employees who perform the basic production tasks.
Strategic Apex The top managers who ensure that the mission is followed and the needs of
the owners are met. They are in charge of overall strategy, long-term plan-
ning, and control.
Middle Line Managers who connect the strategic apex to the operating core.
Technostructure The staff without direct-line management responsibilities but who seek to
standardize the way the organization works. They design procedures and
systems manuals that others are expected to follow.
Support Staff The support staff provide ancillary services, such as clerical staff, cleaning
staff, public relations, legal counsel, cafeteria, IT staff, and so forth.
Organizational Components:
Ideology
Strategic Apex
Techno- Middle Support

structure Line Staff
Operating Core
6
Mintzberg, Henry. The Structuring of Organizations. Englewood Cliffs, NJ: Prentice Hall, 1979.
According to Mintzberg, surrounding every organization is ideology, or the traditions and beliefs that make
each organization unique. There are those who believe that ideology is the sixth component of an organ-
ization.
Mintzberg identifies six different types of organizations, each of which configures or emphasizes the
standard components differently. He suggested that the most suitable configuration would depend on the
type and complexity of the work done by the organization. The six types of organizations, based the dom-
inant component, are listed in the following chart.
Dominant
Component Type of Organization
Operating Core Professional Bureaucracy. This is a complex and formal organization but
also one that is decentralized; the specialists of production have independ-
ence. Top management gives up control, but there is low creativity and there
may be low performance because of inflexibility and an impersonal environ-
ment.
Coordinating mechanism: Standardized skills.
Strategic Apex Simple Structure. There is low complexity and authority is centralized. This
is usually seen in smaller, entrepreneurial organizations where there is less
formal planning or structure.
Coordinating mechanism: Direct supervision.
Middle Line Divisional Structure. Each division essentially operates as its own com-
pany. This can lead to the duplication of many functions within each of the
divisions.
Coordinating mechanism: Standardization of output.
Technostructure Machine Bureaucracy. This is a complex, formal organization that performs

highly routine tasks. There is a strict chain of command and line and staff
functions are separated.
Coordinating mechanism: Standardized work processes.
Support Staff Adhocracy. This is an organization with low complexity and it is not very
formal. There is low vertical differentiation and high horizontal differentiation.
The emphasis is on flexibility and response (for example, advertising agen-
cies and consulting firms).
Coordinating mechanism: Mutual adjustments.
Ideology Missionary Organization. In this type of organization, the members share

a common set of beliefs and values, which can mean that the organization is
usually unwilling to compromise or accept change.
Coordinating mechanism: Standardized norms.
Departmentation
Departmentation is the process of grouping related activities together into significant organizational sub-
systems, which should promote coordination between the different divisions of labor that are created when
a company breaks its operations into separate tasks. Departments of an organization can be established in
a number of different ways.
• Departmentation by function is the most common form of departmentation. The most common
departments are marketing, production, accounting, and finance. The advantage of this system is
specialization by those performing the different tasks, simplified training because of the reduced
breadth of job duties, and the representation of the primary functions in the top level of manage-
ment. Disadvantages include a lack of profit centers7 and a potential lack of coordination between
and among the different functions.
• Departmentation by territory is division along geographic lines and is characteristic of multina-

tional and national companies. It gives the company a quicker reaction time to local changes,
greater familiarity with the local market and issues facing it, and cheaper distribution costs. On
the other hand, there is a greater loss of control through delegation and there is a duplication of
service functions because each department or territory performs service functions.
• Departmentation by product is the system that is most conducive to profit centers because one
department both produces and sells the product. There is a specialization of assets and skills and
it is easier to assess profitability for a department, but there is a need for more managers. In
addition, staff functions are duplicated in the different departments.
• Departmentation by customer allows the organization to provide better service to customers,

but there is a need to have a large customer base. Furthermore, it may be difficult to coordinate
the services offered to customers with the departments actually performing the services.
• Departmentation by project may be used for one-time projects (for example, ship building,
military contracts) and enables easy communication, but reorganization is required at the end of
each project, which may lead to transitional difficulties from one project to another.
Matrix Organizations
A matrix organization results when any two departmentation methods are combined in one company. Often
the two methods are departmentation by function and department by project, where the skills of one em-
ployee are shared by the functional manager and the project manager. An example is an engineer working
in a functional department who is assigned for a short time to assist a project manager with a new project.
Matrix organizations often lead to one employee reporting to more than one manager. This problematic
issue needs to be resolved by prioritizing the different supervisors.
The flexibility that occurs in a matrix organization allows the best people to be assigned where they are
most needed, even if that is somewhere outside of their usual departments. This flexibility will enable the
company to eliminate, or at least reduce, the large changes in the number of people hired for various
projects and then fired afterward. The matrix system allows the organization to take people from other
departments temporarily for a larger project. The main disadvantage of the matrix system is that the unity
of command is broken because one person can have more than one boss.
7
A profit center is a department that is responsible for both revenues and expenses. A department within a store, such
as the hardware department, is an example of a profit center because it has both revenues and cost of goods sold.
Span of Control
The “span of control” refers to the maximum number of subordinates that a manager can effectively
supervise. Five or six is often considered the most manageable number; however, this amount might be
increased because of the benefits received from expanding the span of control.
Under the behavioral school, the more people that a manager supervises, the less time is available to
supervise each individual subordinate. This will lead to the subordinates working with less supervision,
m
thereby increasing their job satisfaction. Also, a wider span for each manager means there will be fewer
levels in the organization, leading to more efficient communication throughout the organization.
o
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The modern approach holds that the number of subordinates a manager can effectively supervise depends
on factors such as the supervisor’s training, abilities, time available to supervise and the subordinates’
a
interest in working with less supervision, commitment to the job, training, and attitudes. Also, the job itself
gm
and the environment of the company will influence the number of subordinates that can be supervised.
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Note: The size of the organization does not affect the span of control.
01
The span of control will affect the number of levels that exist in an organization. A company with a narrow
span of control will be a taller organization because each manager oversees fewer people. In a tall
e1
organization, there is more room for advancement because there are more levels; on the other hand,
lin
because of the additional levels, communication takes longer.
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If a company has a wide span of control, it will have fewer levels and will be a flat organization. A wide
span of control is more appropriate when the tasks performed are more standardized and require little
do
direct supervision by the manager. When employees have less supervision, the risk is greater that compli-
cated tasks will be performed incorrectly, so in a wide-span system the activities should not require a lot
ar
of direct supervision.
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2 B. Risk and Control Implications of Common Business Processes

Note: CIA exam candidates are expected to demonstrate knowledge of risk and control implications
n
of common business processes at the proficient level. They must be able to apply concepts, pro-
me
cesses, or procedures; analyze, evaluate, and make judgments based on criteria; and/or put elements
or material together to formulate conclusions and recommendations.
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2 B 1. Human Resource Processes

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Employees are a valuable company asset; therefore, every company needs a process to ensure that em-
ployees are properly recruited, hired, supervised, and evaluated. Once they are hired, the company must
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have policies to retain and motivate new workers.

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Employee Recruitment
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Employees can be recruited either from within or from outside the organization. Promoting from within can
have a positive motivational effect on employees, is generally less expensive, and it is usually easier to
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identify proven performers. Internal recruiting can be done in these ways:

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• Job posting (internal)
• Review of company database
On the other hand, the main reason for recruiting outside is that an external candidate could bring new
ideas and have more up-to-date training or education. External recruiting can be done in these ways:
• Advertising
• Employment agencies
• Referrals from current employees
• Outside organizations (including colleges, universities, and professional organizations)
Employee Selection
The goal of employee selection is to match the abilities and experience of an individual with specific job
requirements.
Job Analysis
The first step in employee selection is job analysis, which includes assessing requirements, determining
how a job relates to other jobs, and establishing the necessary knowledge, abilities, and experience for the
position.
There are several ways in which this information can be obtained:
• Observe incumbents at work.
• Interview selected incumbents.
• Have incumbents log their activities each day, recording the amount of time spent on each ac-
tivity.
• Have incumbents complete questionnaires.
The information gathered through these methods form the basis of a job description. The job description
itself is a formal, written statement of what a person in this position does, and how and why it is done. The
job description gives content to the job, its environment, and the conditions of employment.
A job specification is also developed through the job analysis. It states the minimum acceptable qualifi-
cations—such as education, knowledge, abilities and experience—that an employee in that position must
possess to perform the job successfully. The job description and job specification are used to guide the
selection process.
Note: Job descriptions identify characteristics of the job itself. Job specifications identify charac-
teristics of the successful job incumbent.
Selection Devices
Selection devices help management determine how well a candidate’s skills, knowledge, abilities, and ex-
perience fit the requirements for the job. Interviews are most useful for assessing an applicant’s applied
mental skills, interpersonal skills, and personal characteristics. In addition, an interview can assess how
well an applicant would fit into the organization’s culture.
Written tests may be used to assess intelligence, aptitude, ability, interest, and integrity. Ability tests
have proved to be helpful in predicting good employees for semi-skilled and unskilled jobs. When cognitive
ability is required, intelligence tests are good predictors. Integrity tests are also used to evaluate traits
such as honesty, dependability, and conscientiousness.
Performance-simulation tests can determine if an applicant can do a job successfully by having the
person perform a task in a simulated, controlled environment. Work sampling tests are hands-on simu-
lations. They are well suited to routine jobs, such as an assembly-line. Assessment centers test
managerial personnel. Candidates go through several exercises simulating real problems they could face in
the position. Executives, supervisors, and psychologists evaluate the candidates’ performance. Assessment
centers are very effective at predicting job performance in managerial positions.
Regardless of the testing regimen, the same test must be given to all applicants and the process must be
free from racial, religious, gender, and national-origin bias.
Other Means of Staffing

Flexible staffing, or the use of temporary or part-time employees, helps a company adjust to changing
market conditions. Temporary employees can be hired on a “temp-to-perm” basis. Under this condition, a
part-time employee could be offered a permanent position if they perform their work satisfactorily.
For other employers, a significant part of the workforce is made up of “long-term temporary” employees
who may never be offered regular full-time employee status. The advantage to this arrangement for an
employer is the ability to end the arrangement at any time without repercussions. Also, such workers are
paid a lower salary and do not receive a full set of benefits. Temporary and part-time workers tend to have
less loyalty to the company and the company receives less long-term benefits from training they receive.
Professional Employer Organizations (PEOs) provide employee leasing services for companies. A
PEO serves as the employer of record for all the company’s employees, both managerial and staff. The PEO
writes the paychecks, provides employee benefits, and pays all the employer’s payroll taxes. The contract-
ing company makes the hiring decisions and supervises the employees, just as if the employees were their
own employees. However, instead of paying salaries and providing benefits to the employees, the contract-
ing company pays the PEO for all associated costs.
The primary market served by PEOs are small employers who may not have the in-house expertise to
manage human resources. The PEO serves as the company’s human resources department, ensuring that
all labor laws and other regulations are followed. Unlike temps, employees who are leased under a contract
with a PEO are regular employees, although they are employees of the PEO, not of the contracting company.
PEO services can be quite expensive.
Risk and control implications in the hiring process:
Organizations should have policies for hiring the most qualified people based on their educational cre-
dentials, prior experience, other accomplishments, and evidence of ethical behavior. Having incompetent
or unethical people in the organization creates multiple risks, from improper performance of duties to
embezzlement.
To prevent the risk of recriminations for discriminatory practices in the selection process, all managers
with hiring responsibilities should receive training in all laws and other regulations that apply.
Interviews should be well organized and questions should be in-depth.
Background checks should be performed on potential employees, including verification of prior work
experience and of educational credentials.
All promises should be in writing to prevent promises being made to candidates that cannot be honored.
If there is an employment contract, the prospective employee should sign the contract before beginning
work.
New Employee Orientation

After new employees are hired, they must be given an orientation to receive information about the overall
objectives of the organization, the organizational chart, benefits, policies, and procedures.
Risk and control implications in new employee orientation:
Orientation procedures should include clear information about the organization’s history, values, culture,
operating style, policies, and objectives.
New employees should receive a copy of the organization’s written code of conduct and should be asked
to formally acknowledge their acceptance of the code.
Orientation should include information on the consequences of noncompliance with the code of conduct.
Employee Training
In addition to an orientation, employees will need initial and ongoing training. Through training the organ-
ization prepares its staff to accomplish the tasks set before them. Ongoing training is important because
technology is always changing, the organization’s needs are always changing, and employees’ skills can
quickly become obsolete. Training methods are classified as formal/informal and on-the-job/off-the-
job. The majority of training is informal and consists of employees helping each other to learn the job.
On-the-job training may involve apprenticeships, understudy arrangements, formal mentoring, and job
rotation. To avoid disruption in the workplace, however, many organizations pay for off-the-job training
such as classroom lectures, seminars, self-study, and Internet courses. Such courses may involve leader-
ship or interpersonal relations, training in the use of equipment or software programs, business ethics,
problem-solving skills, and other related areas. In some instances, organizations need to provide basic
literacy and math training.
Large companies often have formal training departments. A company that contracts with a Professional
Employer Organization will have access to ongoing training opportunities for its leased employees through
the PEO. There are also multiple training companies that offer on-site, off-site, or online training programs
to companies and their employees.
Risk and control implications in the training process:
Training should be conducted in the specific knowledge required for each employee’s job, and the em-
ployee should know who to go to with any questions. Basic knowledge can be taught on the job, but
critical processes should be formally taught by qualified instructors.
Training must be an ongoing process that helps employees keep up with changing technology, changing
regulations, issues, and risks.
Although ethical behavior cannot be taught, formal training should include ongoing reinforcement of
what is acceptable and unacceptable behavior, what workplace discrimination is and the organization’s
policies regarding it, what sexual harassment is and the organization’s policies regarding it, how to
recognize a conflict of interest and how to respond appropriately to it, applicable laws and regulations
that must be adhered to (and changes to them), and so forth, as well as the consequences of noncom-
pliance.
Employees’ attendance at the formal training sessions should be required, and records should be kept
of their attendance (they should sign in and out). If later disciplinary action is required due to noncom-
pliance with a rule or standard of behavior, the attendance record can counter a claim of ignorance of
the rules.
Career Development
Although employees should keep their skills and knowledge up to date, organizations often invest in em-
ployee development to maintain or raise the quality of its workforce. Employee development can be
accomplished in the following ways:
• Communicating the organization’s goals and long-term strategies. Employees who understand the
organization’s plans can develop personal goals that align with the long-term strategy.
• Creating growth opportunities through professionally challenging experiences.
• Offering tuition reimbursement.
• Providing time off for learning experiences.
• Mentoring can also be used to develop employees by providing coaching and guidance.
Employee Evaluations
Criteria Used in Performance Evaluations

An effective performance appraisal system needs to evaluate appropriate factors. For example, evaluation
criteria should be task outcomes, not means.
The following is a list of performance evaluation types:
• Behavior-oriented. Behaviors such as meeting deadlines, helping other employees, or volunteer-

ing for extra work are measured. These are subjective factors, but if they contribute to the overall
goals of the organization then they are appropriate criteria.
• Trait-oriented. Examples of traits that are often evaluated are “good attitude,” “self-confidence,”
or “dependability.”
• Goal-oriented. Goal-oriented performance evaluations measure how well employees achieve ob-
jectives set by management.
Who Should Evaluate an Employee?

Performance evaluations are often conducted by a supervisor; however, peer evaluations can also be a
source of appraisal information. In the case of a team evaluation, peer evaluations can provide multiple
independent judgments. On the negative side, peer evaluations can be affected by coworkers’ unwillingness
to evaluate the employee honestly.
Sometimes an employee is asked to self-evaluate, which can decrease an employee’s defensive attitude
toward a performance appraisal, although it can produce inflated results. Therefore, self-evaluations are
better suited for developmental rather than evaluative purposes. Another source for an evaluation is a
person’s subordinates. However, they may fear reprisal from a boss who received an unfavorable evalua-
tion.
Another approach is the 360-degree evaluation, which asks for feedback from people with whom the
employee interacts, usually around five to ten appraisals in total. 360-degree evaluation works well in
organizations that have teams with high employee involvement.
Potential Problems in the Evaluation Itself

The evaluation process can encounter a number of significant problems.
• The halo effect occurs when a manager draws an evaluation of a person on the basis of a single
characteristic, such as personality or communication skills. If an employee is competent but not
strong on the one trait the manager values, that manager may not evaluate that employee very
highly. Alternatively, an employee who is highly skilled in that one area would be evaluated highly,
even though he or she might actually not be performing the job very well.
• A central tendency error occurs when the manager rates all employees the same, regardless of
individual abilities.
• The recency effect occurs when the evaluator allows the employee’s most recent performance to
outweigh the total performance over the evaluation period.
• Differing standards among managers is a problem when employees are unfairly rated lower or
higher because the evaluator has standards that drastically differ from those of other evaluators.
• Rater bias is the process of evaluating a person’s on-the-job performance according to how much
the manager likes the person.
• Contrast error can creep in if the evaluator allows the employee’s evaluation to be influenced by
evaluations done recently for other employees.
• In forced normal distribution, a manager inadvertently ranks employee performance along a

bell curve, with most of the people in the middle of the scale and a few at the extremes, even if
actual performance does not fall into this distribution pattern. In other words, employees are being
improperly rated in comparison with the others rather than on their own merits.
Risk and control implications in the employee evaluation and promotion processes:
A fair employee performance evaluation system that is not subject to an excessive amount of managerial
discretion should be in place.
Employees should have an opportunity to respond formally to their evaluations, and their comments
should be reviewed by senior management. A situation may exist where senior management is unaware
of factors impacting the employee’s performance. If the employee’s comments are determined to be
valid, then top management has an opportunity to mitigate the situation.
Promotions and other changes should be driven by the performance appraisals in order to demonstrate
the organization’s commitment to advancing qualified employees.
Compensation and Benefits

Employee compensation is a critical factor for both prospective and current employees. Compensation may
take many forms other than money; for example, it may include time off, benefits, insurance, stock, or
pensions. It is important that compensation is in line with prevailing market rates so that employees will
feel that they are being treated fairly.
The primary forms of compensation are:
• Base pay. Base pay is tied to performance evaluations; merit increases reflect good performance.
• Incentive pay. Incentive pay can include any of the following:
o Piecework programs.
o Gain-sharing programs, which reward employees for cost reduction ideas.
o Bonus systems based on financial performance of the entire organization or of one unit.
o Long-term compensation, which provides additional income for managers based on factors
such as stock price or earnings per share.
o Merit pay systems, which base increases on performance.
o Profit-sharing plans, which distribute a portion of the firm’s profits to employees.
o Employee stock-option plans that permit employees to purchase company stock at a below-
market price.
o Incentive pay based on either individual or group performance.
• Benefits. Typical benefits are payment for time off such as vacation, sick leave, holidays and
personal days, employer’s portion of social security contributions, unemployment compensation,
disability insurance, workers’ compensation benefits, life insurance, medical insurance, and pen-
sion plans. Benefits amount to 30-40% of a company’s payroll expense.
• Flexible benefits (“cafeteria” plans). A cafeteria plan is a flexible system that lets employees
choose the combination of benefits that is most appropriate for them. A set amount is designated
for the benefits and the employee chooses how to allocate it.
• Perquisites (“perks”). “Perks” are special privileges, usually limited to top managers, that might
include a company car, company apartment, or a country club membership. Perquisites add to
their recipients’ status and may increase job satisfaction. Some perks are taxable.
• Awards. An in-house award system could recognize exemplary employee behavior.
• Expatriate compensation. When employees are transferred to overseas locations, the employer
can design a compensation package so that the employee’s new living conditions are comparable
to that of the previous location.
Risk and control implications in the employee compensation processes:
Compensation programs should be competitive.
Bonus programs may be useful to motivate and reinforce outstanding performance, but bonuses must
be awarded in a fair and equitable manner.
Bonus programs should not be structured to encourage behavior that is unacceptable. For example,
incentive programs should not encourage risk-taking with respect to safety procedures in order to main-
tain production quotas. Management bonuses should not encourage fraudulent financial reporting.
Necessary controls should be in place to prevent abuses.
Risk and control implications in employee disciplinary actions:
Policies for disciplinary actions should be consistent, well understood, and followed for all employee
infractions, without any preferential treatment.
Employees should know that violations of specific rules will subject them to progressive disciplinary
actions, up to and including dismissal.
Disciplinary actions should be documented, and the documentation should be signed by both the em-
ployee and the supervisor.
Disciplinary actions should send the message that noncompliance with expected behavior is not and will
not be tolerated in the organization.
2 B 2. Procurement
The procurement process contains many opportunities for errors, unethical conduct such as acceptance of
bribes and kickbacks, conflicts of interest, and outright fraud.
Risk and control implications in the organization and responsibilities of the purchasing de-
partment:
The purchasing department should be separate from treasury, accounting, and receiving and shipping
departments.
Only the purchasing department is to make purchases.
The purchasing cycle is the process followed each time a material or service is procured. The basic steps in
the procurement process are as follows:
1) Receive and analyze purchase requisition. A purchase requisition is prepared by the depart-
ment or person that will be the user. The purchase requisition should contain
• The identity of the originator of the purchase requisition
• Signed approval of the requisition
• General ledger account or accounts for the cost to be charged to
• Material specifications
• Quantity required and the unit of measure
• Required delivery date and address to which delivery is to take place
• Any other needed information
Risk and control implications in the requisition process:
All purchase requisitions must be approved. The company should have a policy requiring the use of
approved purchase requisitions and should prescribe procedures for processing them. The approved
requisitions must be maintained on file.
2) Request quotations. If the purchase requisition is for a major item, quotations should be re-
quested from potential vendors. The request for a quote should be in writing, and in addition to
the technical specifications, it should specify price, delivery, and terms of sale. It should be sent
to enough potential suppliers to ensure competitive quotes are received.
3) Evaluate quotes received. The items quoted must be evaluated to make sure they correspond
to the technical requirements. Both the user department and the purchasing department should
be involved in making the choice of suppliers.
4) Determine the price. The purchasing department is responsible for price negotiation with the
chosen supplier and should try to obtain the best price possible.
5) Issue the purchase order. The purchase order is a legal offer to purchase, and it should state
the quantity, the specifications, and the price. It is prepared from information on the purchase
requisition from the requesting department or the quotation and any other information needed. A
copy goes to the vendor and copies are kept by purchasing and are sent to other departments
such as accounting, receiving, and the requesting department. When the supplier accepts the pur-
chase order, it becomes a legal contract for delivery of the goods according to the terms and
conditions in the purchase order.
Risk and control implications in determining the price and issuing the purchase order:
A purchasing officer must review and approve all purchase prices.
The purchasing officer should approve and sign the filed copies of purchase orders. Approved purchase
orders should be required for all purchases.
Purchase order forms should be prenumbered and secured for authorized access only.
The organization should have a code of ethics that specifically prohibits the receipt of gifts from vendors
and restricts business dealings with friends and family. Purchasing agents and purchasing supervisors
should receive regular training and reinforcement in the organization’s code of ethics and in how it
applies to their responsibilities.
Purchasing agent assignments should be rotated periodically to discourage long-term relationships be-
tween purchasing agents and specific vendors.
6) Follow up. The purchasing department follows up to make sure the supplier delivers on time. If
any question arises as to the vendor’s ability to make delivery on time, the purchasing department
needs to know in time to take corrective action such as expediting transportation, finding an al-
ternate supplier, or informing the user so that if necessary, production can be rescheduled.
7) Change orders. If the requisitioning department makes any changes to the specifications or de-
livery requirements, the purchasing department works with the vendor to accomplish the changes.
8) The goods are received and accepted. The receiving department inspects the goods to be sure
the correct items have been received and have not been damaged in transit. The receiving depart-
ment accepts the goods and records the receipt, either by means of a receiving report or by
receiving the items directly in the system. Any variance is noted.
Risk and control implications in receiving:
The receiving department should be separate from the purchasing, accounting, and treasury depart-
ments.
The goods received should be counted and the quantity documented in the receiving department. The
information on the purchase order that is given to the receiving department should not include the
quantity ordered but should require the receiving personnel to physically count the items received and
record the number received. If the receiving personnel know in advance how many items are expected,
they may simply check them off as received without actually counting them.
The goods received should be inspected in the receiving department for quality and receiving information
documented.
If a separate receiving document is used, the forms should be prenumbered and secured against unau-
thorized access.
Policies and procedures for receiving goods should be documented.
9) Additional inspections. If any additional inspection of the order is required, for example by
quality control, the goods are sent for inspection to the other department or held for inspection by
the other department.
10) Problems with an order. If there is any problem with the order, such as damaged goods re-
ceived, the receiving department advises the purchasing department and holds the goods for
further instructions.
Risk and control implications in damaged goods:
If damaged goods are to be returned to the vendor, they are transferred to the shipping department for
processing and documenting. Copies of the rejection and shipping documents should be sent to accounts
payable so the bill does not accidentally get paid.
11) Items received are sent to the originating department or to inventory. If the goods re-
ceived are in order and require no further inspection, they are sent to the originating department
or to inventory.
12) Receipt is reported. The receiving department reports the receipt to the purchasing department,
noting any difference between the received goods and the goods as specified on the purchase
order.
13) Receiving closes out the purchase order. If the order is complete, the receiving department
closes out its copy of the purchase order. If the order is not complete, the receiving department
holds the purchase order open until the order is complete. If another department such as quality
control has also inspected the goods received, it also advises the purchasing department whether
the goods are acceptable or not.
Risk and control implications in receiving:
If partial deliveries are received, they should be properly recorded and monitored for full receipt.
14) Approval of invoice. The supplier’s invoice is approved for payment by the purchasing depart-
ment. The purchasing department checks the purchase order, the receiving report, and the invoice
to determine whether they all agree as to items, quantities, prices, and extensions of prices. The
discounts and terms of the purchase order are checked against the invoice. If all of those things
agree, the purchasing department approves the invoice for payment and sends it to the accounts
payable department to be paid.
Risk and control implications in invoice payment:
Vendors’ invoices should be recorded immediately upon receipt and matched by the purchasing depart-
ment against purchase orders and receiving reports.
No invoices are paid without approval and complete documentation.
Unmatched invoices should be checked frequently with the receiving department to monitor arrival of
goods.
2 B 3. Product Development
Product development is the application of research findings or other knowledge to a plan or design for
the production of new or substantially improved materials, devices, products, processes, systems or ser-
vices before the start of commercial production or use. Development includes not only original, new
products but also product improvements and modifications.
Product development is an area that businesses need to focus on in order to remain competitive and have
something new and fresh to offer to their markets. New technologies, changing customer needs, shortened
product life cycles and competition at home and abroad put companies at risk if they lack strategies for
developing new products.
However, new product development is risky and new products frequently fail. Recent research approximates
the failure rate at 95% in the U.S. and 90% in Europe. Strategy development and implementation are
impeded by development costs and capital shortages, governmental constraints, fragmented markets,
shortages of ways to improve basic products, shorter product life cycles, and the requirements of faster
development time constraints, to name a few.
The best strategy is usually identifying a product that is both unique and superior in the marketplace,
with higher quality, new features, and higher value in use by customers and in having a clearly defined
product concept. The company needs to define and assess the target market, the product requirements,
and the benefits prior to beginning development. To successfully develop new products that will deliver
superior value to its customers, the company must understand its consumers, its markets, and its compet-
itors.
Thus, new product planning requires a systematic new-product development process. The new product
development process has eight steps:
1) Idea generation involves a systematic search for new product ideas. More and more businesses
are naming a person to head up a group that is responsible for innovation. The person might have
a title like chief marketing officer or director of design, or even chief innovation officer; but what-
ever the title, that person is responsible for the systematic generation of ideas.
A company usually finds one idea that is worth pursuing for every 10 ideas put forth, so the
important thing is to generate a lot of ideas. Ideas can come from internal sources, both manage-
ment and non-management employees. Ideas can also result from watching and listening to
customers to find out what they want and need. Sometimes, consumers even create new products
or new uses for existing products on their own. Competition-watching is another way to generate
ideas, by buying competitors’ products to see how they work and watching their advertisements.
Channel partners may also supply good new-product ideas, because they are close to the market
and know about customer problems or new product possibilities.
Companies should have a clear line of communication set up so that anyone can send an idea to
the idea manager. Furthermore, the company should have a formal recognition program in place
to reward people for the best new ideas. Having an idea manager and a systematic method of idea
generation helps to create a culture of innovation, because it demonstrates that top manage-
ment encourages and rewards innovation. A culture of innovation will produce many more ideas.
2) Idea screening is the first stage in the selection process among all of the ideas presented. Idea
screening is used to identify the good ideas and screen out the poor ones as early in the process
as possible. It is important to limit further development to ideas that have the potential to be
developed into profitable products. Therefore, in addition to having an idea manager, the company
should have a multidisciplinary idea committee with people from R&D, engineering, purchasing,
operations, finance, and sales and marketing who meet regularly to evaluate proposed new ideas
for products and services. The committee evaluates each idea against some general criteria, such
as “Would this product be truly useful?” “Is it good for our particular company?” “Do we have the
people, skills and resources to do it successfully?”
3) Concept development and testing. Once a new product idea has been accepted, the next step
is developing it into a product concept. A product concept is the idea stated in detailed, mean-
ingful consumer terms. The idea is developed into alternative product concepts, such as different
versions of the potential product, in order to find out how consumers will react to each one. A
company might create several product concepts. It then does concept testing with groups of
target customers. The consumers are exposed to the concept and are asked to answer questions
about it. Based on their answers, the concepts are screened again to eliminate the ones that do
not have enough appeal to the target consumers. In some concept testing, the company may use
just a description of the product, but companies are also using virtual reality software programs
that simulate the products in their testing of concepts.
4) Marketing strategy development is the next step for products that pass the concept testing
screen. An initial marketing strategy for introducing the new product to the market is designed.
The marketing strategy statement consists of three parts: (1) the target market, the product’s
position in the market, and sales, market share and profit goals for the first few years; (2) the
planned price, distribution, and marketing budget for the first year; and (3) the planned long-run
sales goals, profit goals and marketing mix strategy.
5) Business analysis. Once the product concept and marketing strategy have been decided, man-
agement performs a business analysis to review the sales, costs and profit projections for the
product and determine whether they meet the company’s objectives.
6) Product development is the development of the product concept into a physical product. The
R&D department and engineering group develop and test one or more versions of the product in
order to design a prototype. Testing includes not only whether the product will perform effectively
but also whether it will perform safely. Children’s toys, for example, undergo rigorous testing in
an attempt to create any possible condition that a child could subject the toy to, in order to make
sure that the toy will not be dangerous under any circumstance. Consumers also use the product
and rate it.
7) Test marketing introduces the product and its marketing program into selected markets. Test
marketing gives the marketer some experience marketing the product before incurring the expense
of a full product introduction rollout. Test marketing can be costly, but it is not as costly as making
a major mistake.
8) Commercialization is the last step in the process. If the test marketing goes well, the company
goes ahead with commercialization, or introduction of the new product into the market. Com-
mercialization includes going into full production, which means committing manufacturing facilities
to the new product. Marketing costs for packaging, advertising, sales promotion and other mar-
keting efforts could be quite high. The commercialization step also includes deciding where to
launch the new product and how widely. Smaller companies usually roll out a new product gradu-
ally over time, perhaps entering attractive cities or regions one at a time, while international
companies may use global rollouts.
New product development can be done sequentially as described above, but that process can be very
slow. In a competitive market, where new products are being introduced every day, a company cannot
afford to take too much time developing new products because it could miss too many opportunities and
could bring products to market that are already obsolete. Thus, many companies are using simultaneous
product development. In simultaneous product development, the same steps are completed, but an inter-
departmental team works closely together, overlapping the steps in order to save time. The product does
not get passed from department to department. Instead, the team of people all work on it simultaneously
in their areas of expertise in order to move it through the process faster. One disadvantage to simultaneous
product development is that it can cause increased organizational tension and confusion. Above all, the
company must make sure that it does not rush to market with an inferior product. The goal is to get to
market faster and better, not just faster.
Risk and control implications in product development:
The best way to manage product development risks is to be proactive by identifying the risks to the
project and addressing them before they can adversely affect the project.
One major potential risk is the risk that the new product may not be what customers want and
need. If too few features are included in a new product, customers may deem the product too simple.
Alternatively, if the product contains too many features, customers may reject it as too complex. Thus,
concept testing (step 3) using focus groups of target customers is a vital part of the product development
process. Conducting regular market research is also important for receiving feedback from customers.
Building a working prototype (step 6) helps determine if the product does what it is designed to do, and
the prototype should be tested both within the company and with consumers. Test marketing (step 7)
after the product has been prototyped and thoroughly tested should be performed in order to assess
customer reaction to how the product looks, feels, and functions.
The product development process may also involve technical risks and operational risks. Technical
risks may arise from the need to use new technology or new equipment in the development process.
Operational risks may include material sourcing risks or difficulties in transporting the materials to their
required location. The people involved on the product development team need to have all relevant
knowledge and skills regarding the technical aspects of developing the product, requiring the product
development team to be multidisciplinary. If internal expertise is lacking, outside experts should be
engaged. Finally, a timetable for the completion of the product development process should be used,
and periodic reviews should be scheduled.
Financial risks include the potential that the new product will not be able to generate adequate demand
at a price that will provide a profit. High needs for resources during product development can also cause
financial risks if management continues to add resources to the project. Budgets should be developed
for the various phases of the project, and reports of variances between actual expenditures and budgeted
expenditures should be produced and reviewed regularly. The development process should include strat-
egies to reduce production costs such as seeking ways to simplify the manufacturing, identifying
alternative components, or seeking alternative sources for materials that are of the same quality but
less expensive.
Timing risks may arise if the product development begins before the preliminary steps have been
completed. Furthermore, there may be problems if the company starts developing another new product
while it is still in the process of launching a previous product, especially if it does so before the previous
product has produced any returns. The company’s resources may be spread too thinly, funds may be
limited, and both new products may face delays because of sharing resources. To address these potential
risks, a reasonable timetable should be established to control the pace of product development, and
everyone in the organization should be aware of the company’s objectives and priorities with respect to
new product development.
2 B 4. Sales and Marketing

The sales department is responsible for receiving customer orders. Under the revenue recognition guidance
in IFRS 15, Revenue from Contracts with Customers, certain steps need to be taken every time an order is
received, a sale is made, or a contract is negotiated, and the sales department needs to be involved in
some (though not all) of them.
IFRS 15 applies to all revenue transactions as long as a valid contract exists, with the exception of leases,
insurance contracts, various types of financial instruments such as investment securities and derivatives,
and some nonmonetary exchanges. For all other sales transactions, whether they involve a written contract
or not, IFRS 15 applies.
The steps in revenue recognition include:
1) Identify the contract(s) with the customer
2) Identify the performance obligations in the contract, which are promises to transfer to a customer
distinct goods or services
3) Determine the transaction price, or the amount of consideration the entity expects to be entitled
to receive in exchange for transferring the promised goods or services to the customer
4) Allocate the transaction price to the performance obligations in the contract on the basis of the
relative standalone selling prices of each distinct good or service promised in the contract
5) Recognize revenue when a performance obligation is satisfied by transferring a promised good or

service to a customer.
IFRS 15, Revenue from Contracts with Customers, will be covered in more detail later.
Risk and control implications in sales and marketing:
One of the greatest risks in sales is the imposition of unreasonable sales goals by top management,
particularly when sales personnel’s continued employment or needed commissions are dependent on
reaching their goals.
Not long ago, it was revealed that in an effort to reach unreachable sales goals, employees at a major
U.S. bank had opened millions of accounts in the names of customers who had never requested the
accounts. Some of the unauthorized accounts led to unauthorized fees being charged to the customers.
Some employees who refused to participate in the fraudulent activity were fired for not having reached
their sales goals. More recently, the same problem has been discovered in other banks, as well. A federal
investigation of 40 large and midsize U.S. banks by the Office of the Comptroller of the Currency, trig-
gered by the initial publicity, found similar activity in several of the banks. The OCC’s report stated that
the problem had been caused by short-term sales promotions combined with weaknesses in policies,
procedures, and risk controls at the banks, enabling the unauthorized accounts to be opened.
When management designs incentives, it needs to make sure it is not incenting fraudulent behavior.
Furthermore, it needs to make sure policies and procedures are in place and are followed and that all
necessary controls are in place and are operating.
(Continued)
A few other risk and control implications of sales include, but are not limited to, the following.
● Sales personnel should not be the ones to approve credit for customers. All credit should be approved
by the credit department. No credit sale should be accepted until approved by the credit department.
● All shipments of goods should be authorized by a shipping supervisor and only after receiving all
necessary documentation. Documentation includes a packing slip that has not been prepared until
the invoice has been prepared. For a credit sale, the invoice and packing slip are not prepared until
after the customer’s credit has been approved. If the credit approval includes security for the debt,
results of a lien search and a copy of the financing statement granting the security interest in the
collateral are part of the documentation, and no shipment of goods takes place until the financing
statement has been signed by the customer and filed with the appropriate public authority.
● For a credit card sale, the shipping documentation should not be prepared until the credit card charge
has been authorized. Credit card charges are authorized as “pending charges” when an order is first
received, but they do not become actual charges until the seller releases the charge, and the charge
should not be released until the order is actually shipped. The “pending charge” authorization remains
in effect for only a certain period of time, usually about 5-7 days, depending on the credit card
processor’s policies. If the charge is not released by the seller within that period, the “pending” au-
thorization drops off and a new authorization is required. Therefore, whenever possible, shipment
should always take place and the charge should be released before the initial authorization drops off
because a new charge may not be approved. Or, if shipment cannot take place within that period,
shipment should be delayed until a new charge has been approved.
● Price lists should be provided to sales and marketing personnel, as well as to accounting personnel,
and any price changes should be approved by management and documented. Special price adjust-
ments should be approved by management, as well.
● If sales personnel receive deposits or other payments from customers, procedures and controls for
the handling of the payments should be in place.
● If any sales of items other than items regularly sold take place—for example, the sale of equipment
used for renting to customers—they must be approved by management and all relevant information
documented.
2 B 5. Logistics
Logistics is a subset of supply chain management. Supply chain management is the active management
of supply chain activities by the members of a supply chain with the goals of maximizing customer value
and achieving a sustainable competitive advantage. Supply chain activities cover product development,
sourcing, production, logistics, and the information systems needed to coordinate the supply chain activi-
ties.
According to the Council of Supply Chain Management Professionals,
Logistics management is that part of supply chain management that plans, implements,
and controls the efficient, effective forward and reverse flow and storage of goods, services
and related information between the point of origin and the point of consumption in order
to meet customers' requirements.
Logistics management activities typically include inbound and outbound transportation

management, fleet management, warehousing, materials handling, order fulfillment, logis-
tics network design, inventory management, supply/demand planning, and management
of third party logistics services providers. To varying degrees, the logistics function also
includes sourcing and procurement, production planning and scheduling, packaging and
assembly, and customer service. It is involved in all levels of planning and execution--
strategic, operational and tactical. Logistics management is an integrating function, which
coordinates and optimizes all logistics activities, as well as integrates logistics activities with
other functions including marketing, sales manufacturing, finance, and information tech-
nology.8
Risk and control implications in logistics:
Of the many risks inherent in the supply chain, some of the major ones include facility loss, supplier
loss, and supply chain risks such as quality problems and transportation losses and delays. Risk man-
agement and controls include having a backup plan in case of facility loss, avoiding the use of sole
suppliers, and, for supply chain risks, carrying adequate amounts of safety stock in inventory, particu-
larly when sourcing from overseas. In addition to insurance on facilities, insurance programs are
available to mitigate losses during transportation.9
8
https://cscmp.org/CSCMP/Educate/SCM_Definitions_and_Glossary_of_Terms/CSCMP/Educate/SCM_Defini-
tions_and_Glossary_of_Terms.aspx?hkey=60879588-f65f-4ab5-8c4b-6878815ef921, accessed October 15, 2018.
9
Managing Risk in the Global Supply Chain, a report by the Supply Chain Management Faculty at the University of
Tennessee, Summer 2014.
2 B 6. Outsourcing Business Processes

One reason that companies outsource is so they can concentrate on their core competences and gain com-
petitive advantage. Companies should outsource only those activities that are not vital for its existence,
such as accounting, payroll, and some IT functions. It is also possible that over time the cost of the out-
sourced function will decrease as the company performing the outsourced work becomes more efficient.
Outsourcing a function such as IT or even internal auditing may also be beneficial when a company has
many small operations over a wide geographic area. Instead of having to provide IT support or internal
audit support across a large area, a specialist company may be able to provide the needed support more
cost effectively than if it were done internally.
One potential downside is that the outsourcing company loses direct control of the function. Problems with
the function may be more difficult to identify and correct, and in worst case scenarios the outsourced
function may need to be reassigned or brought back in-house.
Risk and control implications of outsourcing business processes:
A product or service can be outsourced, but the risk cannot be outsourced. The company that outsources
its business processes retains the risk.
The outsource provider’s controls over the outsourced process need to be reviewed and monitored on
an ongoing basis.
Delivery performance and customer satisfaction may decline.
Product or service quality may decline. A company that outsources its processes must select, qualify,
and manage its outsourcing partners carefully to ensure that quality does not deteriorate.
Problems may arise in the transition period if insufficient planning and resources are not dedicated to
the project.
The financial strength of outsourcing partners and suppliers must be reviewed and monitored.
Statistics and performance of the outsourcing partner need to be monitored. The service agreement
should be reviewed and updated periodically. Billing accuracy needs to be monitored.
2 C. Project Management Techniques

Project management entails planning, managing, and controlling large projects that are composed of many
different jobs performed by many different departments and people. When projects are very large and
complex, the manager needs a system for keeping track of all the information and coordinating the various
activities to complete the entire project on time.
Many activities in a project are dependent upon the completion of other activities, and they cannot begin
until the other activities have been completed. Some activities are critical because they must be completed
exactly as scheduled to avoid slowing down the whole project, whereas other activities are non-critical and
may be delayed for a while before their delay harms the entire project.
Proper scheduling can make the difference between completing the project on time and within budget or
missing deadlines and having cost over-runs. In addition, proper scheduling can help foresee and avoid
potential difficulties in the completion of a project, thereby reducing total time required and related costs.
Thus, in order for organizations to be competitive, they must reduce project time.
A project is a temporary endeavor undertaken to achieve some specified aim or objective, such as
creating some unique product or service. It is important to understand that even though projects are tem-
porary, they help organizations achieve long-term objectives. The planning, execution, and monitoring of
major projects sometimes involve setting up a special temporary organization consisting of project teams
and one or more work teams.
The project life-cycle consists of the following stages:
• Conceptualization is the setting of project goals and objectives.
• Planning is organizing facilities and equipment, personnel and task assignments, and scheduling.
• Execution is the actual work that is performed.
• Termination occurs when the project is released to the end user and project resources are redis-
tributed.
Project planning has certain unique guidelines:
• Projects are schedule-driven and results-oriented. The schedule and the results are more im-
portant than adhering to a process.
• Achieving overall objectives and adhering to the little details are of equal importance.
• Project planning is done out of necessity.
• Project managers know the motivational power of a deadline. Deadlines shape individual and
team objectives.
Two of the more common project management techniques are Gantt Charts and PERT/CPM.
2 C 1. Gantt Charts
In a Gantt chart, a project is divided into activities or tasks. These tasks are then plotted on a chart that
has “tasks” listed on the vertical axis and “time” on the horizontal axis. The tasks are then placed into the
time frame during which they need to be completed. A Gantt chart does an excellent job of showing when
different steps need to be started and completed, and the tasks may be color coded in order to show who
oversees which task or when they should be completed. Gantt charts are easy to complete and also provide
a quick way to see whether or not the project is on schedule.
However, Gantt charts have a few weaknesses.
• They do not show the interconnection between the different steps of the project.
• They do not show the critical path of the project.
Below is an example of a Gantt Chart.
Gantt Chart
Report Date
22/10 29/10 5/11 12/11 19/11 26/11 3/12 10/12 17/12 24/12 31/12
Preliminary
Investigation
Write Report
Interviews
Training
Evaluation
Final Report
In the above example, the “evaluation” stage is ahead of schedule. The “report writing” stage, however, is
behind schedule because it should have been completed by the current report date.
2 C 2. PERT/CPM
The Concept of PERT/CPM

Program Evaluation and Review Technique (PERT) and Critical Path Method (CPM) have the same
general purpose. Through PERT/CPM, one group of activities controls the entire project because it is the set
of activities that will take the longest time to complete. Thus, management resources should be concen-
trated on these “critical” activities, which will determine the fate of the entire project. Other less critical
activities can be rescheduled, if necessary, and their resources can be reallocated to a degree without
affecting the whole project.
PERT/CPM involves graphical representations of the project, called the project network. The project’s
beginning, end, and each activity are represented by nodes on the network. Lines, or arcs, connect the
nodes and show the relationships between and among them. The project network helps the manager visu-
alize the activity relationships and assists in carrying out the PERT/CPM computations.
Once the form of the project network is understood, the time requirement for each activity can be ascer-
tained, along with the set of critical activities and the time required for the whole project. Each activity,
represented by a node, is assigned a time for completion.
Once the expected time for each activity is known, the most critical path can be pinpointed. A path through
the network is a series of connected nodes that go all the way from the beginning to the end of the project.
A network may have many paths, and all of the paths must be completed in order to complete the project.
Therefore, the critical path is the one that requires the most time, because if activities on that path are
delayed for any reason, the entire project will be delayed. Activities on the critical path are called critical
activities for the project.
Some activities may have slack time, which is the amount of time that an activity can be delayed without
putting the whole project behind schedule. Paths that are not designated as critical have slack time. The
expected time to complete the entire project is the sum of the expected times for each of the activities on
the critical path.
The figure below is an example of a PERT/CPM diagram:
4 8
2 2
S A C E F
3 5
2 6
Immediate
Activity Time (Hours) Predecessor
SA 2
AB 4 SA
AC 3 SA
BE 8 AB
CD 2 AC
CE 5 AC
DF 6 CD
EF 2 CE
In the chart, the critical path is SABEF because that is the path with the longest completion time: 16 hours.
Path SACEF takes only 12 hours. Activity CE is not part of the critical path and therefore it has slack time.
Activity CE could be increased in time by 4 hours and the project as a whole could still be completed on
time.
The company can use this information to reallocate resources from one of the paths with slack to the critical
path, reducing the overall time. However, it is important to remember that there will always be a critical
path. If the company reduces the time for activity BE to 4 hours, the time for path SABEF becomes only 12
hours, and path SACDF then becomes the critical path with a time of 13 hours.
2 D. Contracts
A contract is a promise or an agreement between two or more parties that is enforceable, which means
that if one party fails to perform as they are supposed to under the contract, the other party may go to
court to enforce the terms of the contract. If a party is unable to or refuses to perform as required by the
contract, the courts can award monetary compensation to the other party. In addition, in order to be
considered legally enforceable, contracts must be entered into voluntarily by all parties.
Bilateral Contracts Versus Unilateral Contracts

Bilateral contracts are contracts in which each party to the contract has an obligation to the other party
to keep a promise it has made in the contract. In other words, each party is both an obligor and an obligee.
Almost all business contracts are bilateral because they impose requirements on both parties.
Note: An obligor is a party that is legally or contractually obliged (required) to provide something to
another party, whether it be goods, services, or a payment. An obligee is the party to whom a particular
obligation is owed.
In a bilateral contract, if the provider fails to provide the promised good or service, the provider can be
found in breach of contract; and if the recipient of the good or service fails to pay, the recipient can be
found in breach of contract.
Unilateral contracts are contracts where only one of the parties makes a promise to the other one. The
party that makes the promise usually promises to pay the other party if the other party provides a good or
a service. However, unlike with bilateral contracts, the provider is not obligated to actually provide the good
or service. If the provider does, in fact, provide the good or service, though, the recipient is obligated to
pay the specified amount.
Because under a unilateral contract there is no guarantee that the good or service will be provided, unilat-
eral contracts are almost never used in business. They are enforceable under contract law, but legal issues
cannot arise unless the providing party claims to have fulfilled the promise in the contract. Usually legal
issues arise if the recipient has not paid the promised amount. In that case, determination of contract
breach would depend on whether or not the terms of the contract were clear and whether or not it can be
proven that the provider fulfilled the contract adequately.
Elements of Valid Contracts

The primary elements for contracts to be enforceable are:
• Offer
• Acceptance
• Consideration
• Proper Form
• Lawful Object
• Competent Parties (Legal Capacity to Contract)
Offer
The offer is what will be performed under the contract. One party must present the offer to the other party.
In order for an offer to be valid, it must be seriously intended, communicated, and definite in terms.
1) Seriously intended. Offers are not enforceable unless they are seriously intended. When deter-
mining the seriousness of an offer, courts apply a “reasonable person” standard, also known as
the reasonable person test. Under this standard, courts make the following inquiry: “Would a
reasonable person have concluded that the offer was seriously intended by the offeror?” If the
answer is “yes,” then the courts will enforce the offer. Illusory promises (that is, promises made
on a whim) or promises made in jest (that is, jokes) fail the reasonable person test and therefore
are not enforceable offers.
Example: Ann says to Bob: “If I feel like it, I will sell you my car for 10.” Is this a valid offer?
No, this is not a valid offer.
2) Communicated. Offers may be communicated either through words or actions.
3) Definite in terms. Generally, time, quantity, and price must be stated.
Revocation (Canceling) of an Offer

Offers may generally be revoked by the offeror. However, there are specific rules that govern the offer
revocation process:
• A revocation is effective at the time it is received by the offeree, not when it is sent by the
offeror.
• Usually, an offeror can revoke an offer any time before the offer is accepted.
• Even though an offeror may guarantee an offeree that the offer will be held open, the offeror
can revoke the offer before it is accepted (notwithstanding the guarantee and even if the
guarantee has been reduced to writing).
Acceptance
After an offer is made, it must be accepted by the other party for there to be a contract. Acceptances must
be both unconditional and communicated.
• Unconditional. The offeree must comply with all the offeror’s terms and conditions, and the
terms or conditions cannot be changed. For example, if the offeror specifies that acceptance must
be sent via certified mail, that condition must be honored. Thus, an offeree who sends acceptance
via FedEx or other private delivery service changes a term of the contract.
o Requests and inquiries do not end an offer. If the offeree asks for clarification of a term
or asks for more information about an item involved in the contract, this does not constitute a
rejection. For example, Ann offers to sell Bob a car for 500. Bob then asks Ann if she is willing
to lower the sales price. This is not a counteroffer; it is merely an inquiry. Thus, Ann’s offer
is still open.
o A counteroffer ends an offer. A counteroffer is the offeree changing one of the terms of
the offer and resubmitting it to the offeror. For example, Ann offers to sell Bob a car for 500.
Bob then tells Ann that he is willing to pay only 400. Bob has made a counteroffer. Ann’s
original offer ended when Bob made his counteroffer.
o Rejection ends an offer. Once the offeree rejects an offer, he or she may not have a change
of mind and later try to resurrect the original offer. Rejection of an offer occurs when the
offeror receives notice of the rejection.
o Revocation ends an offer. An offeree may not accept an offer once it has been revoked.
Revocation of the offer is effective when the offeree receives notice of the revocation.
o Death or insanity ends an offer. An offer ends if either contractual party dies or becomes
insane before the offer is accepted; that is, the required “meeting of the minds” cannot occur.
Thus, if the offeror dies or goes insane after making the offer but before it is accepted, then
the offeree cannot accept the offer even though it was made while the offeror was alive and/or
competent.
o Destruction of the subject matter ends an offer. If the subject matter of the contract is
destroyed, there is no remaining object for the contract. As such, the offeree cannot accept
the offer that was made while the subject matter was whole.
o Being contrary to public policy ends an offer. If an offer is considered to be against public
policy, such as restraining competition, the offeree cannot accept the offer.
o Sale of the subject matter ends an offer. If the offeror sells the subject matter to a party
other than the original offeree and the original offeree learns of this sale, then the offer
ends when the original offeree learns of the sale.
o The passing of a reasonable amount of time after an offer is made and it is neither
accepted or responded to ends the offer. This is called lapsing.
• Communicated. The offeror and offeree must communicate in some fashion. This communication
may occur through words or through actions (such as using the property).
Note: Acceptance may not be assigned to another party. An offer can be accepted only by the offeree,
the party to whom the offer is made. The offeree may not assign the right of acceptance to another
person.
Consideration
Consideration is what is given up in the contract. Both parties must give up something, though the value
of what they give up does not need to be equal. This concept of consideration is represented in the Latin
phrase quid pro quo, which means “this for that.”
Outlined below is what may make up consideration and what may not.
• Legally sufficient. In order for a contract to be enforceable, consideration must be “legally suffi-
cient.” However, “legally sufficient” does not mean that consideration must be of equal value;
instead, courts expect and allow contractual parties to make their own deals. In fact, consideration
need not even be measurable in a monetary sense.
Example: Uncle Jim promises to pay Bob 25,000 if Bob stops smoking and drinking alcohol
during his senior year in college. Bob stops smoking and drinking for the specified time, but
when he tries to collect the 25,000, Uncle Jim refuses to pay and says, “It was good for your
health.” Is Bob entitled to the 25,000?
Yes, Bob is entitled to the 25,000 because there was adequate consideration since he gave up
something that he was legally able to do.
• Not limited to money. Consideration can take many different forms. For example, consideration
can involve personal services that are difficult to measure in a monetary sense.
• Past consideration is not legally sufficient. A promise to do something that already has been
done is not sufficient because there was no mutual bargaining between the parties.
• Pre-existing obligations are insufficient consideration. That is, demanding additional mone-
tary compensation to do something that one already is contractually obligated to do is
unenforceable.
Example: Ann agrees to pay Cam 5,000 if he will build her a new garage by December 23.
Cam agrees but later discovers that he has insufficient staff to complete the job on time. Cam
demands an additional 1,000 to finish the job on time, and Ann agrees to the extra payment.
Cam finishes the job on December 23, but Ann refuses to pay the extra 1,000. Is Ann contrac-
tually obligated to pay Cam the extra 1,000?
No, Cam may not collect the extra 1,000 because there was a failure of consideration.
Additional Consideration When There Is a Modification to a Contract

When a contract term is changed, new consideration must be provided because a new contract is created
if a substantial contractual term is changed. Therefore, new consideration is required to satisfy the elements
of the new contract.
Proper Form
Generally, contracts do not need to be in writing, nor do they need to have a specific form or format.
An oral contract is usually as enforceable as a written contract. However, the Statute of Frauds requires
that some contracts be in writing to be enforceable, such as:
• Realty Contracts. For the purchase of realty but not rental realty.
• Long-Term Contracts. More than one year in duration; the time frame is measured from the
time the contract starts, not from the time performance starts.
Note: A long-term contract that has been performed does not need to be in writing.
• Assumption of the Debt of Another Person. Promises to answer for the debts of another,
including an executor’s promise to be personally liable for the debts of an estate.
• Marriage Contracts.
Lawful Object
In order for a contract to be valid, the subject matter of the contract must be legal. Thus, contracts that
have a subject matter that is illegal are void as a matter of law.
Covenants not to compete are enforceable as long as they are reasonably needed to protect a business,
are specified for a reasonable amount of time, and are reasonable as to physical proximity.
Example: Bill sells his bookstore to Cathy. Bill agrees not to open another bookstore within the same
city for the next three years. Is this agreement enforceable?
This agreement is enforceable because it meets the reasonableness standards.
Competent Parties
In order for an enforceable contract to exist, there must be a meeting of the minds (mutual assent) between
the involved parties. Incompetent parties are incapable of achieving the required mutual assent. The most
common types of incompetent parties are minors (usually under the age of 18), those who are mentally
disabled, those incapacitated due to drug or alcohol abuse, and the insane. It is generally a matter of public
policy to protect these groups from the enforcement of contracts against them.
Minors (Legal Infants)

Minors are individuals who have not yet reached the age of legal majority. This age, which varies depending
upon the individual’s state or country of residence, is usually 18. Minors have different rights under con-
tracts than people of legal age. Minors have the absolute right to disaffirm contracts at any time while they
are underage, and they also may disaffirm within a “reasonable” time after reaching the age of majority.
Example: At age 16, Ann bought a new car. She kept the car for two years and drove it 40,000 miles.
At the end of year two, Ann returned the car to the dealer. May the dealer deduct any money for vehicle
wear and tear, or must Ann’s total purchase price be refunded?
The dealer must refund Ann’s original purchase price; the dealer may not deduct any money for vehicle
wear and tear.
Minors do have a duty to return whatever goods they received when they disaffirm a contract. Also, minors
are liable for any laws that they break in the course of their dealings (for example, presenting false docu-
mentation claiming they are 18).
Example: Referring to the previous example of Ann, age 16, purchasing a car, assume that at the time
of the purchase she provided the dealer with false identification indicating that she was an adult. Is the
dealer required to refund the total purchase price to Ann?
Although Ann still has the right to disaffirm the contract, she is liable for tort damages. Accordingly, to
compensate for damages caused by Ann’s fraud, the dealer will be allowed to retain a reasonable amount
from Ann’s original purchase price.
Mentally Incapacitated Individuals or Incapacitation Due to Alcohol Abuse or Drug Abuse

Individuals may disaffirm a contract if, due to their consumption of alcohol or drugs or because of a mental
disability, they were incapable of understanding the nature of the contract.
Insanity
Insane parties to a contract may disaffirm the contract. If such parties fail to disaffirm, then a valid contract
remains in place. However, once an individual is adjudicated insane (that is, determined to be insane by
a court of law), all future contracts entered into by that individual are void.
3. Data Analytics CIA Part 3
3. Data Analytics
Data analytics is the process of gathering and analyzing data in a way that produces meaningful
information to aid in decision-making. As businesses become more technologically sophisticated, their
capacity to collect data increases. However, the stockpiling of data is meaningless without a method of
efficiently collecting, analyzing, and utilizing it for the benefit of the company.
Why is data analytics important to internal auditors? At its core, an internal auditor’s job is data-centered
and internal audit is therefore responsible for ensuring that the company’s data is accurately recorded,
stored, evaluated, and reported. Data analytics provides auditors with the tools to manage data. The IIA’s
GTAG 16: Data Analysis Technologies, which is available to IIA members for free from their website,10
provides a high-level overview of data analytics and also shares a key insight: “[Data analytics] enables
internal audit to identify changes in organizational processes and ensure that it is auditing today’s risks—
not yesterday’s.”
Big Data and the Four (or Five) V’s of Data

Big data refers to vast quantities of information that cannot be analyzed using standard software tools,
giving rise to the need for data analytics. “Big data” can be broken down into three categories:
1) Unstructured data has no defined format or structure. Examples include word processing docu-
ments, email, audio recordings, photos, videos, and information contained on websites and social
media.
2) Semi-structured data has some format or structure but does not follow a defined model. Exam-
ples include XML files, CSV files, and most server log files.
3) Structured data is organized, oftentimes in a database. Examples include the data in CRM or ERP
systems.
The four V’s of data refer to the following four attributes:
1) Volume: The amount of data that exists. Data analytics is best suited to process immense
amounts of data.
2) Velocity: The speed at which data is created. Data analytics is designed to handle the rapid influx
of new data.
3) Variety: The types of data. Data analytics can capture and process diverse and complex forms of
information.
4) Veracity: The accuracy of data. Controls and governance over data are essential to ensure that
data is accurate because poor-quality data leads to inaccurate analysis and results, commonly
referred to as “garbage in, garbage out.”
Some data experts have added a fifth V:
5) Value: The benefit that the organization receives from data. Without the necessary data analytics
processes and tools, an organization is more likely to be overwhelmed by data than helped by it.
An investment in big data and data analytics should provide measurable benefits.
10
https://na.theiia.org/standards-guidance/recommended-guidance/practice-guides/Pages/GTAG16.aspx
Section I 3. Data Analytics
Real-World Example of Data Analytics

A common, real-world example of data analytics can be found in the alerts that banks send out to their
credit and debit card holders when there is a suspicion of fraudulent activity. The bank’s data analytics
system creates a unique user profile based on spending history and habits, then scrutinizes incoming
charges to highlight any activity outside established purchasing patterns.
Sometimes suspicious purchase patterns are obvious. For example, a bank would most likely flag a charge
made in Argentina on a card from a person living in Japan, especially if that individual has no purchase
history in South America. A very large transaction—for example, one that is twenty times higher than the
average purchase amount—would most certainly trigger an alert. The data analytics algorithms that are
designed to spot suspicious activity can be highly sophisticated. For example, a fraud alert might be raised
if a city-dweller’s card were used to purchase farming equipment.
It would be impossible for one person to make such complex analyses in real-time, especially when it is in
the bank’s best interest to process transactions instantly. The cost of developing data analytics is a worth-
while investment for banks because card fraud is expensive for merchants and inconvenient for customers,
and preventing card fraud is much less costly than mitigating it after the fact.
Data Analytics Process

The data analytics process has five steps:
1) Define the question. Knowing which questions need to be answered will guide the entire process.
Questions of particular interest to an internal auditor might be “Where is fraud occurring?” or “Who
is committing fraud?”
2) Obtain relevant data. While this step is straightforward on the surface, gathering data can often
be the most challenging part of the process. All of the necessary data may not be in the same
system, may not be in the same format, or may not even be accessible to the internal auditor
without working with the organization’s IT staff.
3) Cleaning/normalizing the data. Cleaning the data is the process of removing duplicate data
and making sure that data pulled from different systems has the same format. For example, one
system may use two fields—“First Name” and “Last Name”—to identify each customer, while an-
other system may have only one field titled “Customer Name.” Normalizing the data after
cleaning is the process of ensuring that the data is consistent and does not contain any irregular
or unexpected data, which could represent a problem either with the data or the underlying pro-
cess. For example, if sales each month are between a certain range but one month shows sales
ten times higher than any other month, there most likely is an issue with the data; either revenue
was recorded incorrectly or the data was not obtained accurately.
4) Analyze the data. Once the data has been gathered, cleaned, and normalized, only then can it
be analyzed and interpreted. Auditors will need to trace results back to source data and work with
other business units to make sure that it is correctly interpreted.
5) Communicate results. Regardless of how helpful the results of the analysis and audit are, they
are useless if they cannot be communicated. The auditor must provide the results of the analysis
to the right people in a way that can be understood and so that appropriate action can be taken.
Visual tools such as graphs and charts can present complex data in a format that can be easily
processed.
Data governance—the policies and procedures that define how a company creates, transforms, stores,
protects, and uses data—can make the process of obtaining, cleaning, and normalizing the data significantly
easier. With well-defined data governance parameters, the internal audit activity can more easily obtain
high-quality data that requires less work to use.
Types of Data Analytics

There are four categories of data analytics.
1) Descriptive analytics answer the question, “What happened?” by reporting past events. Descrip-
tive analytics is the simplest type of data analytics, but it still requires that the auditor have the
data necessary to create an accurate picture of past events.
2) Diagnostic analytics answer the question, “Why did it happen?” through the process of breaking
data down into segments. For example, an auditor might break sales data down into parts such as
revenue by region or by product rather than revenue in total.
3) Predictive analytics answer the question, “What is going to happen?” by processing large quan-
tities of data to identify patterns and make predictions about the future. A sales forecast that looks
at past trends to predict future sales is a form of predictive analysis.
4) Prescriptive analytics answer the question “What needs to happen?” by charting the best course
of action based on an objective interpretation of the data. For example, prescriptive analytics
might generate a sales forecast and then use that information to determine what additional pro-
duction lines and employees are needed to meet the sales forecast.
Some other specific types of data analytics include the following:
• Anomaly detection. Identifying data that does not fit generally-established patterns.
• Network analysis. Putting data into a graphic form and looking for patterns. (“Network” in this
context refers to a network diagram, not a computer/data network.)
• Text analysis. Gathering data from text rather than structured data. An example of text analysis
would be to harvest information from company emails.
• Audio-visual analytics. Gathering data from audio or video sources. In the context of internal
audit, this could include data extracted from video surveillance.
Implementing Data Analytics in the Internal Audit Activity

Implementing data analytics is a continuous process that requires ongoing investments in people, pro-
cesses, and technology. Without properly trained staff, defined procedures, and the necessary analytics
software, it would be extremely difficult to successfully integrate data analytics into the IAA.
Ideally, the CIO and other executives should promote data analytics from the top down, creating an envi-
ronment where the implementation of data analytics is a priority. Investment in data analytics from the
entire organization also increases the likelihood that the internal audit activity will have the necessary
funding for the personnel and technology required for a successful data analytics operation.
Sometimes, data analytics can raise concerns or cause pushback from employees who are unfamiliar with
its application and potential benefits. Therefore, the CAE should take the lead in championing data analytics
and provide support as needed to integrate it into the company’s culture. For example, the CAE should
make a conscious effort to highlight instances where data analytics has proven beneficial to the organiza-
tion. As other departments realize the benefits of data analytics, it is likely that personnel will feel less
anxiety and may be more willing to share data and resources, thus expanding the usefulness of these
procedures. Over time, the usefulness of data analytics increases as more resources are allocated to it.
Staffing Considerations for Data Analytics

One of the challenges for the internal audit activity in implementing data analytics is ensuring that the IAA
has the necessary skills. In a large internal audit department, it is not necessary for every auditor be a data
analytics expert, but every auditor should at least be aware of data analytics to know when it would be
useful. Very large organizations may even be able to have a dedicated analytics expert on staff.
Section I 3. Data Analytics
When hiring new internal auditors, organizations should look for critical thinkers who can work as both
auditors and data analysts. For auditors already on staff, the CAE should cultivate those with the interest
and skills in analytics. Training should be budgeted both up front and on an ongoing basis to ensure that
the internal audit activity can develop and maintain an effective data analytics skillset.
Benefits of Implementing Data Analytics in the Internal Audit Activity

Data analytics increases the efficiency and effectiveness of the internal audit activity. By harnessing the
power of data analytics, auditors can do more in less time and with fewer human resources.
The following chart is taken verbatim from Data Analytics – Elevating Internal Audit’s Value and provides
some common uses of data analytics within internal audit:11
Internal Audit Function Data Analytics Use Examples
Compliance Evaluate expense reports and purchase card usage for all transactions.
Perform vendor audits by utilizing line-item billing data to identify anomalies
and trends to investigate.
Assess regulatory requirements (e.g., receiving an alert when the words
“pay to play” are noted on an expense report—could be indicative of a For-
eign Corrupt Practices Act violation).
Identify poor data quality and integrity around various data systems that
are key drivers to (non)compliance risks.
Fraud Detection Identify ghost employees, potential false vendors, and related parties or
and Investigation employee-vendor relationships.
Highlight data anomalies that pose the greatest financial and/or reputational
risk to the organization.
Investigate symptoms of an asset misappropriation scheme to answer the
“who, what, where, when” questions.
Operational Isolate key metrics around spend analysis (e.g., payment timing, forgone
Performance early-payment discounts, and payment efficiency).
Perform duplicate payment analysis and recovery.
Perform revenue assurance/cost leakage analysis.
Perform slow-moving inventory analysis.
Identify key performance and key risk indicators across industries and busi-
ness lines.
Internal Controls Perform segregation of duties analysis.

Perform user access analysis.
Assess control performance.
Identify potential outliers that would indicate control failures or weaknesses.
When the internal audit department provides robust data analysis, it also moves the audit activity into an
advisory role and significantly increases the value of internal audit to the organization. Rather than just
looking for problems in past transactions, an auditor skilled in data analytics can provide meaningful con-
sultative services. Because an internal auditor is already in the business of data, it would be a natural
progression to upgrade their skillset to encompass data analytics.
11
Stippich, Warren W. Jr. and Bradley J. Preber. Data Analytics – Elevating Internal Audit’s Value. Altamonte Springs:
IIARF, 2016. Page 24.
Continuous Auditing
Traditionally, auditors select a statistical sample and verify those transactions, which is useful for extrapo-
lating the accuracy of the entire population. However, testing the entire population provides a much higher
degree of certainty, especially if it can be done on an ongoing basis, as is done in continuous auditing.
The IIA’s GTAG 3: Continuous Auditing: Implications for Assurance, Monitoring, and Risk Assessment de-
fines continuous auditing as:
Any method used by auditors to perform audit-related activities on a more continuous or

continual basis. It is the continuum of activities ranging from continuous controls assess-
ment to continuous risk assessment—all activities on the control-risk continuum.
Technology plays a key role in automating the identification of exceptions and/or anomalies,
analysis of patterns within digits of key numeric fields, analysis of trends, detailed transac-
tion analysis against cut-offs and thresholds, testing of controls, and the comparison of the
process or system over time and/or other similar entities.
Therefore, continuous auditing, which uses technology-based tools such as CAAT or other customized data
analytics packages, is an automated audit repeated on a regular or ongoing basis. By automating standard
audit tasks, internal auditors can spend more time reviewing results and the organization’s processes and
controls.
The Future of Data Analytics

As internal auditors become increasingly proficient in data analytics, particularly as it relates to continuous
auditing, these time- and resource-saving processes can free up a tremendous amount of time so that the
internal audit activity can focus on other value-added activities for the organization.
In the long run, data analytics will become even more powerful with technologies like machine learning,
which could allow computers to recommend courses of action. Under such conditions, a computer could
look at all of the company’s data, decide where the greatest risk of fraud exists, and suggest which controls
would mitigate that risk. An internal auditor armed with such information would be able to improve the
organization’s controls with precision. Such a future is not here yet, but it is clear that the value of internal
audit hinges on its ability to utilize data analytics to enhance its capabilities.
Section II Section II – Information Security
Section II – Information Security

Section II covers Information Security (IT) and accounts for 25% of the exam. All of Section II is covered
at the basic cognitive level. The main topics in this section include:
• Types of common physical security controls
• Forms of user authentication and authorization controls
• Purpose and use of various information security protocols
• Data privacy laws and their impact on data security policies and practices
• Emerging technologies and their impact on security
• Existing and emerging cybersecurity risks
• Cybersecurity and information security-related policies
Even though information systems present unique situations and challenges, it is important to remember
that controls for information systems have the same goals as overall organizational internal controls:
• Promoting effectiveness and efficiency of operations in order to achieve the company’s objectives.
• Maintaining the reliability of financial reporting through checking the accuracy and reliability of
accounting data.
• Assuring compliance with all laws and regulations that the company is subject to, as well as ad-
herence to managerial policies.
• Safeguarding assets.
Note that the terminology in this section may be slightly different from standard workplace vocabulary.
Because internal auditing is by its nature an internal activity, it is often impractical to establish standardized
terms across all industries and companies. Therefore, although it is important to learn these terms for the
exams, it is not necessary to adopt them for your vocabulary at work.
A. Physical Security Controls CIA Part 3
A. Physical Security Controls

Physical security includes both physical access control and security of the equipment and premises. The
goal of these controls is to reduce or eliminate the risk of losing organizational assets and the risk of harm
to employees. Controls should be identified, selected, and implemented based on a thorough risk analysis.
Some common examples of general physical security controls include:
• Walls and fences
• Locked gates and doors
• Manned guard posts
• Monitored security cameras
• Guard dogs
• Alarm systems
• Smoke detectors and fire suppression systems
Physical access to servers and networking equipment should be limited to authorized persons. Keys are
the least expensive way to manage access but also the weakest because keys can be copied. A more
effective method is card access, where a magnetically encoded card is inserted into or placed near a
reader. The card access also provides an audit trail that records the date, time, and identity of the person
who entered. One significant limitation of card access, however, is that a lost or stolen card can be used by
anyone until it is deactivated.
Biometric access systems can be used when physical security needs to be rigorous. Biometric access sys-
tems use physical characteristics such as blood vessel patterns on the retina, handprints, or voice
authentication to authorize access. In general, there is a low error rate with such systems. That said, no
single system is completely error-free, so biometric access systems are usually combined with other con-
trols.
Controls can also be designed to limit activities that are performed remotely. For example, changes
to employee pay rates can be restricted to computers physically located in the payroll department. Thus,
even if online thieves managed to steal a payroll password, they would be prevented from changing pay
rates because they would not have access to the premises.
The auditor’s role is to evaluate the effectiveness of the existing controls and security. If weaknesses are
found in any of the controls, the auditor should report the exposures. Techniques for assessing security
risks include:
• Analyzing past incidents.
• Reviewing industry-wide incident statistics.
• Auditing processes and procedures for possible gaps.
• Mapping all possible situations, including “worst case” scenarios.
• Using standards such as the ISO 27000 family (discussed in Section III) for assessing risk and
implementing appropriate controls.
Section II B. User Authentication and Authorization Controls
B. User Authentication and Authorization Controls

Companies need to have strict controls over access to their proprietary data. Poor data oversight can leave
a company vulnerable to accidents, fraud, and malicious parties who manipulate equipment and assets.
Logical security focuses on who can use which computer equipment and who can access data.
Logical access controls identify authorized users and control the actions that they can perform.
To restrict data access only to authorized users, one or more of the following strategies can be adopted:
1) Something you know
2) Something you are
3) Something you have
Something You Know

User IDs and passwords are the most common “something you know” way of authenticating users. Security
software can be used to encrypt passwords, require changing passwords after a certain period of time, and
require passwords to conform to a certain structure (e.g., minimal length, no dictionary words, restrict the
use of symbols). Procedures should be established for issuing, suspending, and closing user accounts; in
addition, access rights should be reviewed periodically.
Something You Are

Biometrics is the most common form of “something you are” authentication. Biometrics can recognize
physical characteristics such as:
• Iris or retina of the eyes
• Fingerprints
• Vein patterns
• Faces
• Voices
Biometric scanners can be expensive and are generally used only when a high level of security is required.
Something You Have

Some very high-security systems require the presence of a physical object to certify an authorized user’s
identity. The most common example of this “something you have” authentication is a fob, a tiny electronic
device that generates a unique code to permit access; for increased security, the code changes at regular
intervals. A lost fob may be inconvenient but not a significant problem because the fob by itself is useless.
Furthermore, a stolen fob can be remotely deactivated.
Two-Factor Authentication
Two-factor authentication requires two independent, simultaneous actions before access to a system is
granted. The following are examples of two-factor authentication:
• In addition to a password, some systems require entering additional information known only to the
authorized user, such as a mother’s maiden name or a social security number. However, this
security feature can be undermined if the secondary information can be obtained easily by an
unauthorized third party.
• Passwords can be linked to biometrics.
C. Information Security Controls CIA Part 3
• In addition to a password, a verification code is emailed or sent via text message that must be
entered within a few minutes to complete the login.
• A biometric scan and a code from a fob are combined to allow access.
When evaluating the effectiveness of a logical data security system, the auditor should consider:
• Does the system provide assurance that only authorized users have access to data?
• Is the level of access for each person appropriate to that person’s needs?
• Is there a complete audit trail whenever access rights and data are modified?
• Are unauthorized access attempts denied and reported?
Other User Access Considerations

Besides user authentication, there are other security controls related to user access and authentication to
prevent abuse or fraud:
• Automatic locking or logoff policies. Any login that is inactive for a specific period of time can
automatically be logged out. As a result, there will only be a narrow window of time for someone
to take advantage of an unattended system.
• Logs of all login attempts, whether successful or not. Automatic logging of all login attempts
can detect activities designed to gain access to an account by repeatedly guessing passwords.
Accounts under attack could be proactively locked in order to prevent unauthorized access.
• Accounts that automatically expire. If a user needs access to a system only for a short period
of time, the account should be set to automatically expire at the end of that period, which prevents
open-ended access.
C. Information Security Controls

Controls for a computer system are broken down into two types, both of which are essential.
• General controls relate to all systems components, processes, and data in a systems environ-
ment.
• Application controls are specific to individual applications and are designed to prevent, detect,
and correct errors and irregularities in transactions during the input, processing, and output stages.
General Controls
General controls relate to the general environment within which transaction processing takes place. Gen-
eral controls are designed to ensure that the company’s control environment is stable and well managed.
A stable and well-managed control environment strengthens the effectiveness of the company’s application
controls. General controls include:
• Administrative controls, including segregation of duties.
• Computer operations controls.
• Controls over the development, modification, and maintenance of computer programs.
• Software controls.
• Hardware controls.
• Data security controls.
• Provision for disaster recovery.
Section II C. Information Security Controls
Application Controls
Application controls are specific to individual applications. They ensure that only authorized data is pro-
cessed by the application and that the data is processed completely and accurately. Thus, application
controls are designed to prevent, detect, and correct errors in transactions as they flow through the input,
processing, and output stages of work. They are organized into three main categories.
Input Controls
Input controls are designed to provide reasonable assurance that input entered into the system has proper
authorization, has been converted to machine-sensible form, and has been entered accurately. Input con-
trols can also provide some assurance that data has not been lost, suppressed, added, or changed in
transmission. Some common input controls are:
• Edit checks verify the validity and accuracy of input data, such as whether each field has the
proper numeric, alphabetic, or alphanumeric format and whether the information is reasonable.
• Key verification means inputting information twice and comparing the two inputs. A common
example is entering a new password twice to make sure that it is set correctly.
• A redundancy check is the process of sending additional sets of data to confirm the original data.
• An echo check is the process of sending the received data back to compare with what was origi-
nally sent to make sure that it is identical.
• Completeness checks determine whether all necessary information has been sent.
Internal auditors should recognize that input errors are the most common error, and they should dedicate
a significant amount of effort to reviewing input controls. Internal auditors can interview the programmers,
review program abstracts, examine edit reports, or even review source code to verify input controls. Audi-
tors can also observe balancing procedures, examine documents for authorizations and approvals, and
determine whether key verification or some other means of verification is being used for critical data.
Processing Controls
Processing controls are designed to provide reasonable assurance that processing has occurred properly
and that no transactions have been lost or incorrectly added.
• Posting checks compare the contents of the record before and after updating.
• Cross-footing compares the sum of the individual components to the total figure.
• A zero-balance check is used when a total sum should be 0. All of the numbers are added
together and compared to 0.
• Run-to-run control totals check that critical information is correct at certain points in processing,
which allows for earlier detection of errors.
• Key integrity checks make sure that the keys (the characteristics of data that allow it to be
sorted) are not changed during data processing.
In reviewing processing controls, the auditor should assess whether the application is processing input data
in an accurate and timely manner and without unauthorized modifications. Some common audits include:
• Reviewing the use of processing controls.
• Determining whether duties are properly segregated or if not, if compensating controls exist.
• Determining whether transactions are retained so data files can be reconstructed, if necessary.
• Determining whether transaction logs are adequate to trace data back to the point of origin.
• Determining what procedures are followed to reprocess transactions that are in error.
• Determining whether suspense items are being cleared in a timely manner.
• Reviewing operators’ run instructions so that even if operators are unfamiliar with the jobs,
they will be able to complete the necessary tasks.
Output Controls
Output controls are designed to provide reasonable assurance that input and processing have resulted in
valid output and that only authorized personnel receive the output. The output of the system is supervised
by the data control group.
One type of output control is forms control, such as physical control over company checks. Checks should
be kept under lock and key, and only authorized persons should have access. In addition, because checks
are prenumbered, the preprinted check number on the form must match the computer-generated number
that is printed on the check. If the starting computer-generated number does not match the first check in
the stack, such a discrepancy must be investigated because it could mean that one or more checks are
missing. Any other prenumbered forms should be controlled in the same manner as checks.
An example of output controls is the protocol regarding report distribution. There should be an author-
ized distribution list for every report, and only the minimum number of necessary copies should be
created. For a confidential report, it is preferable to have each person sign when they receive it.
Example: A payroll register with employees’ social security numbers and pay rates is confidential infor-
mation and its distribution must be restricted.
Internal auditors should review the following when assessing output controls:
• Determine whether output is supervised by a data control group. The control group should
balance and reconcile the output.
• Determine whether exceptions are flagged for follow-up.
• Determine whether totals on reports are being examined for reasonableness.
• Determine whether reports are relevant, timely, reliable, and sorted properly.
• Determine whether an up-to-date distribution list is maintained for all reports, whether
there is an output log, if reports are being lost or misrouted, and there is a checklist to determine
whether all reports have been received.
• Determine whether dual-custody controls are being used to protect negotiable documents
such as checks, stock certificates, and sensitive outputs such as payroll listings.
• Review retention policies for outputs such as hard copy reports.
Note: Confidential reports should be shredded when they are no longer needed.
Firewalls
Once a company is connected to an external network, there are some specific additional security control
requirements that must be properly addressed. The company must make sure that its policies allow the
intended and authorized users to have access to the internal network while also preventing unauthorized
access and manipulation of sensitive data.
Using port scans, hackers can look for computer systems and software programs with particular vulnera-
bilities that they can exploit. Once hackers have identified a target computer or software application, they
can create a back door—that is, an exploitable point of entry—in order to re-enter it at a later time.
Therefore, even if the original entry point is detected and closed, the “back door” functions as a hidden,
undetected way back in.
The best defense against port scans is a strong firewall. A firewall serves as a barrier between the internal
and the external networks and prevents unauthorized access to the internal network. A properly configured
firewall makes a computer’s ports invisible to port scans. A firewall can also prevent backdoors, Trojan
horses, and other unwanted applications from sending data from the computer. Most firewalls can prepare
a report of Internet activity, including any abnormal or excessive usage, as well as attempts to gain unau-
thorized entry to the network. A firewall can be software directly installed on a computer or it can be a
piece of hardware that is installed between the organization’s computers and the connection to the Internet.
Auditors should ensure that firewalls are working properly and cannot be bypassed or disabled. Working
with the network administrators, auditors should review the firewall rules and ensure that they are kept up
to date. Logs can be helpful to determine if the firewall is working correctly. It is also important to remember
that firewalls have limitations. While they can prevent unauthorized access of data over the Internet, they
cannot prevent theft of a physical device (like a CD or USB drive) or malicious acts by authorized users.
An organization can also use a proxy server, which creates a gateway to and from the Internet. The proxy
server contains a list of approved web sites and handles all web access requests, limiting exposure to only
those sites contained in the access control list. These restrictions enable an employer to deny its employees
access to sites that are unlikely to have any productive benefits. The proxy server also examines all incom-
ing requests for information and tests them for authenticity. In this way, a proxy server functions as a
firewall. In addition, the proxy server can contain limited information, such as a subset of the database that
the company could afford to lose in case of unauthorized access. Thus, if this server is compromised, the
organization’s main servers remain functional and the data secure.
Intrusion Detection Systems

In the context of information security, an intrusion means that an attacker has gained access to one or
more of the organization’s systems. If a company can detect an intrusion the moment it occurs, it can
respond immediately and mitigate the risk to its information assets. That said, while properly implemented
security controls can minimize the risk of an intrusion, no controls are 100% effective.
An intrusion detection system uses a variety of methods to analyze activity across the network and company
systems to identify any activity or data that does not belong or is out of the ordinary. When the intrusion
detection system detects a possible attack, it may respond passively (e.g., alerting a system administrator,
logging the possible intrusion, setting off an alarm) or actively (e.g., thwarting the user from further access,
reconfiguring the firewall, launching a program to start tracing the origin of the attack).
Encryption
Unauthorized observation, interception, or monitoring of data transmissions is called electronic eaves-
dropping. The best protection against traffic interception is encryption. In encryption, the sender of data
converts the information into a code that can only be “unlocked” by the receiver with a special “key.”
Therefore, even if unauthorized third-parties intercept the coded information, without the proper key they
cannot read it. Thus, an attacker may be able to see where the traffic came from and where it went, but
not the content.
The encryption process can be either in the hardware or the software. There are two methods of software
encryption: secret key and public key/private key.
• In a secret key system, the sender and receiver each has a single key that encrypts and decrypts
the messages. The advantage of this system is that the uniqueness of the keys makes the inter-
action virtually impossible to compromise. However, this system has its disadvantages. Every pair
of senders and receivers must have a separate set of matching keys, but if several pairs of
sender/receivers all used the same set of keys, then any one party with key access can decrypt
anyone else’s information. Furthermore, this system is impractical over the Internet, especially for
a company with thousands of sender/receiver relationships (such as with customers and suppliers).
• The public key/private key encryption system is more secure than the secret key system. In
a public-key/private-key encryption system, each entity that needs to receive encrypted data pub-
lishes a public key while keeping a private key to itself as the only means for decrypting that data.
Anyone can encrypt and send data to the company using its published public key, but only the
company’s private key can decrypt the data.
A company obtains a public key and an accompanying private key by applying to a Certificate
Authority. The certificate is used to identify a company, an employee, or a server within a company.
The certificate includes the name of the entity it identifies, an expiration date, the name of the
Certificate Authority that issued the certificate, a serial number, and other identification. The cer-
tificate always includes the digital signature of the issuing Certificate Authority, which permits
the certificate to function as a “letter of introduction” from the Certificate Authority.
Encryption strength is determined by the bit length of the keys, such as 256-bit or 2048-bit. Different
encryption methods have different bit lengths, so it is not always useful to compare the bit length of two
different encryptions to determine which is stronger. However, for the same encryption method, a longer
key will always be more secure (i.e., 2048-bit RSA is always stronger than 1024-bit RSA).
Auditors should ensure that encryption is being used everywhere and that all encryption keys are protected
against disclosure. Encryption keys are frequently created with passwords, so there should be guidelines in
place and enforced for creating sufficiently strong passwords. Auditors should also ensure that SSL (Secure
Sockets Layer) is being used with web sites that send or receive sensitive information. SSL is a public
key/private key encryption system built into all modern web browsers and it does not require any technical
knowledge to use because the web browser automatically handles the encryption.
Digital Signatures
Digital signatures verify the identity of a sender, usually in the context of an email or document.
Digital signatures use a public key/private key system. Because only the sender’s public key can decrypt a
message encoded with the sender’s private key, the recipient is able to verify the sender because only that
sender possesses the private key.
Antivirus Software: Protection against Viruses, Trojan Horses, and Worms

A computer virus is a program that alters the way a computer operates. Viruses can damage programs,
delete files, and reformat drives. Some viruses do not do damage; instead, they might replicate themselves
and display text, video, or audio messages. Although such viruses may not cause obvious damage, they
can take up computer memory, cause erratic behavior, or induce system crashes that can lead to data loss.
To be considered a virus, an invasive program must meet two criteria:
1) It must execute itself. A virus often places its code in the path of the execution of another pro-
gram.
2) It must replicate itself. A virus can replace other executable files with a copy of the virus-infected
file.
A Trojan horse is software that appears to be legitimate but in fact contains malicious code that, when
triggered, will cause loss or theft of data. A Trojan horse is different from a virus because it does not
replicate itself, whereas viruses do. A Trojan horse also focuses on a particular target—a specific computer
or system—on which to run a program.
Trojan horses can only work when the target user can be tricked into inviting it onto a computer by:
1) Opening a malicious email attachment.
2) Downloading and running a file from the Internet.
A worm is a program that replicates itself from system to system without any host file. Worms generally
exist inside other files, often Word or Excel documents. The difference between a worm and a virus is that
the worm does not require the use of an infected host file. Usually the worm releases a document that
contains the worm macro that then spreads from computer to computer, making the entire document the
worm.
Note: The difference between a virus and a Trojan is that a virus replicates itself; a Trojan does not.
The difference between a virus and a worm is that the virus requires an infected host file in order to
replicate itself, while the worm can replicate itself without a host file.
A virus hoax is a piece of text, often an email, that attempts to trick people into harming their own
computers. The unsolicited email falsely claims that a certain file is infected with a virus, names a specific
system file as the culprit, and asks users to delete it. The genius of this kind of attack is that the file it
identifies is found in all system files; therefore, anyone who follows the directions will find the presumably
infected file. As a result of this unnecessary deletion, the computer will most likely malfunction.
Antivirus software, regularly updated with the latest virus definitions, is the best defense against viruses,
Trojan horses, and worms. Antivirus software recognizes and incapacitates viruses before they can do
damage. It is important to keep antivirus software up-to-date because new viruses appear constantly.
Programs that specifically defend against Trojan horses are also available.
D. Privacy CIA Part 3
D. Privacy
Privacy refers to rights that individuals have to control how personal information is collected, stored, and
used by third parties. Any information that can be tied back to a specific individual is considered personal
information. In the context of information technology, privacy applies to both customers and employees.
While it is necessary to collect certain information about both customers and employees to process business
transactions, it is also important for all parties to feel that their privacy is respected.
While specific privacy laws vary by country, common standards can be found in the Fair Information
Practice Codes:
• Notice. People should be told who is collecting the data, what data is being collected, how that
data will be used, and how that data is being protected.
• Choice. People should be able to choose how their personal information is used, both for the
immediate business purpose and in the future.
• Access. People should be able to easily view and update their stored personal information.
• Security. Companies should take reasonable steps to ensure adequate controls over personal
information. This includes preventing unauthorized access, use, or distribution of the information.
• Enforcement. Privacy policies must be enforced. A privacy policy is worthless if it is not enforced
at all levels within the company.
The following is a list of significant privacy laws passed in the United States and the European Union:
• Federal Privacy Act of 1974 (US). This law regulates government agencies and their responsi-
bilities to protect individuals’ personal data.
• Health Insurance Portability and Accountability Act of 1996 (US). Also known as HIPAA,
this law protects healthcare data and provides standards for how it should be received, stored,
accessed, and exchanged. The penalties for HIPAA violations are harsh, with fines up to $250,000
US or ten years in jail.
• Financial Services Modernization Act of 1999 (US). This law requires financial institutions to
have and disclose their privacy policy regarding the sharing of their customers’ personal infor-
mation. In addition, companies must provide a way for customers to opt out of data-sharing.
• General Data Protection Regulation (EU). Passed in 2016 and implemented in 2018, GDPR
applies to any business that is established in or has customers within the European Union. GDPR
requires that organizations receive explicit consent from users to collect and store their personal
information, and they must provide controls to protect personal data. Individuals also need to be
provided with their data and have a way to request that it be erased. Violations come with fines
as high as €20 million or 4% of worldwide revenue, whichever is greater.
While the board and management are responsible for identifying privacy risks and ensuring that an appro-
priate privacy framework is in place, the IAA has an important role in auditing the organization’s privacy
practices. It may be necessary for both the board and the IAA to consider multiple privacy laws, regulations,
and frameworks, especially in multi-national organizations that need to comply with privacy laws in more
than one country.
Section II D. Privacy
The IIA Practice Guide Auditing Privacy Risks12 provides guidance on all stages of assessing privacy risks
and conducting a privacy audit. The Practice Guide identifies the following risks related to privacy:
• Possible damage to the organization’s public image and branding.
• Potential financial or investor losses.
• Legal liability and industry or regulatory sanctions.
• Charge of deceptive practices.
• Customer, citizen, or employee distrust.
• Loss of customers and revenues.
• Damaged business relationship.13
To help reduce the company’s risk related to privacy, an effective privacy program should include the
following:
• Privacy governance and accountability.
• Roles and responsibilities.
• Privacy statement/notice.
• Written policies and procedures for the collection, use, disclosure, retention, and disposal of per-
sonal information.
• Information security practices.
• Training and education of employees.
• Privacy risk assessments and maturity models.
• Monitoring and auditing.
• Compliance with privacy laws and regulations.
• Inventory of the types and uses of personal information.
• Data classification.
• Plans to address privacy risks for new or changed business processes and system development.
• Controls over outsourced service providers.
• Incident response plans for breach of personal information.
• Plans to address corrective action.14
The auditor’s role with regards to privacy is to be sure that privacy laws, regulations, and policies are
communicated and enforced, including any necessary documentation to show compliance. In some cases,
auditors may need to consult legal counsel regarding requirements and compliance. Employees also need
to understand how the privacy policies affect the execution of their jobs and the penalties for non-compli-
ance. Under no circumstances, however, should the IAA assume responsibility for designing or
implementing any aspect of the organization’s privacy program.
12
https://na.theiia.org/standards-guidance/recommended-guidance/practice-guides/Pages/Auditing-Privacy-Risks-
Practice-Guide.aspx
13
Ibid., page 5.
14
Ibid., page 6.
D. Privacy CIA Part 3
Auditing Privacy Risks also includes a list of “Top 12 Privacy Questions CAEs Should Ask.” While this list is
not exhaustive, it makes a good starting point for some of the main issues that an internal auditor should
consider when planning and conducting a privacy audit:
1) Does the organization have a governing body in place to address the acceptable level of privacy
risk it will take?
2) What level of privacy risk is management prepared to accept?
3) What privacy laws and regulations currently impact the organization or may likely be required in
the near future?
4) What type of personal information does the organization collect, who defines what is personal or
private, and are the definitions consistent and appropriate?
5) Does the organization have privacy policies and procedures with respect to collection, use, reten-
tion, destruction, and disclosure of personal information?
6) Does the organization have responsibility and accountability assigned for managing a privacy pro-
gram?
7) Does the organization know where all personal information is stored and who has access?
8) How is personal information protected at various levels — databases, networks, system platforms,
application layers, and business process/functional levels?
9) Is any personal information collected by the organization disclosed to or processed by third parties?
10) Do employees receive privacy awareness training and have guidance on their specific responsibil-
ities in handling privacy requirements, issues, and concerns?
11) Does the organization have and provide adequate resources to develop, implement, and maintain
an effective privacy program?
12) Does the organization complete a periodic assessment to ensure that privacy policies and proce-
dures are being followed and meet new or current requirements?15
Because of the IAA’s key role in the governance of privacy, the CAE should be sure that the IAA has
sufficient knowledge and training to conduct privacy audits. Internal auditors should also take extra care
with personal information to ensure that the audit itself does not violate any privacy laws or regulations. If
necessary, auditors should consult with legal counsel before sharing any personal data or privacy audit
results outside of the organization.
Note: Auditors conducting a privacy engagement should read the IIA’s Practice Guide Auditing Privacy
Risks in full. The Practice Guide has over 10 pages on planning, performing, and communicating the
results of privacy engagements.
15
Ibid., page 22.
Section II E. Emerging Technology Practices and Their Impact on Security
E. Emerging Technology Practices and Their Impact on Security

A difficult challenge facing many companies is identifying the latest technologies that may pose potential
risks, both internally and externally. Auditors must therefore stay current with the latest technology trends
and be vigilant about new devices being used in the workplace, particularly those for which the company
may not have official policies to regulate their use. Where policies do not exist, the internal auditor should
conduct a risk assessment to help develop appropriate guidelines.
The following is a sample list of technological innovations that can introduce risk to the work environment:
• Smart devices. These are any devices that can connect to the Internet, including smart phones
and tablets, which may be company-owned. One major risk with smart devices is that they can be
hacked or used to access the company’s internal systems. In addition, they often have cameras,
which means that pictures and videos of critical assets (e.g., documents, machines, processes)
could be taken without the company’s knowledge and then distributed to outside parties. They also
are usually GPS-enabled, which means they can be converted into tracking devices.
“Bring your own” devices (BYOD) are any personal electronic devices, especially Wi-Fi or
cellular-enabled smart devices, that an employee brings for work-related purposes, such as a per-
sonal phone or tablet. Risk and audit issues connected to “bring your own” smart devices are
examined next.
• The Internet of Things. This term refers generally to the broader range of Internet-connected
devices such as cars, robots, manufacturing equipment, refrigerators, thermostats, security sys-
tems, doorbells, lightbulbs, smart meters (e.g., electric meters), pet or baby monitors, and
personal-assistant speakers (e.g., Google Home, Amazon Alexa). Because these devices are con-
nected to the Internet, usually over Wi-Fi, they are streaming information that could be
compromised. Such devices could also be hacked, controlled remotely, or have information erased
or taken hostage. For example, a refrigerator with a built-in microphone to accept commands for
building a grocery list could have the microphone hijacked or converted into a listening device.
Manufacturing equipment that is connected to the Internet could be accessed remotely and have
its safety features disabled.
• Wearables. These are any Internet-enabled devices that a person wears on his or her body, such
as a smart watch. Other types of wearables include fitness trackers, glasses, heart rate monitors,
shoes, and even clothing. Because wearables tend to be small and, in many cases, operate out of
sight, the company may not have a good handle on the type and number of these devices being
introduced to the workplace by employees, contractors, or clients. Even if a company has a wear-
ables policy in place, such devices are small enough that employees could feel confident ignoring
company regulations. While many wearables do not pose a risk, the auditor should conduct a risk
assessment on common wearables and possible risks to the organization.
• The cloud. While the cloud is no longer an emerging technology, security and privacy of data
on the cloud remain active topics of concern. The main risks associated with the cloud are unau-
thorized access (i.e., a data breaches), loss of data, and sharing of data with third parties. ISO
27017 Information technology—Security techniques—Code of practice for information security con-
trols based on ISO 27002 for cloud services provides controls and guidance for both cloud providers
and cloud users, adding seven cloud controls to those listed in ISO 27002 that address issues of
responsibility, data protection, administrative procedures, monitoring of activity, and more. The
single best way to protect data in the cloud is by encrypting it so that it is unreadable to anyone
except the authorized user.
E. Emerging Technology Practices and Their Impact on Security CIA Part 3
Auditing Smart Devices

Note: The IIA has published a Global Technology Audit Guide (GTAG) entitled Auditing Smart Devices:
An Internal Auditor’s Guide to Understanding and Auditing Smart Devices. The GTAG is the source for
much of the information in this topic.
The use of employee-owned smart devices (for example, phones, tablets, and wearables) at work is com-
monplace, making it essential that internal auditors understand the risks and threats that such devices
create in order to successfully mitigate those risks.
Impact of Smart Devices

Prior to smart devices, working remotely usually meant that employees connected a company-owned com-
puter or device to a company server. Now, employee-owned smart devices allow employees to easily
access, change, and/or transfer data between locations and devices. Because these devices are employee-
owned, it is possible that employees do not maintain the proper level of physical or logical security on their
devices to protect business information.
Because smart devices are part of the information systems of a company, the risks associated with smart
devices fall under the scope of work for the IAA. This is listed in the Standards for Risk Management (2120)
and Control (2130) because the IAA must evaluate risk exposures and controls related to the company’s
information systems.
2120.A1 – The internal audit activity must evaluate risk exposures relating to the organization’s govern-
ance, operations, and information systems…
2130.A1 – The internal audit activity must evaluate the adequacy and effectiveness of controls in re-
sponding to risks within the organization’s governance, operations, and information systems…
Risks Connected to Smart Devices

There are three categories of risks related to smart devices:
1) Compliance risks
2) Privacy risks
3) Security risks
1) Compliance Risks
Because employees are responsible for making certain that the operating system, software, and security
are kept up to date on their devices, policies should be in place that require employees to maintain their
devices with the necessary updates and security. The IT department may also need to expand its knowledge
and skills to support the growing variety of devices, operating systems, and applications in order to manage
the possible risks and vulnerabilities.
2) Privacy Risks
All of the privacy issues that a company has with respect to keeping information private and protected on
their own systems are multiplied with the use of employee-owned smart devices. The company should have
policies and guidelines in place for employees regarding the security and protection of company data stored
or accessed on smart devices.
It is also possible that non-employees may access the company network when on-site, such as when joining
a Wi-Fi network. Controls need to be in place to protect the system so that it is not accessed inappropriately
by such individuals.
3) Security Risks
The security risks connected to smart devices are broken down into two areas:
A) Physical security risks related to the device itself being lost or stolen because information that
is stored on the phone may be at risk when the device is lost or stolen. The company should have
protocols in place to report loss or theft and for remotely wiping data on the device.
B) Information security risks related to the security and privacy of the data on the device, such as:
• Data backup and storage. Devices need to be backed up to prevent data loss and sensi-
tive information should be encrypted.
• Operating systems. Every operating system has its own unique security features and
possible vulnerabilities that need to be addressed and managed.
Note: Jailbreaking (for Apple) or rooting (for Android) is when the user removes some
of the software restrictions that are built-in to the operating system, which introduces
security risks to the device and the information stored on it. Jailbreaking is often done to
enable the user to install Apps that are not installed through the normal process.
• Network connections. The use of insecure network connections, such as public Wi-Fi
networks, can create additional security risks. When connected to a public Wi-Fi network,
a device is more vulnerable to hacking and transmitted data is more susceptible to being
intercepted. Session hijacking, eavesdropping, and man-in-the-middle attacks are exam-
ples of some of the risks that can be introduced by using insecure network connections.
• Applications. Third-party applications can introduce security vulnerabilities as well as vi-

ruses, trojan horses, and other malware.
• Location. Smart devices with GPS can be tracked to monitor behavior or locate specific
places where the device is used. Pictures may also contain location data that can be used
to plan an attack.
Controls for Smart Devices

Controls for smart devices are categorized into controls that are connected to the smart devices themselves,
and controls that are related to the policies the company has related to IT.
Smart Device Security Controls

Smart devices have some built-in controls, but these controls need to be used and not disabled in order to
be effective. Examples of built-in controls include:
• User authentication prevents unauthorized users from accessing the device by requiring a pass-
word, a swipe pattern, biometric features such as a face scan or fingerprint, security questions, or
a combination of methods (two-factor authentication). Even if a company cannot enforce how a
user secures the device, a company app could have its own authentication requirements.
• Remote wiping allows the employee or the IT department to lock down or wipe the data off the
device if the user no longer has physical possession of it (if it has been lost or stolen, for example).
• Encryption on the device means that all applications and data on the device are encrypted until
it is unlocked. This is a key control in protecting data that is stored on smart devices.
• Software encryption should be required for all company apps, especially email. Software encryp-
tion can be used when device encryption is not available.
• Encrypting transmitted data. The device should encrypt all information that is sent and received
by using industry standard encryption or by securely connecting to the company network via a
virtual private network (VPN).
IT Policy Control Considerations

In addition to device-based controls, there should also be policies and procedures in place, such as:
• Protections against malware, which include not only anti-malware software, but also keeping
operating systems updated, downloading apps only from trusted providers, updating apps regu-
larly, and not jailbreaking or rooting the device.
• Policies or application controls that discourage and/or prevent downloading sensitive data.
• Secure backup of company applications and data to company servers rather than user-controlled
locations such as their personal computer or cloud storage.
• Mobile application management software addresses how an app is developed, managed,

used, modified, and transferred to the smart device, and how the app secures its data.
• Mobile device management software protects data by using the security controls that are built
into the device’s operating system.
• Wi-Fi restrictions that limit connecting only to properly secured networks.
• A specific BYOD policy that includes the following elements, taken directly from the Auditing
Smart Devices GTAG:
o Approved devices and possibly operating systems (e.g., iOS, Android) and responsibilities for
maintenance.
o Expectations and responsibilities related to organizational and personal information stored on

the smart device. For example, the organization may be responsible for restricting data down-
loads or transfers, and the employee may be responsible for not sharing the device with other
family members if confidential data resides on the device.
o Minimum security requirements, such as strong passwords and up-to-date operating systems.
o Timely reporting of a security breach and lost or stolen devices.
o Accessing the organization’s data, apps, and network resources, including who can access what
apps and by what means (e.g., web, VPN, or app-based).
o Backups and transfers, specifically how and where to back up the organization’s data and what
can be transferred to other devices. For example, can an employee transfer or back up organ-
izational data to a home computer or a public data hosting service? These decisions may impact
data security and compliance with certain privacy, regulatory, or contractual obligations (e.g.,
U.S. Health Insurance Portability and Accountability Act (HIPAA), U.S. Sarbanes-Oxley Act of
2002, Payment Card Industry Data Security Standard (PCI DSS), and Personally Identifiable
Information (PII)).
o Remote wiping. Users should enable the remote wipe option and identify specific applications
to be remotely wiped. One concern is that a remote wipe could impact PII, as well as organi-
zational data. It is important to establish whether the organization can access or delete all the
data or just organizational data. Organizations with BYOD policies should involve their legal
counsel when developing and implementing appropriate remote wipe policies and procedures.
o Process for retiring smart devices, including options for selling, exchanging, swapping, donat-
ing, or otherwise disposing of a smart device.
o Employee acknowledgement and sign-off of all appropriate policies and procedures.
The Smart Device Audit Engagement

The IAA should assess risk exposures and the effectiveness of the risk management processes and controls
that are in place. A smart device audit engagement should understand and assess smart device strategy
and governance as well as policies, relevant standards, and procedures. Specific areas to examine include
employee awareness and training, smart device and app management, and data protection. A work pro-
gram needs to be created that addresses the risks and will provide foundation for a conclusion about the
risks, the effectiveness of controls already in place, and any changes that need to be made.
The Auditing Smart Devices GTAG provides a list of inquiries that the work program could include to assess
the current policies and controls related to smart devices:
• Is the organization’s network accessible via smart devices?
• Is access limited to messaging, or does it include the organization’s data?
• Does the organization provide employees with smart devices?
• Are employees permitted to use their own smart devices to conduct business?
• How does smart device technology integrate with the organization and user base?
• Who owns the smart device strategy and enforces the organization’s smart device policies and
procedures?
• How is back-end information stored and maintained?
• How does the organization protect itself against data loss, data corruption, security breaches,
network downtime, and lost or stolen devices?
• Are smart devices supported and protected as assets or tools for the organization to help accom-
plish business goals?
• Does the organization continue to conform to legal and regulatory policies?
Appendix C of the Auditing Smart Devices GTAG presents a sample Smart Device Audit Program. While the
entire audit program is not reproduced here, the 11 objectives that make up the work program are:
Objective 1: Plan and Scope the Audit
Objective 2: Identify and Obtain Supporting Documents (Standard 2310)
Objective 3: Understand the Smart Device Environment
Objective 4: Understand the IT Architecture Supporting the Smart Device Environment
Objective 5: Understand the Smart Device Security Features
Objective 6: Understand How Smart Devices Are Enrolled in the MDM Software
Objective 7: Understand How Smart Devices are Provisioned for Email, Contacts, and Address Books
Objective 8: Understand How Applications are Installed on Smart Devices
Objective 9: Understand How Smart Devices are Connected to the Organization’s Network
Objective 10: Understand Regulatory and Compliance Requirements Related to Smart Devices
Objective 11: Understand Management Reports Produced Related to Smart Devices
End-User Computing
In the end-user computing (EUC) model, end-users are responsible for installing systems, application soft-
ware, and performing software upgrades. In effect, the systems programming and development is shifted
from a centralized IS department to the various end-user departments. EUC can be thought of as an
officially sanctioned “bring your own device” policy. However, The IIA raised a number of critical issues
regarding the EUC model and offered remedies:
Audit and control concerns.

• The potential for a decrease in internal controls.
• The potential decrease in application reliability.
• The potential effect on financial statements.
• The lack of a data processing role in developing applications.
• The potential decrease in organizational control over computing resources.
• The lack of effective evaluation procedures to ensure that the right system is developed.
Risk of organizational inefficiencies.

• The lack of computing direction.
• The lack of central control and responsibility.
• The potential for data incompatibility.
• Non-defined ownership and responsibility for systems.
Potential problems with end-user computing.

• Long-term planning could become more difficult.
• The lack of economic analysis of application developments.
• The lack of standardized application controls.
• The potential for an unclear definition of responsibilities.
Suggested recommendations to IS management:

• Benchmark end-user computing practices.
• Planning, budgeting, billing and evaluation processes should be formalized.
• Organize EUC resources to satisfy documented client needs.
• Enlist the participation of both the end-users and the IS department for EUC policy development.
• Provide proper training and education.
• Create procurement guidelines that promote fast response but also ensure that products foster
connectivity and interoperability.
• Maintain tight data security to protect the hardware, software, and data.
• Create extended audit programs for compliance and substantive testing when material financial or
operational risks are identified.
Section II F. Cybersecurity Risks
F. Cybersecurity Risks
Cybersecurity is the process or methods of protecting Internet-connected networks, devices, or data from
attacks. Cyberattacks are usually made to access, change, or destroy data, interrupt normal business op-
erations, or they may involve extortion.
Some specific cybersecurity risks include the following:

• Copyright infringement is the theft and replication of copyrighted material, whether intellectual
property, such as computer programs or textbooks, or entertainment property such as music and
movies.
• Denial of Service (DOS) attacks occur when a website or server is accessed so frequently that
legitimate users cannot connect to it. Distributed Denial of Service (DDOS) attacks use multiple
systems in multiple locations to attack one site or server, which makes stopping or blocking the
attack difficult. Sophisticated firewalls and network monitoring software can help to mitigate DOS
and DDOS attacks.
• Buffer overflow attacks are designed to send more data than expected to a computer system,
causing the system to crash, permitting the attacker to run malicious code, or even allowing for a
complete takeover of the system. Buffer overflow attacks can be easily prevented by the software
programmers adequately checking the amount of data received, but this common preventative
measure is often overlooked during software development.
• Password attacks are attempts to break into a system by guessing passwords. Brute force
attacks use programs that repeatedly attempt to log in with common and/or random passwords,
although most modern systems effectively prevent brute force attacks by blocking login attempts
after several incorrect tries. Two-factor authentication can also prevent brute force attacks from
being successful because a password alone will not allow access to the system. Internal auditors
should be sure that systems include sophisticated logging and intrusion-detection systems to
prevent password attacks and that there are password requirements that reject short or basic
passwords such as “password” or “123456.”
• Phishing is a high-tech scam that uses spam email to deceive people into disclosing sensitive
personal information such as credit card numbers, bank account information, Social Security num-
bers, or passwords. Sophisticated phishing scams can mock up emails to look like the information
request is coming from a trusted source, such as state or local government or even a coworker.
The best defense against phishing is awareness and common sense. Recipients should be wary
about any email that requests personal or financial information and resist the impulse to click on
an embedded link.
• Malware broadly refers to malicious software, including viruses. Spyware can secretly gather
data, such as recording keystrokes in order to harvest banking details, credit card information,
and passwords. Other types of malware can turn a PC into a bot or zombie, giving hackers full
control over the machine without alerting the owner to the problem. Hackers can then set up
“botnets,” which are networks consisting of thousands or millions of “zombies,” which can be made
to send out thousands of spam emails or emails infected with viruses.
• Ransomware is particularly dangerous malware that encrypts data on a system and then de-
mands a ransom for decryption. If the ransom is not paid, the data is lost forever. The most
common way that ransomware is installed is through a malicious attachment or a download that
appears to come from a trusted source. The primary defenses against ransomware are to avoid
installing it in the first place and having data backups.
• “Pay-per-click” abuse refers to fraudulent clicks on paid online search ads (e.g., on Google or
Bing) that drive up the target company’s advertising costs. Furthermore, if there is a set limit on
daily spending, the ads are pushed off the search engine site after the maximum-clicks threshold
is reached, resulting in lost business and inflated advertising costs. Such scams are usually run by
one company against a competitor.
F. Cybersecurity Risks CIA Part 3
Some cybercrime is conducted on a more personal and in-person fashion. Through social engineering an
individual may pose as a trustworthy coworker, perhaps someone from the company’s IT support division,
and politely ask for passwords or other confidential information. Dumpster diving is the act of sifting
through a company’s trash for information that can be used either to break into its computers directly or
to assist in social engineering.
Outsiders are not the only threat to the security of a company’s systems and data. Insiders can also be a
source of security risks. For example, disgruntled employees or those who are planning to work for a
competitor can steal proprietary information or sabotage computer systems.
Software Piracy
Software is intellectual property that is protected by copyright law and end-user licensing agreements. In
most cases, the purchase of a software application is not a purchase of the software itself but the purchase
of a license to use it. Therefore, under most circumstances software cannot be legally transferred from
one user to another. Software piracy is a form of theft involving the unauthorized transfer or copying and
use of software.
Auditors should be aware of the legal issues associated with software piracy and the methods to avoid
legal liability. Software licensing agreements permit users to download either a specified or an unlimited
number of copies of a software product at given locations or throughout the company. Such software li-
censing agreements are often much cheaper than purchasing individual copies of software for each
computer.
On a periodic basis, internal auditors should review management’s policies concerning software licensing in
order to make sure that software copyright laws are being followed. These periodic reviews can mitigate
the risk of penalties and negative publicity from the illegal use of copyrighted software. In addition, pirated
software also increases the chance of introducing computer viruses or errors into the organization’s internal
systems because pirated software is less likely to have been tested for viruses, or it may have been modi-
fied, causing unexpected or erratic behavior.
Controls that should be implemented to prevent the use of unlicensed software include the following:
• Establishing policies that guard against unauthorized usage or copying of software.
• Establishing a log of all licensed application and systems software.
• Centralizing software installations so that only licensed software can be used.
Section II G. Cybersecurity and Information Security-Related Policies
G. Cybersecurity and Information Security-Related Policies

Information security policies direct how technology should be used and detail the penalties for failure
to comply with those policies. It is important to distinguish operating procedures from policies. For
example, operating procedures would provide instructions on how to receive and send email, while pol-
icies would detail the acceptable uses of email. Therefore, policies are less about technical controls and
more about management and ethics.
Information security-related policies will generally fall into one of three categories:
• The enterprise-wide security policy is the “general” security policy that details the structure of
information security, the shared responsibilities for security for all members of the organization,
and specific responsibilities for security that apply only to certain departments or roles. This policy
will guide the creation and management of the specific security policies.
• An issue-specific security policy covers the proper use of technology such as email, the Inter-
net, photocopiers, portable storage devices, cloud storage, using work computers at home, using
home devices at work, and so forth. Usually all such policies are combined into one centrally-
managed document for ease of maintenance and distribution. Appropriate penalties for violations
should be included and there should also be a mechanism for anonymously reporting violations.
• A system-specific security policy details the procedures used for configuring and maintaining
systems and which security protocols needs to be implemented.
Issue- and system-specific policies should be regularly reviewed to ensure that they are complete and
relevant. Internal auditors need to be aware of the security policies and review them to be sure that they
provide adequate controls to protect the company’s information assets. Larger organizations may have a
policy administrator to oversee the necessary reviews, updates, and implementations of the security
policies.
Three Lines of Defense

The IIA’s Position Paper The Three Lines of Defense in Effective Risk Management and Control presents the
Three Lines of Defense Model that “provides a simple and effective way to enhance communications on
risk management and control by clarifying essential roles and duties.” The Three Lines of Defense Model is
not specific to IT controls, but the IIA’s Assessing Cybersecurity Risk: Roles of the Three Lines of Defense
applies the Three Lines of Defense Model to cybersecurity and is a key resource for internal auditors imple-
menting information technology and cybersecurity controls.
First Line of Defense: Operational Management

Operational managers are responsible for identifying risks and taking corrective actions to address any
control deficiencies. For cybersecurity, IT managers and officers such as the Chief Information Office, Chief
Technology Officer, and Chief Security Officer are collectively responsible for identifying threats to the
organization’s information assets and the controls that protect those assets.
Common first line defense activities include:
• Keeping systems and software up-to-date.
• Implementing firewalls and intrusion-detection systems.
• Using encryption wherever possible.
• Creating and implementing physical and user-access security controls.
• Creating an inventory of information assets.
G. Cybersecurity and Information Security-Related Policies CIA Part 3
Second Line of Defense: Risk Management and Compliance Functions

The second line of defense is a separate risk management function that monitors the first line of defense
(i.e., the operational management) that may intervene as necessary to modify or develop the internal
controls. For cybersecurity, the second line of defense would include the IT risk management and IT com-
pliance functions, which are responsible for assessing cybersecurity risks against the organization’s risk
appetite, creating cybersecurity awareness at all levels of the organization, assessing and monitoring se-
curity risks from outside vendors, and overseeing the first line of defense.
Common second line of defense activities include:
• Conducting cybersecurity risk assessments.
• Implementing cybersecurity policies and training.
• Monitoring and responding to any security incidents.
• Writing, implementing, and testing disaster recovery plans.
Third Line of Defense: Internal Audit

The third line of defense is internal audit, which provides the highest possible level of independence and
objectivity within the organization. Internal auditors are responsible for auditing cybersecurity risks and
controls across the entire organization and therefore provide an important layer of additional oversight over
the controls in the first line of defense. The internal auditors will usually work closely with the second line
of defense and can usually rely on—with verification—the work of the second line of defense. Any observed
deficiencies should be reported to senior management and the board.
Common third line of defense activities include:
• Auditing IT controls.
• Tracking any control deficiencies or security events for proper remediation.
• Ongoing risk assessment of outside parties, in conjunction with first and second lines of defense.
Section III Section III – Information Technology
Section III – Information Technology

Section III covers Information Technology (IT) and accounts for 20% of the exam. All of Section III is
covered at the basic cognitive level. The main topics in this section include:
• Core activities in the systems development lifecycle and the importance of change controls
• Basic database terms
• Basic Internet terms
• Characteristics of software systems (e.g., CRM, ERP, GRC).
• IT infrastructure network concepts
• Operational roles within IT
• Purpose and application of IT control frameworks
• Disaster recovery
Specific terminology used on the CIA exam may differ from the vocabulary at any specific company. Alt-
hough you should internalize these terms for the exams, you are not at all obligated to change your
vocabulary at work.
Introduction to Information Technology

The extensive use of computers in a company’s operations and accounting systems can automate difficult
tasks and provide extensive benefits such as saving labor costs and accelerating tedious, repetitive pro-
cesses. In addition, the ever-growing expansion of e-commerce, virtual organizations, broadband and
wireless communications, reliance on data encryption, and open systems presents a broad horizon of op-
portunities for companies to enlarge their customer base and increase revenue.
Such a heavy reliance on technology, however, increases the company’s exposure to inaccuracies and
internal fraud, and the interconnectedness of commerce means that businesses are more vulnerable to
external threats. Therefore, internal auditors should pay close and special attention to the inner workings
of the information technology that the company uses.
There are countless ways that a company’s information technology systems can cause headaches for inter-
nal auditors because the automatic processing of data, the volume of the data processed, and the
complexity of the processing can increase both the risk of loss and the potential dollar loss from exposures.
There are many intricate, highly detail-oriented, time-consuming issues that can only be addressed, recti-
fied, and overseen by a fully competent internal auditor.
For example, because IT is a highly specialized field requiring years of training and specialized knowledge,
and because programs are written in specialized computer languages, there are numerous ways in which
fraudulent activity can be secretly embedded and go undetected for a long period of time. Oftentimes, it
takes a highly skilled specialist to identify and rectify fraudulent code.
Other IT issues can arise even in the absence of ill will and deliberate fraud. Ideally, well-written programs
should eliminate all errors because the code, not a fallible human, is making calculations and processing
transactions. Yet even under the best of circumstances, programmers will make occasional errors, and thus
a mistake in the programming can lead to an error in every transaction that the defective program pro-
cesses.
An additional factor that can complicate the work of internal auditors is that audit trails for computer-related
tasks may exist for only a short period of time because support documents may be periodically deleted.
Audit trails are the lifeblood of internal auditing because they provide documentary evidence for transac-
tions and verification of control techniques to prove that a given transaction was properly authorized and
processed. When an audit trail is absent, either because the data was accidentally deleted, improperly
recorded, or otherwise lost, the reliability of an accounting information system is questionable.
1. Application and System Software CIA Part 3
Even the physical location of data can be a risk factor. A company with highly centralized data storage or
server facilities puts itself in danger if the location is threatened (perhaps due to weather or accident) or
some catastrophe wipes out the data and there is no backup.
Although information systems present unique challenges, it is important to remember that internal control
goals for an information system are the same as those for the overall organizational internal controls:
• Promote effectiveness and efficiency of operations in order to achieve the company’s objec-
tives.
• Maintain the reliability of financial reporting through checking the accuracy and reliability of
accounting data.
• Assure compliance with all laws and regulations that the company is subject to, as well as
adherence to managerial policies.
• Safeguard assets.
1. Application and System Software

Systems Development Lifecycle
When a new computer system is being created, it is important that the development process be structured,
documented, and controlled. The systems approach to problem-solving, which can be applied to the
development of large, highly structured application systems, involves a process called the systems devel-
opment life-cycle approach (SDLC). The SDLC assumes that any information system has a limited life
because organizational priorities change, technology becomes obsolete, and a new lifecycle must begin
when the current system is no longer adequate. The SDLC involves planning, analysis, design and im-
plementation and it provides a framework for planning and controlling the detailed activities involved in
systems development.
The entire process is broken down differently depending on the exact methodology, but the main steps are
divided into two categories: project definition and project initiation.
Project Definition Stage
1) Statement of Objectives. This proposal outlines the need for the new system, indicates the
support for it within the organization, and gives an overview of various timing issues.
2) Systems Investigation and Feasibility. A study should include an analysis of the existing sys-
tem to determine whether a new system is really needed or whether the existing system can be
fixed. In addition, any control deficiencies in the existing system that previous audits identified
should also be considered. Toward this goal, three feasibility studies are needed:
a. Technical feasibility. This study determines if the necessary hardware and software are
currently available. If not, it further looks into whether or not the appropriate hardware and
software can be developed in the required time.
b. Economic feasibility. A cost-benefit study assesses whether or not expected cost savings,
increased revenue or profits, reductions in required investment, and other benefits will make
the investment in the new system worthwhile. The auditor should also evaluate cost estimates
to see if they are reasonable.
The methods of a financial evaluation are the same as with any capital investment project:
• Payback period. The payback period is the length of time it takes for the project to re-
cover its initial project investment. Based on a certain set of criteria, management should
select an acceptable timeframe within which the project must recoup its costs.
Section III 1. Application and System Software
• Return on Investment (ROI). The equation to calculate a project’s return on investment

is:
Average annual profit

ROI =
Average capital employed
• Net Present Value (NPV). The project’s cash inflows and outflows are discounted to
their present value to reflect the time value of money. If the NPV is equal to or greater
than zero, then the project should be considered viable and accepted. Otherwise, the pro-
ject should most likely be rejected.
• Internal Rate of Return (IRR). This is the discount rate at which the NPV of an invest-
ment equals 0. An IT project would be considered viable if the IRR exceeds a target
minimum rate of return that is greater than the organization’s cost of capital.
c. Operational feasibility. This study is designed to determine how well the proposed system
will work once it is in operation. For example, it can find out how willing management, em-
ployees, customers, and suppliers are to operate, use, and support the new system.
Note: Throughout the feasibility study, the internal auditors should be mindful of the organization’s
objectives. Auditors should make sure that the study includes representatives of all departments that
will be affected and that at least one member is an expert in hardware and software capabilities. Speci-
fications for the new system should include projections of future growth.
Project Initiation Stage
3) Systems Analysis. In this initial phase, the analyst assesses the system to get a clear overview
of what is needed, what is not needed, and what should be allowed to remain.
a. To understand the existing system’s strengths and weaknesses, the analyst first conducts an
organizational analysis or a systems survey to learn as much as possible about the com-
pany, its management, employees, business, other systems it interacts with, and its current
information system.
b. Next, the analyst identifies users’ information requirements and functional require-
ments. Information requirements might include input and output needs, database
requirements, and specific characteristics of the system’s operation.
“Functional requirements” refer to everything not necessarily tied to the hardware, software,
network, data, and human resources, including user interface requirements for data entry,
processing requirements (e.g., automatic calculations), storage requirements (e.g., databases
for fast retrieval), and control requirements (e.g., error messages in data entry).
c. System requirements must be identified and fulfilled.
d. Through a cost-benefit analysis, the analyst evaluates alternative designs for the proposed
system.
e. For the final step, the analyst issues a systems analysis report that documents the system
specifications and the conceptual design of the proposed system.
4) Systems Design and Development. For this next phase, software architects and developers
take the recommendations from the analysis report and create the new system.
a. The development team draws up detailed design specifications, working backwards from
the desired outputs to the required inputs.
b. Next, the team assesses the processing requirements to determine which ones are nec-
essary to convert the available inputs into the desired outputs. The team must also study the
workflow, decide which programs and controls are needed, and draw up a list of the necessary
hardware, backups, security measures, and data communications.
c. Storage components needs to be evaluated so that the development team fully grasps
the data requirements, namely how much will be created and how much will be stored. During
this stage, the team will also design the database and the appropriate data dictionaries.
d. The team prepares the systems design report. It includes everything that is necessary to
implement the proposed system, including input requirements, processing specifications, out-
put requirements, control provisions, and cost estimates.
e. Documentation comes next. Designated team members write the manuals, forms, and other
related materials.
f. An essential part of system documentation is the creation of a flowchart. This graphical de-
piction, which illustrates the processes and the flow of documents, helps all those involved
understand how the system works.
g. Once all the technical architecture is in place, programmers are brought in to write the code.
This is the program development stage.
5) Systems Implementation. In this phase, the system goes “live.” At this point, a number of key
events must be carefully coordinated and employees must receive adequate training in the new
system. This can be a stressful time for the company, as the moment of transition from old to new
will invariably encounter unexpected setbacks and, on occasion, resistance from employees.
The system conversion can be done in a number of ways:
a. Parallel operation. Both the old and the new systems run concurrently for a period of
time to make certain that everything is functioning properly. This method is the least risky
but it consumes considerable resources to run two fully operational systems at the same
time.
b. Phased or modular conversion. Only parts of a new application or only a few locations
at a time are converted, allowing the conversion to take place gradually.
c. Pilot conversion. The new system is tested in one department or worksite before full
implementation.
d. Plunge or direct conversion. Changing from the old to the new system happens at once.
This is the quickest but riskiest conversion method.
Whichever conversion method is used for system implementation, controls should always be in
place, such as record counts, reviewing reports, hash totals, and reconciliations.
6) Systems Evaluation and Maintenance. An oversight group must conduct a post-implementation

review to ensure that the new system meets its objectives and also to correct any errors. The new
system should be continually monitored and periodically audited to make sure it functions properly.
Over time, the new system will need to be modified to adapt to changing needs. Any modifications
should be authorized by management and subjected to controls. As is true for all systems, modi-
fications should be tested fully and approved by the users as well as the IT management. From
time to time, a full systems test should be performed in order to ensure that the changes work as
planned and do not cause unintended results.
Prototyping as an Alternate Method of Systems Development

The systems development steps discussed above work best for a management team that knows precisely
what it needs. However, the strict application of a systems development plan does not always work for
every company and every circumstance. Fortunately, there are other methods of achieving a successful
transition from one system to the next.
When user requirements are unclear, prototyping is a useful systems development approach because it
is an iterative process; that is, it progresses through a structured series alternating between input and
feedback. Initially, the programmer estimates user requirements, builds a prototype, then allows the user
to try it out. Based on positive and negative responses, the programmer may add new features, delete
poorly designed elements, or modify existing portions. This feedback process continues until the users are
satisfied.
Prototyping has a few advantages. It is useful when it is difficult to know in advance what the user re-
quirements are, and it allows users to try a system before extensive development costs are incurred. In
addition, through prototyping the system can be developed in a short period of time.
Prototyping also has its disadvantages. A system might be accepted as final before it is actually finished,
and thus the program may lack important testing, documentation, and controls when put into service. Also,
because the endpoint is not always clear, there is a risk that the prototype’s feedback series might never
be finished as users continue to request minor changes. Prototyping can also be expensive.
Rapid Application Development (RAD)

Rapid Application Development (RAD)16 refers to any number of free and commercial software tools that
allow programmers to develop applications very quickly using pre-built components, such as NetBeans,
Microsoft Visual Studio, Apple Xcode, and FileMaker. RAD tools provide a vast library of functionality “out
of the box” and only require the developer to create the relationships that process data between and within
the various components of the program.
Advantages of RAD:
• When used in conjunction with prototyping, RAD enjoys the same benefits as prototyping.
• Systems can be built more rapidly by reusing existing software components rather than designing
every component from scratch.
Disadvantages of RAD:
• When used in conjunction with prototyping, RAD suffers the same drawbacks as prototyping.
• Choosing the wrong RAD tools may slow development or lead to systems that cannot be completed
without a costly conversion to a different RAD framework.
System and Program Change Controls

Any proposed changes to existing programs or systems must be approved by the appropriate management
personnel and be subject to strict change controls. In order to avoid serious disruptions and system-wide
failures, all programming work must be done on a designated copy of the system, never the “live” version.
As the work progresses, it is crucial for the programmer to keep detailed listings of each line of source code
that has been changed, and these records should be easily available.
As programmers test the results of their work, on occasion they should try using incorrect information to
make sure that the program has the necessary controls to detect errors. For an extra layer of security, the
16
Martin, James. Rapid Application Development (1991). Originally, Martin’s process was focused on prototypes, but
the term was broadened over time to mean reusing software components and using fewer formal development methods.
prior version of the code should be kept close at hand so that in the case of serious mistakes the program-
mer can compare old content with new to identify and rectify problems. Furthermore, any changes must
also be properly reflected in all of the related documentation.
Throughout the system-change process, programmers must maintain a history or an audit trail, including
a list of all individuals who have authorized, initiated, and implemented the changes. Once all interested
parties have signed off, the librarian is responsible for moving the changes from development to production.
Indeed, the librarian should not act without the proper signatures.
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The internal auditor determines whether or not the program changes were properly authorized, tested, and
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implemented by performing the following tests:
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• Examine change authorization documents to determine if changes were properly authorized.
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• Determine if controls are adequate over program- and job-control language libraries.
• Review procedures for making emergency changes. On rare occasions, system-related crises
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will emerge with such urgency that there is not enough time to get formal authorization to inter-
vene. For such events, there must be policies in place to guide programmers so that they know
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which steps they can take on their own. For such cases, there should also be a follow-up process
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and subsequent review of the changes.
The auditor should also establish that management reports are available indicating the number of
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emergency changes and other program changes.
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Databases
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A database is a series of related data files, combined in one location to eliminate redundancy, that can be
used by different application programs.
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Basic Data Structures

• A bit is either a 0 or a 1.
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• A byte is a group of 8 bits. A byte usually represents a single character.
• A field is an item within a record, such as an address, phone number, or account number.
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• A record is a group of fields related to the same item.

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• A file is a logical collection of records.

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• A key is an attribute of a record that allows the record to be sorted. The primary key is the
primary identifier for the record, and a secondary key may be used to further sort the records.
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• A database is a collection of related data.

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Entity-Relationship Modeling
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Database administrators use the Entity-Relationship Model to plan and analyze database files and records.
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An entity-relationship diagram utilizes symbols to represent the relationships between and among the
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different entities in the database. The three most important relationship types are one-to-one, one-to-
many, and many-to-many. These relationship types are known as database cardinalities and show the
nature of the relationship between the entities.
To understand how a database works, consider the example of worker at a company who, over time, will
have collected numerous monthly paychecks. Her company will have at least two kinds of database files:
the first for the employee’s name and ID number, and the second for the ID number and all paychecks that
have been issued. The connection between the employee (a single person) and her paychecks (which are
many) is an example of a one-to-many relationship.
Database Management System (DBMS)

A database management system is a software package that serves as an interface between users and the
database. It can create the database, maintain it, safeguard the data, and make it available for applications
and inquiries. Database management systems perform four primary functions:
1) Database development. Database administrators develop databases and create database rec-
ords.
2) Database maintenance. Includes record deletion, alteration, and reorganization.
3) Database interrogation. Users can ask questions in a query language in order to select subsets
of records to extract information.
4) Application development. Developing queries, forms, reports, and labels for a business appli-
cation and allowing many different application programs to easily access a single database.
Note: A Database Management System is not a database but rather a set of separate computer pro-
grams that enables the database administrator to create, modify, and utilize database information; it
also enables applications and users to query the database.
Database Development
The DBMS is used to create a description of the logical and physical structure or organization of the database
and the relationships among the data elements in the database. The map or plan of the entire database is
called the schema. It specifies the names of the data elements contained in the database and their rela-
tionship to each other.
A subschema defines the data required for specific end-user applications and limits the data elements and
functions available to each application. A “subschema” is the description of a particular part of the database,
often called a view. One common use of views is to provide read-only access to data that only certain
users are allowed to update but which many users can query.
The database administrator uses a Data Definition Language (DDL) to create or modify the schema,
subschema, and the record structure of the database. In defining the record structure for each table, the
database administrator gives each field a name and a description, determines how many characters the
field will have and what type of data each field will contain (i.e., text, integer, decimal, date), and may
specify other requirements such as how much disk space is needed for the table.
The format of the input is also defined (i.e., “a telephone number will be [XXX] XXX-XXXX”). The input
mask for a data field creates the appearance of the input screen so that a user who is entering data into
the table will see a blank field or fields in the style of the format (e.g., a date field will appear as
__/__/____). The input mask helps ensure input accuracy.
Once the record structure of the database table is in place, the records can be created.
Database Use and Maintenance

A data manipulation language (DML) is used to maintain a database and consists of “insert,” “delete,”
and “update” statements. Databases are usually updated by means of transaction processing programs
that utilize the data manipulation language; as a result, users do not need to know the specific format of
the data manipulation commands.
A query of a database may be made using a query language. Structured Query Language (SQL) is a
DML, a DDL, and a query language. SQL has been adopted as a standard language by the American National
Standards Institute (ANSI). All relational databases in use today allow the user to query the database
directly using SQL commands. SQL uses the “select” command to query a database. However, business
application programs usually provide a graphical user interface (GUI) that creates the SQL commands
to query the database for the user, so users do not need to know the specific format of SQL commands.
DBMS packages usually include one or more programming languages that can be used to develop custom
applications by writing programs that contain statements calling on the DBMS to perform the necessary
data handling functions. When writing a program that uses a database that is accessed with a DBMS, the
programmer only needs the name of the data item, and the DBMS locates the data item in the storage
media. Thus, the application programs are independent from the physical arrangement of the data.
The Internet and Internet Terms

Accessing the Internet involves data going through a series of progressively larger networks. Individual
computer users connect to small Internet Service Providers (ISPs), and small ISPs connect to larger ISPs.
The largest ISPs maintain high-speed “backbones” for an entire nation or region through fiber-optic lines,
undersea cables, and satellite links. The term "Internet backbone" now loosely refers to these high-
speed “trunk” connections of the Internet that carry vast amounts of data between the largest ISPs.
These backbones may be operated by commercial, academic, or governmental agencies. The most signifi-
cant advantage of this design is that the failure of a single backbone will not cause a major disruption;
Internet communications can be automatically re-routed onto other backbones.
Because there is no central computer system or telecommunications center for the Internet, it has no
headquarters or governing body. Communications standards have been developed by international stand-
ards groups of individual and corporate members, such as the World Wide Web Consortium. These
standards are the key to the flow of information on the Internet.
Internet addresses begin as a domain name, also called a Universal Resource Locator (URL), such as
www.google.com. When you type an Internet address into your web browser, it communicates with a do-
main name server and translates the text-based domain address into a numeric Internet Protocol (IP)
address such as 64.233.187.99. Every device connected directly to the Internet has a unique IP address,
making it possible for you to connect to any device or server. Online search engines like Google enable
locating web pages by clicking through the hyperlinked pages of businesses, government, public interest,
and other websites. The process of following a link from one page to another is called click-through.
The protocol for transmitting data between a web browser and a server is called Hypertext Transfer
Protocol (http), which shows as http:// in the browser address bar. Any data transmitted over http is
easily intercepted, and so http should not be used for sending any sensitive data. As discussed previously
under Encryption, SSL is used to securely transmit data over http, which is shown as https:// in the
browser address bar. Data is considered to be securely transmitted if it is transmitted over https.
Connections between a web browser and server are stateless, meaning that the server does not remember
or retain information about the status or result of each connection. Any website that offers a login capability
or remembers anything about a visitor uses a cookie to store data. Web browsers store these cookies in
order to enable stateful sessions with a server. The common troubleshooting step of “clearing your cook-
ies” deletes this form of tracking, thereby removing any saved information about interactions with servers
on the Internet.
In an effort to improve privacy, web browsers offer a private or incognito browsing mode where no data is
stored. By deleting data after each browsing session, web sites are not able to track users through the
cookies that are usually left behind. Sites visited during a private browsing session are also not stored in
the browser history.
XML (Extensible Markup Language) is an open standard for encoding documents. The foundation of
XML is tags and elements, such as: <header>Document Header</header>, where the tag is in bold and
the element is in italics. XML is extensible, allowing users to create whatever tags they need for their data.
By following a standard format, tags and elements can be used to create complex documents with a hier-
archy of information that can be easily processed by a computer but also still understood by a person.
XBRL (eXtensible Business Reporting Language) is an extension of XML specifically designed for busi-
ness information. One of the most common uses of XBRL is for encoding financial statements in a computer-
readable format. Some governmental agencies such as the SEC require XBRL for financial reporting.
Electronic Data Interchange (EDI)

Electronic Data Interchange was the earliest type of B2B e-commerce. EDI automates repetitive transac-
tions and is the process of connecting different companies’ networks to transmit data for common business
documents using a standardized EDI format. For example, EDI can automatically monitor inventory levels,
trigger orders, confirm deliveries, and process invoices. In this way, EDI assists in the process of just-in-
time (JIT) inventory management. This automation works both up and down the supply chain, both for raw
materials from suppliers and finished goods delivered to vendors.
EDI has increasingly moved to using the Internet instead of dedicated lines. Transmission over the Internet
may be done by means of a secure virtual private network (VPN), or through use of a third-party service
bureau. For a fee, the EDI service bureau can provide smaller suppliers with the translation software capa-
bility so that they do not have to make an investment in their own software and hardware.
A value-added network (VAN) service may also be used by a large company to connect with its suppliers.
A VAN service acts as an EDI message center. Any member can connect to the VAN and leave or pick up
messages from other members. In addition to routing messages, a VAN also provides translation software,
encrypts and authenticates messages, and checks for message completeness and authorization.
Benefits of EDI include:
• Survival. Many smaller organizations have been forced to implement EDI in order to continue
doing business with larger organizations.
• Conflicts are reduced and communication is improved. Suppliers may be given access to
information about what is selling and what is not, which can enable the supplier to forecast cus-
tomer demand and thus be more responsive to consumer needs.
• Data is timely and accurate. Forecasting, analysis, and cash management are improved.
• Processes are streamlined. There is an across-the-board reduction in costs of such mundane
tasks as entering data manually or preparing and faxing or mailing purchase orders and other
documents.
• Accuracy is increased. Data does not have to be entered manually.
Costs of EDI include:
• Time spent to negotiate contracts between the parties or VAN providers.

• Employee training in the use of the system.
• Reengineering the affected applications.
• Hardware and software required for the system to work.
• Added costs for security and control procedures.
Audit and Control considerations with EDI include:
• Proper authorization of transactions is required. Because signatures are not used for author-
ization, there has to be some other way of authenticating that a message is authorized by a person
who has the proper level of authority. Digital signatures may be used.
• Making sure that the message is actually sent to the party that is intended to receive it.
• Controls must be in place to ensure that a clerical error in incoming data is not replicated in the
input to the receiver’s system.
• Program change controls and physical security of the computer system are more important
because the computer will be initiating and authenticating messages.
• If a third party or value-added network is used as an intermediary between the two parties, con-
trols must be in place to ensure correct translating and routing of messages, and security
procedures must prevent compromise of confidential data.
• Encryption (cryptography) may be required to protect the data during transmission.
• An EDI system eliminates much of the paperwork that used to exist for orders, so there are
additional issues for an auditor in performing an audit. Because the record of transactions may not
exist for a long period of time, the auditor may need to perform auditing procedures more often
and need to seek other sources to confirm the transactions and the validity of the transactions.
• The auditor will need to test the controls that are in place to ensure that only authorized trans-
actions are performed.
• Continuous auditing may be built into the system through embedded audit modules that
trigger an alert whenever suspect data is transmitted or if there is an attempt to access the system
without authorization.
Software Systems
A software system refers to a large group of inter-related software components that together can do much
more than any one component could do by itself. Such systems can significantly enhance a company’s
ability to meet its goals and objectives by managing data and automating tasks across multiple depart-
ments.
Note: The term software system should not be confused with system software, which is a computer’s
operating system.
Many software systems use the software as a service (SaaS) model, also known as web-based software,
on-demand software, hosted software, or cloud computing. Rather than purchasing its own server and
installing, configuring, and maintaining it, a company can subscribe to a SaaS system operated by a third
party and accessed via the Internet for a monthly or annual fee.
The main advantage of SaaS is that companies of all sizes can get access to powerful software systems
that might otherwise be too complicated or too costly to purchase outright. The main disadvantage is that
a company loses of control over its proprietary data, because it is entrusted to the third party providing the
SaaS system. Furthermore, it is nearly impossible to audit a SaaS system because the auditor does not
usually have easy access to it.
Customer Relationship Management (CRM) Systems

Customer Relationship Management (CRM) software is a system for building and managing customer rela-
tionships. CRM systems can track customer information, customer purchases, customer interactions across
multiple departments (e.g., sales, billing, shipping, support), marketing campaigns, email sent and re-
ceived, and other information.
A very large organization may be able to afford its own CRM system, but many small to mid-size businesses
might choose a CRM system offered as a cloud service, which means that the data is stored online and
accessed via the Internet. These cloud systems must be thoroughly audited to ensure that they are securely
transmitting and storing the data, but audits can be difficult without direct access to the cloud-based sys-
tem.
Advantages of CRM
The main advantage of a CRM system is that anyone with proper credentials has access to all of the infor-
mation about any given customer. For example, if the customer calls in to the sales department, the
representative can see a full history of all sales, payments, interactions, and any other relevant information,
and therefore is in a position to offer better customer service. With the support of a CRM system, this kind
of personalized service is an effective method for building customer loyalty.
CRMs can also automate customer interactions. For example, CRM software could automatically send an
invoice after a customer places an order, reminders if the invoice is not paid within a certain amount of
time, text messages when a package has been shipped or delivered, follow-up calls confirming that the
customer received the order in good condition, and targeted marketing with offers for similar products. In
addition, a CRM system can be integrated with social media so that it can recognize customers when they
send a tweet to the company’s support team.
Disadvantages of CRM
A robust CRM system will produce a significant amount of data, but without the capacity to efficiently and
easily process the data a company will have a difficult time meeting its business objectives or improving
customer relationships. Therefore, the company must make sure that it has properly-trained personnel in
place who understand the flow of information and the methods to retrieve useful information from the CRM
system. Furthermore, an internal auditor could be overwhelmed with the task of auditing such a large
system, so the IAA must also have the tools and expertise to deal with the volume of data produced by
and stored in a CRM.
Introduction to MRP, MRPII, and ERP

MRP, MRPII, and ERP systems are all integrated information systems that have evolved from early database
management systems.
• MRP stands for Material Requirements Planning
• MRPII refers to Manufacturing Resource Planning
• ERP stands for Enterprise Resource Planning
MRP and MRPII systems are predecessors of ERP systems, though MRP and MRPII are still used widely in
manufacturing organizations.
Material Requirements Planning (MRP) systems help determine what raw materials to order for production,
when to order them, and how much to order. Manufacturing Resource Planning (MRPII) systems followed
MRP and added integration with finance and personnel resources.
Enterprise Resource Planning (ERP) takes integration further by including all the systems of the organiza-
tion, not just the manufacturing systems. ERP systems address the problem of paper-based tasks that
cause information in organizations to be entered into systems that do not “talk” to one another. For exam-
ple, a salesperson takes an order and submits the order on paper to an order entry clerk, who prepares the
invoice and shipping documents. The shipping documents are delivered manually to the shipping depart-
ment, and the shipping department prepares the shipment and ships the order. After shipping, the sale is
recorded and the customer’s account is updated with the receivable due. If the organization maintains
customer relations management software, the order information is entered separately into that database,
so that if the customer calls about the order, the customer service person will be able to discuss the order
with knowledge, since the customer service person does not have access to the accounting records.
The above is only a minor example, and it does not even include the communication needed with production
to make certain the product ordered will be available to ship. Entering the same information into multiple
systems causes duplication of effort and leaves the organization more vulnerable to input errors.
Enterprise Resource Planning integrates all departments and functions across a company onto a single
computer system with a single database so that the information needed by all areas of the company will be
available to the people who need it for planning, manufacturing, order fulfillment, and other purposes.
MRP, MRPII, and ERP all provide information for decision-making by means of a centralized database.
Material Requirements Planning (MRP)

Material requirements planning, or MRP, is an approach to inventory management that uses computer
software to help manage a manufacturing process. It is a system for ordering and scheduling of dependent
demand inventories.
Dependent demand is demand for items that are components, or subassemblies, used in the production
of a finished good. The demand for them is dependent on the demand for the finished good.
MRP is a “push-through” inventory management system. In a push-through system, finished goods are
manufactured for inventory on the basis of demand forecasts. MRP makes it possible to have the needed
materials available when they are needed and where they are needed.
When demand forecasts are made by the sales group, the MRP software breaks out the finished products
to be produced into the required components and determines total quantities to be ordered of each com-
ponent and the timing for ordering each component, based on information about inventory of each
component already on hand, vendor lead times and other parameters that are input into the software.
Once the quantities and the timing have been worked out, the required cash to pay for the components can
be forecasted and arranged. MRP can be used to reduce the amount of cash needed by the organization,
which in turn improves profitability and ROI. MRP creates the antithesis of the situation often found in old
manufacturing organizations where large amounts of cash are tied up in inventory before products can be
assembled and sold. Instead, MRP aims to decrease the amount of cash tied up through careful planning
and management.
Although MRP is primarily a push inventory system, it can also be used in a “demand-pull” situ-
ation, for example if an unexpected order is received, to determine the components to be purchased and
when each should be purchased in order to produce the special order as efficiently and quickly as possible
using just-in-time (JIT) inventory management techniques.
MRP uses the following information in order to determine what outputs will be necessary at each stage of
production and when to place orders for each needed input component:
• Demand forecasts for finished goods.
• A bill of materials for each finished product. The bill of materials gives all the materials, compo-
nents, and subassemblies required for each finished product.
• The quantities of the materials, components, and product inventories to determine the necessary
outputs at each stage of production.
The need for management accountants to collect and maintain updated inventory records is a challenge in
using MRP. Accurate records of inventory and its costs are necessary. Management accountants also need
to estimate setup costs and downtime costs for production runs. When setup costs are high, producing
larger batches and thus incurring larger inventory carrying costs actually reduces cost because the number
of setups needed is reduced.
Manufacturing Resource Planning (MRPII)

Manufacturing Resource Planning (MRPII) is a successor to Material Requirements Planning. While MRP is
concerned mainly with raw materials for manufacturing, MRPII’s concerns are more extensive. MRPII inte-
grates information regarding the entire manufacturing process, including functions such as production
planning and scheduling, capacity requirement planning, job costing, financial management and forecast-
ing, order processing, shop floor control, time and attendance, performance measurement, and sales and
operations planning.
An MRPII system is designed to centralize, integrate and process information for effective decision making
in scheduling, design engineering, inventory management and cost control in manufacturing.
However, if a firm wants to integrate information on its non-manufacturing functions with the information
on its manufacturing functions, it needs an ERP system.
Enterprise Resource Planning (ERP) Systems

Enterprise Resource Planning (ERP) integrates processes in manufacturing, logistics, distribution, account-
ing, finance, and human resources into an ERP system. ERP systems can track the status of sales,
inventory, shipping and invoicing, forecast raw material requirements, and analyze human resource re-
quirements. All of these functions are also integrated with the accounting process. ERP systems are used
in reengineering business processes for increased efficiency and responsiveness to customers and suppliers.
Note: The major components of an ERP system are:
• Production Planning
• Integrated Logistics
• Accounting and Finance
• Human Resources
• Sales, Distribution, and Order Management.
Any subdivision of any of the above components is, by itself, not a component of an ERP system.
The main focus of an ERP system is tracking all business resources and commitments regardless of
where, when, or by whom they were entered. Writing a program that serves the needs of finance as
well as human resources and those in the warehouse is not an easy task because each of the individual
departments in a company usually has its own system and software to help perform its specific work.
However, through ERP all relevant information is combined into a single, integrated software program.
All of the data for the entire company is stored in a single location called an enterprise-wide database,
also known as a data warehouse. By having all of the information from different departments in the same
location, a company is able to more efficiently manage and access this information. Through data ware-
housing and data mining facilities, individuals can sort through and utilize the company’s information more
quickly and easily than if it were stored in separate locations. In data mining, data is analyzed to reveal
patterns and trends and to discover new correlations in order to develop business information.
The advantages of ERP are:
• Better customer service.
• Production and distribution efficiencies.
• Centralizing computing resources and IT staff reduces IT costs.
• Cross-functional information is quickly available to managers regarding business processes and

performance, significantly improving their ability to make business decisions. This allows the busi-
ness to adapt more easily to change and quickly take advantage of new business opportunities.
The disadvantages of ERP systems include:
• Business re-engineering (i.e., developing business-wide integrated processes for the new ERP sys-
tem) is time-consuming and requires careful planning.
• Converting data from existing systems into the new ERP system can be time-consuming and costly
and, if done incorrectly, can result in an ERP system that contains inaccurate information.
• Training employees to use the new system disrupts existing workflows and requires employees to
learn new processes.
• Most significantly, an unsuccessful ERP transition can result in system-wide failures that disrupt
production, inventory management, and sales, leading to huge financial losses. Because the entire
business relies on the new ERP system, it is critical that it be completely functional and completely
understood by all employees. There is no opportunity to “work out the bugs” or “learn the ropes”
when the entire business relies on one system.
2. IT Infrastructure and IT Control Frameworks CIA Part 3
Internal auditors need to be intimately involved in two areas of ERP software: the evaluation and selec-
tion process for the ERP system and maintaining the integrity and security of the data.
Governance, Risk Management, and Compliance (GRC) Systems

Governance, Risk Management, and Compliance (GRC) is a broad term that refers to an organization’s
overall framework to achieve its objectives, address risk, and comply with regulations. GRC systems are
designed to automate and consolidate these activities into a single process across the entire organization,
similar to what CRM and ERM systems do for customers and materials. The benefits of a GRC system include
the following:
• A common set of processes and policies across the entire organization.
• A comprehensive system for managing regulatory compliance on a company-wide basis.
• A unified view of all enterprise risk and compliance programs in the company.
• Consistent reporting on GRC processes and results across departments.
• Improved data analytics by having all of the risk and compliance data in one place.
2. IT Infrastructure and IT Control Frameworks

Networking Concepts
A network is a system that connects computers together. The table below describes several types of
networks.
Public-Switched Standard public telephone lines. They are widely available and inexpensive
Network to use, but are slow and insecure.
Value-Added A private network that connects businesses to securely exchange data. VANs
Network (VAN) are not prevalent anymore due to the Internet, but they are still common in
industries such as health care.
Local Area A local network set up within a home or office. Either each computer is con-
Network (LAN) nected to all of the other computers (a peer-to-peer network) or through
one or more servers (a client/server network).
Ethernet is the most common way of connecting devices on a LAN.
Wide Area A WAN is like a LAN, but spread over multiple offices that may be geograph-
Network (WAN) ically far apart or even in another country. The different locations are usually
connected by high-speed broadband connections.
Virtual Private A VPN uses encryption to create a private network over the Internet. It is
Network (VPN) most frequently used to allow employees to work remotely and still have
access to the company’s network as if they were on-site.
Network Protocols
Protocols specify a common set of rules and signals that computers on the network use to communicate.
The protocol is responsible for taking data packets from one device and sending them to other devices.
TCP/IP is a system of protocols used on the Internet, intranets, and extranets. Client/server networks using
TCP/IP technology are commonly called IP networks. TCP/IP has become so widely used that it is almost
equivalent to a network architecture, even though it is a protocol.
Section III 2. IT Infrastructure and IT Control Frameworks
Network Architecture
A network’s architecture may be one of two major types: peer-to-peer or client/server.
• Peer-to-peer networks permit users to share files and resources such as printers and Internet
access on their own computers and access files and resources on other computers in the network.
In a peer-to-peer network, there is no server and all computers have the same ability to use all
the resources available on the network.
The advantage of a peer-to-peer network is that it is less expensive because there is no need for
a dedicated server. Also, it is simple to set up; all that is needed is reconfiguring existing software.
The disadvantage of the peer-to-peer configuration is that, because it is decentralized, there is no
central storage of files and applications and thus there is no access to a centralized backup routine.
It also does not provide the security that would be available on a client/server network. Due pri-
marily to the lack of control, use of peer-to-peer networks is usually limited to small workgroups.
• The primary architecture of networks used in businesses is the client/server architecture. In a

client/server network, the server provides centralized Internet access, email, file and printer shar-
ing, and security across the network.
Client/Server Networking
In client/server networks, the network centralizes functions and applications in one or more dedicated
servers. The servers are the heart of the system, providing secure access to resources and files. Individual
workstations, called clients, are linked by local area networks and access the resources on the file servers
by requesting the server to perform a task. The server’s job is to perform the tasks requested by the client,
retrieve and update data, and return responses.
The server manages shared resources such as databases, printers, Internet access, and other communica-
tion links. Software applications, such as word processing or spreadsheet programs, generally reside on the
client computers, while the databases and their related software such as accounting systems are stored on
the server. The benefit of a central server is simultaneous access to the shared resources. For example, a
server may control the Internet connection or central database for hundreds of clients at once.
The advantages of a client/server network are as follows:
• It is centralized. Resources and data security are controlled through the server.
• It is scalable. Client workstations can be added or removed fairly easily. Or, if necessary, the
server can be replaced with a larger and faster server or with multiple servers.
• It is flexible. New technology can be integrated into the system.
• It has interoperability. All of the components—client, network, and server—work together.
• It is accessible. The server can be accessed remotely.
• Thin-client systems can be installed using simple terminals instead of more expensive PCs. When
thin clients are used, all the application software resides and is executed on the server. The thin
client processes and transmits only user interface information like keystrokes and mouse clicks
over the network to the server. Costs to deploy and maintain a thin client/server network can be
significantly lower, network administration is simplified, and network security is improved.
The disadvantages of a client/server network include the following:
• Expense. It requires an initial investment in one or more dedicated servers.
• Maintenance. A large network requires a staff of administrators to ensure efficient operation.

Even a small network may require the services of an on-call consultant.
• Operations are completely dependent upon the server. If the server goes down, all opera-
tions across the network cease.
• Distributed data. Multiple copies of the same file may be stored on various servers in the system,
making backup and recovery more difficult and causing difficulties in data synchronization.
• System maintenance is more difficult. Upgrading to a new version of an application can be

more difficult because the system usually requires consistency in these programs across servers.
• User access and security are more complex. Access privileges can vary widely among em-
ployees, and a client/server system requires that proper access rights be set for all users.
Connecting Networks to Each Other

Networks can be connected to one another using several different kinds of devices:
• A bridge connects networks of the same type. It directs the network traffic based on the destina-
tion address of the packet that is being sent.
• A gateway connects networks of different kinds. A gateway is used to connect a local area network
to the Internet, to another local area network, or to a corporate intranet. A gateway acts as a
“protocol converter” to connect the different types of networks.
• A router connects several networks. A router connects several LANs across a WAN if, for example,
a company has several LANs at several different offices. A router also directs the communications
traffic and can look for alternate communication routes if one link fails.
• A switch is another type of device used to link LANs and route packets among them. Unlike a
router, however, a switch does not have any logic and serves only to transmit data.
Operational Roles with IT

Information Operations is an important part of a business’s control structure. While there are many possible
ways to organize the Information Operations, depending on the size of the business, many companies now
have a Chief Information Officer (CIO) who reports directly to the CEO. The CIO is responsible for all IT
operations, including strategy, controls, and compliance.
Under the CIO, Information Operations are further divided into departments based on the size of the busi-
ness. As an example, here is one way that IT functions might be divided:
• Operations: Responsible for the day-to-day functions such as data entry, computer and network
setup and configuration, and the internal help desk.
• Systems Development: Responsible for planning and development of new IT systems, beginning
with the initial analysis through programming and testing.
• Security: Responsible for ensuring that all information systems are secure, including contingency
planning and disaster recovery.
• Data and Databases: Responsible for overseeing the company’s databases and policies, including
who has access to the data.
• Technical Support: Responsible for providing support to all of the Information Operations, in-
cluding user training.
Organization and Operation of the Computer Facilities

Separate Responsibilities within the Information Technology Department
The most important organizational and operating control is the segregation of duties, even within the IT
environment. Effective separation of duties should be instituted by separating the authority over and
responsibility for different IT functions. The auditor must understand the IT environment, the division of
the departments, and the roles of the key individuals in the departments. The auditor also needs to know
what functions, if any, are outsourced. While reputable vendors most likely will not need to be audited, it
may be helpful for the auditor to understand how the outsourced functions operate and connect with the
business.
The various positions within a computer system and the responsibilities of each are as follows:
• The Database Administrator (DBA) develops and maintains the database, establishes proper
controls, manages access to various files and source codes, and oversees program changes.
• Systems analysts review systems to make sure that they meet the needs of the organization
and provide the design specifications to programmers for any new systems. Systems analysts
should not do programming, nor should they have access to hardware, software, or data files.
• Programmers write, test, and document the systems. They can modify programs, data files, and
controls, but should not have access to the computers and programs that are in use for processing.
• Computer (console) operators process data. They should not have programming functions and
should not be able to program. Their responsibilities should be rotated so no one operator is always
overseeing the running of the same application. The most critical separation of duties is between
programmers and computer operators.
• Librarians maintain the documentation, programs, and data files. They should have no access to
equipment. Librarians should restrict access to the data files and programs to authorized personnel
at scheduled times. Furthermore, the librarians maintain records of all usage and those records
should be reviewed regularly by the data control group for evidence of unauthorized use.
• The data control group receives user input, logs it, monitors the processing of the data, recon-
ciles input and output, distributes output to authorized users, and checks to see that errors are
corrected. They also maintain registers of computer access codes and coordinate security controls
with other computer personnel. They must keep the computer accounts and access authorizations
current at all times. They should be organizationally independent of computer operations.
For transaction authorization, users should submit a signed form with each batch of input data
to verify that the data has been authorized and that the proper batch control totals have been
prepared. Data-control group personnel should verify the signatures and batch control totals before
submitting the input for processing. This would prevent a payroll clerk, for example, from submit-
ting an unauthorized pay increase.
IT Control Frameworks
As technology became commonplace in the workplace starting in the 1960s, each company had its own
methods for managing and controlling their IT resources. Over time, IT control frameworks were developed
to provide a set of standardized guidelines for the management of IT resources and processes. Control
frameworks provide numerous benefits to an organization:
• They identify specific roles and responsibilities that need to be met.
• They provide a benchmark for assessing risks and controls.
• Following a framework provides a higher likelihood of implementing effective controls.
• Frameworks break down IT activities and controls objectives into groups.
• Regulatory compliance may be easier to achieve by following effective control frameworks.
The IIA’s GTAG 1: Information Technology Risk and Control, which is available to IIA members for free
from the IIA’s website,17 provides guidance for internal auditors and CAEs and their role with IT controls.
While it is not necessary for internal auditors to know the details of how to select and implement specific
IT controls, internal auditors need to be aware of the risks to IT systems and the range of IT controls
that are available. The CAE also needs to certify that the organization’s controls are consistent with its
risk appetite and that the IT control framework is effectively managing risk.
The following section provides an overview of some of the most prominent IT frameworks currently in use.
COSO
The Committee of Sponsoring Organizations (COSO), made up of five professional organizations, cre-
ated one of the first IT control frameworks in 1992 with the publication of Internal Control—Integrated
Framework and it introduced the concept of controls for IT systems. Internal Control—Integrated Frame-
work was updated in 2013. COSO defines internal control as “a process, effected by18 an entity’s board of
directors, management, and other personnel, designed to provide reasonable assurance regarding the
achievement of objectives relating to operations, reporting, and compliance.” According to the Integrated
Framework, the internal control system should consist of five interrelated components:
1) The control environment
2) Risk assessment
3) Control activities
4) Information and communication
5) Monitoring
In 2004, COSO published Enterprise Risk Management—Integrated Framework to provide a process for
enterprise-wide risk management. In 2017, COSO published an update and revision to the 2004 publication,
Enterprise Risk Management—Integrating with Strategy and Performance, to address the increased com-
plexity of risks and new risks that had emerged since 2004.
The five interrelated components of enterprise risk management according to the 2017 publication are:
1) Governance and culture
2) Strategy and objective-setting
3) Performance
4) Review and revision
5) Information, communication, and reporting
COSO is one of the most commonly used enterprise-wide risk management frameworks today and is the
basis for many regulations and laws related to internal controls. COSO is also the only framework mentioned
by the SEC and the PCAOB, the latter being the agency created by the Sarbanes-Oxley Act.
17
18
To “effect” something means to cause it to happen, put it into effect, or to accomplish it. So “effected by” means “put
into effect by” or “accomplished by.”
COBIT
Control Objectives for Information and Related Technology (COBIT), first published in April 1996, defines
control as “the policies, procedures, practices, and organizational structures designed to provide reasonable
assurance that business objectives will be achieved and that undesired events would be prevented or de-
tected and corrected.”19 Furthermore, “COBIT is a tool that allows managers to communicate and bridge
the gap with respect to control requirements, technical issues, and business risk.” 20 The COBIT control
framework links the goals of the business with the goals of IT so that IT resources can provide the infor-
mation that the enterprise needs to achieve its objectives. COBIT has become an IT governance tool that
helps assist management with implementing adequate controls over IT processes. The primary responsi-
bility for internal control lies with management and the board.
Further, controls should be subjected to cost/benefit analysis. This means that management should not
spend more on controls than the amount expected to be received in benefits from the controls. This is a
matter of judgment on the part of management to determine what is required to attain reasonable as-
surance that the control objectives will be met without spending more than can possibly be gained.
Even though COSO’s Internal Controls—Integrated Framework and COBIT are both applicable to the internal
control of information systems, COBIT is specifically focused on IT controls, whereas COSO provides entity-
wide control guidance.
COBIT was designed with three distinct audiences in mind:
1) Management. Managers need to balance risk and control investments in the IT environment.
2) Users. The system’s users need assurance about the security of, and controls over, internal and
third-party IT services.
3) Information Systems Auditors. IT auditors must be able to substantiate their opinions conveyed
to management and others about the state of internal controls.
The three parts of the COBIT framework are Information Criteria, IT Processes, and IT Resources.
1) Information Criteria are the minimum standards necessary to meet business goals. Information
Criteria has three parts:
• Quality requirements, which include quality, cost, and delivery.
• Fiduciary requirements, which include the effectiveness and efficiency of operations, relia-
bility of information, and compliance with laws and information.
• Security requirements, which include confidentiality, integrity, and availability.
2) IT processes are required in order to ensure that the information is properly gathered and meets
the Information Criteria. IT processes are organized into four stages or domains:
• The Planning and Organization stage focuses on integrating the IT processes into the or-
ganization and communication of overall business objectives. It regulates how IT can be used
in a company to help achieve its goals and objectives as well as the organizational form that
IT should take in order to maximize its benefits.
• The Acquisition and Implementation stage is where solutions are acquired or developed
and implemented. It identifies the requirements for IT, acquires the technology, and puts it
into practice. It also provides guidance for developing and adopting a maintenance program in
order to prolong the life of the IT system.
19
Control Objectives for Information and Related Technology (COBIT) 3rd Edition, copyright 2000, IT Governance Insti-
tute, www.itgi.org.
20
COBIT 3rd Edition, pg. 7.
• The Delivery and Support stage includes training staff, maintaining security, and controlling
the delivery of services such as the execution of the applications within the IT system.
• The Monitoring stage includes getting feedback so that management can assess the IT needs
of the company and whether or not the current IT system still meets the business objectives
for which it was designed. It also assesses controls.
3) IT Resources are required to gather information. The required resources include:
• People. Staff needs to have the proper skills, awareness, and productivity to plan, organize,
acquire, deliver, support, and monitor information systems and services.
• Application systems. The manual and programmed procedures.
• Technology. The hardware, operating systems, database management systems, networking,

and so forth.
• Facilities. These are the resources necessary to house and support the information system.
• Data. Data comes in many forms, including external or internal, structured or unstructured,
graphics, sound, and so forth.
COBIT Components
Information Criteria
Domains
Application Systems
IT Processes
Processes
Technology
Facilities
Data
People
Activities
COBIT 5
The latest version of COBIT is COBIT 5: A Business Framework for the Governance and Management of
Enterprise IT. COBIT 5 focuses on two main areas:
• The balance between optimizing risk and resource use.
• Governing technology on an enterprise-wide level.
COBIT 5 presents five principles for building an effective governance and management framework:
1) Meeting stakeholder needs. It is not uncommon for internal and external stakeholders of a
given organization to have conflicting agendas. COBIT 5 includes a goals cascade that can help
prioritize the stakeholders’ needs.
2) Covering the enterprise end-to-end. COBIT 5 does not focus solely on IT, but rather integrates
IT governance into corporate-wide governance. COBIT 5 also considers IT an asset of everyone in
the company, not just the IT department; therefore, IT-related assets are part of everyone’s re-
sponsibility across the organization.
3) Applying a single integrated framework. COBIT 5 can be used in conjunction with other en-
terprise and IT control frameworks and it can function as the overarching control framework.
4) Enabling a holistic approach. Rather than just looking at one department or function at a time,
COBIT 5 uses a series of seven enabler goals to support the company’s IT goals, which in turn
supports the enterprise goals, which can enable the company to meet its stakeholders’ needs.
5) Separating governance from management: Governance is the responsibility of the board,

while management is the responsibility of the company’s executives. Governance focuses on meet-
ing the needs of stakeholders, setting the enterprise objectives, and monitoring performance
towards those objectives. Management plans and builds the company’s activities based on the
directives from the company’s governance. As long as the enterprise objectives are being met,
management can organize the operations however they see fit.
COBIT Maturity Model

Maturity models provide a standard for a company to evaluate the management of its IT processes. Such
models are not intended to be strictly interpreted; rather, they provide guidelines for companies to assess
and improve their IT processes. The COBIT Maturity Model provides six levels, numbered zero through five,
that describe a company’s IT processes:
• 0: Non-existent. There are no processes in place and no awareness of the need for them.
• 1: Initial/Ad Hoc. There is awareness of the need for processes, but those that are being used
are not documented or applied consistently.
• 2: Repeatable but Intuitive. Processes have been created, but there is no single process that
all parties follow, and therefore performance may vary.
• 3: Defined Process. Documentation and training exist, but there may not be controls in place to
monitor adherence to the process.
• 4: Managed and Measurable. Procedures are monitored for compliance; continuous improve-
ment will refine the processes.
• 5: Optimized. Processes are followed and monitored throughout the organization; in addition,
they improve the organization’s efficiency and effectiveness.
As a process becomes more clearly defined, it becomes easier to control. However, it is important to bear
in mind that maturity models do not assess the strength of controls. Regardless of the process, manage-
ment still needs to decide which controls need to be performed.
Note: Maturity models measure only how capable a process is, not how much of that capability needs
to be performed or deployed based on the company’s risk objectives. It is possible that for certain
applications a fully optimized process may not be required for the company to meet its goals and objec-
tives.
ISO 27000
ISO 27000: Information Technology–Security Techniques–Information Security Management Systems–
Overview and Vocabulary is an international standard that provides an overview of the ISO 27000 standards
for modeling an Information Security Management System (ISMS). From the introduction for ISO
27000:
Through the use of the ISMS family of standards, organizations can develop and implement a
framework for managing the security of their information assets, including financial information,
intellectual property, and employee details, or information entrusted to them by customers or third
parties. These standards can also be used to prepare for an independent assessment of their ISMS
applied to the protection of information.
Similar to other IT control frameworks, ISO 27000 provides a model for creating policies and procedures
based on the company’s tolerance for risk, managing IT resources, and protecting the company’s infor-
mation. The ISO 27000 family has guidance for creating an ISMS for different business sectors:
• ISO 27010 provides controls and guidance for information security in inter-organizational and
inter-sector communications.
• ISO 27011 includes guidance specific to telecommunications companies.
• ISO 27017 specifies additional controls for cloud-based services.
• ISO 27018 covers controls for processing personally-identifiable information. The General Euro-
pean Protection Regulation (GDPR) that went into effect in 2018 raised awareness worldwide of
the need for protections of personal data, and ISO 27018 and other documents in the ISO 27000
family can help create systems compliant with GDPR.
• ISO 27019 addresses security controls specific to the energy utility industry (e.g., gas, oil, elec-
tricity), except nuclear power facilities.
• ISO 27799 is aimed at the special security needs of personal health data.
ISO 27000 outlines the following steps for creating and improving an ISMS:
1) Identify information security requirements. Identify the information assets, the processing
and storage needs, and any legal, regulatory, and contractual requirements.
2) Assess and treat information security risks. Identify and prioritize the risks to the information
assets against the objectives of the organization and its risk appetite.
3) Select and implement controls. Determine the controls that are needed to mitigate identified
risks and implement them. Ideally, controls should be considered during the project-design stage
in order to maximize their effectiveness and keep costs down.
4) Monitor, maintain, and improve effectiveness (continuous improvement). Existing sys-

tems and controls should be monitored on an ongoing basis with a focus on continuous
improvement to reduce risk to the company’s information assets.
It is important to remember that ISO 27000 provides only a framework and that every organization will
need to tailor its ISMS for its specific risks and risk tolerance. Other control frameworks should also
be used in conjunction with ISO 27000 to further improve the integrity and security of the company’s
information.
ITIL
Originally developed in the 1980s as a framework for managing IT resources within the British government,
Information Technology Infrastructure (ITIL) is now published and owned by Axelos, a joint venture
between the public and private sectors. The most recent version of ITIL is Version 3, released in 2011. At
the time of this writing, ITIL Version 4 has been announced for release in the first quarter of 2019.
The ITIL framework describes five stages for aligning a company’s IT services with its business needs:
1) Service Strategy: Create a strategy to ensure that IT services are aligned with business goals.
2) Service Design: Design the implementation of IT services to meet the goals described in the
Service Strategy.
3) Service Transition: Ensure that IT services are deployed in a way that meets the Service Design.
4) Service Operation: Continually monitor the daily operation of IT services and correct any prob-
lems or failures.
5) Continual Service Improvement: Continue to focus on improving the quality and cost effective-
ness of IT services.
ITIL should be an ongoing process and is best introduced in stages; in other words, all five stages should
not be introduced at the same time across the organization. A common strategy is to start with what is
most important or where the greatest benefits can be achieved.
Note: ITIL is not a Standard. Furthermore, a company cannot become “ITIL Certified.” Rather, ITIL
is a framework that a company can adopt for the advantages that it will provide. Individuals can
become ITIL-certified, and there are different “levels” for mastery of the ITIL framework concepts
and experience implementing ITIL. The ITIL certification is managed by Axelos.
ITIL complements other IT-related standards and frameworks. ISO 20000 provides standards that define
IT management; moreover, even though ISO 20000 and ITIL are not based on or derived from each other,
they cover similar concepts. More specifically, ISO 20000 focuses on what to do and ITIL focuses on how
to do it. Similarly, ISACA considers ITIL to be complementary to COBIT, which focuses strongly on control
and governance. A company could use ITIL for implementing IT systems and COBIT for governing and
controlling those systems.
3. Business Continuity and Contingency Planning CIA Part 3
3. Business Continuity and Contingency Planning

Business continuity management refers to the plans and processes to mitigate incidents that could
otherwise interrupt the company’s activities. The risks to the company’s operation should be ranked ac-
cording to which systems are the most essential.
In any computer system, one of the most essential elements is having a plan for the backup and recovery
of data. Several different processes function as part of the backup and recovery plan.
• Program files, as well as data files, should be backed up regularly. Backup systems need
to be very methodical, ensuring that all backups are properly stored, labeled, and secured. At least
two backup storage media should be used to protect against failure, such as hard drives, optical
discs (CD, DVD, or Blu-ray), magnetic tapes, and flash memory.
• Copies of all transaction data are stored as a transaction log as they are entered into the
system. Should the master file be destroyed during processing, computer operations will roll back
to the most recent backup; recovery takes place by reprocessing the data transaction log against
the backup copy.
• Backups should be stored at a secure, remote location so that data can be reconstructed in
the event of a physical disaster. It would do little good to have a backup tape in the same room
as the computer if that area were destroyed by fire. Backup data can be transmitted electronically
to the backup site through a process called electronic vaulting. The security of the remote loca-
tion needs to be evaluated periodically.
• The cloud can be used for backups as long as the data is transmitted and stored securely; in other
words, data should be encrypted.
• Grandparent-parent-child processing is used because of the risk of losing data before, during,
or after processing work. Files from previous periods are retained and if one is damaged during
updating the previous files can be used to reconstruct a new current file. These files should be
stored off-premises.
Other useful elements of a business continuity plan include the following:
• Computers should be on an Uninterruptible Power Supply (UPS) to provide protection in the

event of a power failure. Software is available that works in tandem with the UPS to perform an
orderly shutdown of the system.
• Generators may provide power to an entire facility in the event of a prolonged power outage.
• Fault-Tolerant Systems utilize redundancy in hardware design so that if one system fails an-
other one will take over. A common example of redundancy is servers using Redundant Array of
Independent Disks (RAID) so that the failure of a hard drive does not cause data loss. Another
example would be to use two different Internet providers to connect to a data center; if one con-
nection goes down, the data center remains online.
• Manual procedures can be defined and used during times when computer systems are tempo-
rarily unavailable.
Every business continuity plan will be different depending on the business’s specific needs. Internal auditors
can help managers throughout the organization understand and prioritize the risks in their area and the
impact that disruptions could have on the entire business. The IAA should also review the documentation
and results of periodic testing and identify any gaps that need to be addressed.
Section III 3. Business Continuity and Contingency Planning
Disaster Recovery
Every company should have a formal disaster recovery plan to address the effects of extreme incidents
such as a hurricane, fire, earthquake, flood, criminal act, or terrorism. A disaster recovery plan should
include the following:
• An introduction that emphasizes the importance of contingency planning and disaster re-
covery plans to the long-term success of the organization.
• Periodic risk assessment to review and re-prioritize critical business functions.
• A list of the recovery options and strategies, including the action plans for each and the prior-
ities for what business units should be recovered first.
• A detailed list of the backups, where the backups are stored, and how to recover the backups.
• Appropriate hardware, software, and facilities to be used.
• A list of the personnel responsible for the disaster recovery operations, including a hierar-
chy of who is in charge and current contact information.
• Emergency procedures for any problems that may arise during the disaster recovery process.
• A requirement to test recovery plans on a regular basis.
• The name of the person in charge of keeping the disaster recovery plan current.
Note: A disaster recovery plan may also be called a contingency plan.
Arrangements for alternative facilities as a disaster recovery site and offsite storage of the company’s
databases are also part of the disaster recovery plan. An alternative facility might be a different building
owned by the company or it might be a facility contracted from a different company. The locations should
be a significant distance away from the original processing site.
Disaster recovery sites may be either hot or cold. A hot site is a backup facility that has a computer system
similar to the one that is used regularly. The hot site must be fully operational and immediately available,
with all necessary telecommunications hookups for online processing. A cold site is a facility where power
and space are available to install processing equipment, but it is not immediately available. If an organiza-
tion uses a cold site, its disaster recovery plan must include arrangements to get computer equipment
installed and running quickly. A warm site is in between a hot site and a cold site. It has the computer
equipment and necessary data and communications links installed, just as a hot site does. However, it does
not have live data. If use of the warm site is required because of a disaster, current data will need to be
restored to it.
There are also companies that operate “mobile recovery” centers. In the event of a disaster that destroys
operations facilities, a mobile recovery center arrives within hours in a tractor-trailer or van that is fully
equipped with their client’s platform requirements, 50 to 100 workstations, and staffed with technical per-
sonnel to assist in recovery. Contracts for mobile recovery centers can be expensive, but they alleviate the
need to create and maintain dedicated recovery centers.
Personnel should be trained in emergency procedures and re-training should be done regularly. The disaster
recovery plan should be tested periodically by simulating a disaster in order to reveal any weaknesses in
the plan. This test should be conducted using typical volumes of data and processing times should be
recorded. The disaster recovery plan should be reviewed regularly and revised when necessary, and the
members of the disaster recovery team should each keep a current copy of the plan at home.
3. Business Continuity and Contingency Planning CIA Part 3
The IIA’s GTAG 10: Business Continuity Management, which is available to IIA members for free from the
IIA’s website,21 discusses testing of disaster recovery plans, including seven different types of exercises. A
testing plan should include requirements for:
1) Testing the plan at regular intervals.
2) Testing a variety of threats and recovery strategies.
3) Tracking any deficiencies in the plan and who is responsible for resolving any issues found.
One of the more difficult aspects of disaster recovery plans is determining how often they should be tested.
Too much testing wastes time and resources, but too little testing leaves the organization exposed to
significant risk. Testing once or twice a year should be sufficient unless there are significant changes in
business processes, technology, personnel responsible for disaster recovery, or an anticipated business
disruption. 22
The internal auditor needs to determine two basic things with respect to the planning and preparation for
disaster recovery:
1) Could the organization survive a massive information system disaster?
2) If so, what is the likely extent of a disaster?
The auditor will need to determine how dependent the company is on its information systems, whether a
disaster recovery plan has been developed, and if the plan is adequate. Does the plan include priorities for
which are the critical applications that are to be executed first and which can be omitted? Are there backup
means of transmitting data as well as plans to restore the data center itself?
Internal auditors should observe a simulation of a disaster and execution of the disaster recovery plan, and
they should help assess what parts of the plans worked and what areas need to be improved.
21
22
Ibid.
Section IV Section IV – Financial Management
Section IV – Financial Management

Section IV covers Financial Management and it accounts for 20% of the exam. The two primary topics
in this Section are Financial Accounting and Finance and Managerial Accounting.
1. Financial Accounting and Finance

Note: Because the CIA exam is a global exam, the accounting questions on the exam are referenced to
International Financial Reporting Standards (IFRS), set by the International Accounting Standards Board
(IASB), and International Accounting Standards (IAS), set by the IASB’s predecessor, the International
Accounting Standards Committee (IASC) and adopted by the IASB as part of the body of IFRSs. There-
fore, the accounting topics covered in this study material are based on International Financial Reporting
Standards. Standards set by the IASB are referenced in this volume by their IFRS identification numbers
and standards set by the IASC and adopted by the IASB are referenced by their IAS identification num-
bers, which have not been changed.
The CIA exam does not test the U.S. Generally Accepted Accounting Principles (US GAAP) set by the
U.S. Financial Accounting Standards Board (FASB). Therefore, U.S. GAAP is not covered in these study
materials. However, on occasion U.S. GAAP is referenced along with IFRS.
1 A 1. Financial Accounting Concepts and Principles

Financial accounting provides the means for management and external users to judge the general health
and well-being of a company.
Objectives of Accounting Information

According to the IASB’s publication, the Conceptual Framework for Financial Reporting (September 2010),
the objective of financial reporting is to provide financial information about the reporting entity that is useful
to existing and potential investors, lenders, and other creditors in making decisions about providing
resources to the entity. The types of decisions are varied and numerous, but in general they involve deci-
sions regarding buying, selling, or holding equity and debt instruments and providing or settling loans and
other types of credit.23
Examples of the decisions that are made with the financial information are:
• Investment and credit decisions – Will the company be able to repay its loans? Will the com-
pany be able to pay a dividend or other return on investment?
• Assessing cash flows – Will the company be able to meet its short-term obligations as they come
due? Are the incoming cash flows from investments commensurate to the risk involved in them?
• Enterprise assets and claims on those assets – What assets does the company own? How
liquid are they? What claims do other companies or individuals have on those assets?
Therefore, financial reporting should provide information that fulfills the following requirements:
• General purpose financial reports should provide information about the financial position of
a reporting entity, or information about the entity’s economic resources and the claims
against the reporting entity to help users assess the reporting entity’s liquidity and solvency,
its needs for additional financing, and how successful it is likely to be in obtaining that financing.
• General purpose financial reports should provide information about the effects of transac-
tions and other events that change a reporting entity’s economic resources and claims
against them. Information about the entity’s financial performance helps users understand the
23
The Conceptual Framework for Financial Reporting, International Accounting Standards Board, September 2010, Par-
agraph OB2.
Financial Accounting and Finance CIA Part 3
return the entity has produced on its economic resources, providing an indication of how well
management has fulfilled its responsibilities to make efficient and effective use of the entity’s
resources.
• Financial reports should be prepared on the accrual basis.
There are two basic methods of recording transactions in the accounting records – the cash basis
and the accrual basis.
Under the cash method, nothing is recorded in the accounting records until cash is actually trans-
acted. This means that each journal entry will have either a debit or a credit to cash in it. The cash
basis is not generally accepted accounting principles.
Accrual accounting, on the other hand, depicts the effects of events on an entity’s economic
resources and claims to them in the periods in which those effects occur, even if the resulting
cash receipts and payments occur in a different period. For example, expenses are recognized as
liabilities when they are incurred, even if they will not be paid until sometime in the future. Gen-
erally accepted accounting principles require the use of the accrual method.24
Of the many possible types of accrual journal entries, two examples are as follows:
o Accrual entries are recorded when an event has occurred but no money has been transacted
yet, usually resulting in a payable or a receivable.
o Deferral entries are recorded when money has been exchanged but the goods or services
have not yet been exchanged.
• An entity’s financial performance is reflected by its past cash flows, and information about cash
flows during a period helps users to assess the entity’s ability to generate future net cash inflows,
how the entity obtains and spends cash, including information about its borrowing and repayment
of debt and its payment of cash dividends to investors, and other information that may affect its
liquidity or solvency.
• General purpose financial reports should also provide information about changes in a report-
ing entity’s economic resources and claims against them not resulting from its financial
performance, such as issuing new ownership shares.
However, despite this focus, financial information is not limited to what is in the financial statements. Useful
information comes from news reports, other press releases from the company, and other regulatory re-
porting forms. However, most of this additional financial information is not audited or even reviewed by
someone other than the company releasing the information. Therefore, users will need to treat this infor-
mation outside the financial statements with skepticism.
Because of the variety of information that is potentially available and the various circumstances that sur-
round a business, financial reports by themselves are not a complete or final evaluation of the performance
of management or a measure of the value of the business. General purpose financial reports are not de-
signed to show the value of a reporting entity, although they do provide information to help existing and
potential investors, lenders, and other creditors to estimate the value of the reporting entity. In order to
get a complete perspective or view of a company, it is necessary to consult more than the general-purpose
financial statements.
24
Per IAS 1, Presentation of Financial Statements, Paragraph 27, “An entity shall prepare its financial statements, except
for cash flow information, using the accrual basis of accounting.”
Section IV Financial Accounting and Finance
Qualitative Characteristics of Accounting Information
Note: The difference between qualitative and quantitative may be summed up in this way: qualitative
deals with the quality of something and is expressed in words. On the other hand, quantitative charac-
teristics are related to the amount of something and are expressed in numbers.
According to the Conceptual Framework for Financial Reporting, the qualitative characteristics of financial
information that is useful are segregated into fundamental qualitative characteristics and enhancing
qualitative characteristics.
Fundamental Qualitative Characteristics

The fundamental qualitative characteristics of useful financial information are relevance and faithful rep-
resentation.
Relevance
Relevant financial information is information that is capable of making a difference in the decisions made
by users. Financial information is capable of making a difference
• if it has predictive value (it can be used to predict future outcomes),
• if it has confirmatory value (it provides feedback that confirms or changes previous evaluations),
or
• if it has both predictive and confirmatory value.
To be relevant, financial information should also be material. Materiality is an entity-specific aspect of

relevance and what is material is dependent on the context of an individual entity’s financial report. There-
fore, no uniform quantitative threshold for materiality can be specified. However, if omitting information or
misstating it could influence decisions made by users, that information is material.
Therefore, determination of what is and what is not material requires judgment. It requires evaluating the
relative size and the relative importance of an item. For example, an unusual gain of 50,000 might be
immaterial in the financial statements of a multinational company with 100 billion in net income, but it
might be material in the financial statements of a small company with 1 million in net income. If an item is
judged to be immaterial, it may be combined with other items and thus not segregated or shown on a
separate line. If an item is judged to be material, though, it should be reported separately.
Faithful Representation
To be useful, financial information must faithfully represent the economic phenomena that it purports to
represent. Faithful representation has three characteristics:
1) The financial information is complete. It includes all the information needed for a user to under-
stand the phenomena being depicted, including all necessary descriptions and explanations.
2) The financial information is neutral. A neutral depiction has no bias in the selection or presentation
of financial information. It is not slanted, weighted, emphasized, de-emphasized, or otherwise
manipulated in order to affect whether it will be received favorably or unfavorably by users.
3) The financial information is free from error. There are no errors or omissions, and the process
used to produce the information has been selected and applied with no errors in the process. “Free
from error” does not mean perfectly accurate in all respects because financial reporting makes use
of estimates, and an estimate cannot be determined to be accurate or inaccurate. However, a
representation of an estimate is faithful if the amount is described clearly and accurately and
identified as an estimate, the nature and limitations of the estimation process are explained, and
no errors have been made in selecting and applying an appropriate process for developing the
estimate.
Enhancing Qualitative Characteristics

The enhancing qualitative characteristics of useful financial information that is relevant and faithfully rep-
resented are comparability, verifiability, timeliness, and understandability.
Comparability
Financial information is more useful for decision-making if it has comparability. Financial information has
comparability if it has the following traits.
• It can be compared with similar information about other entities, meaning the accounting principles
that companies apply to the recording of financial transactions are standardized.
• It can be compared with similar information about the same entity for another period or on another
date, meaning accounting principles within a company have been applied consistently.
Consistency is related to comparability, but it is not the same thing. Consistency means the same methods
have been used for the same items from period to period within a reporting entity or in a single period
across entities. Consistency helps to achieve the goal of comparability.
Verifiability
Verifiability means that different observers could reach a consensus that a particular depiction of an event
is a faithful representation. Verification can be direct—the amount or other representation is verified by
direct observation such as by counting cash—or indirect—by checking inputs and recalculating the outputs
using the same methodology.
Timeliness
Timeliness means the information is available to decision-makers in time to be useful in influencing their
decisions. Older information is generally less useful. However, information that is older may be useful for
assessing trends.
Understandability
Information that is understandable has been classified, characterized, and presented clearly and concisely.
Making information understandable does not mean excluding information that is inherently complex and
difficult to understand, however, because the reports would be incomplete and potentially misleading if that
were done.
Going Concern Assumption

Financial statements are normally prepared under the assumption that the entity is a going concern and
will continue in operation for the foreseeable future. If the entity has the need to liquidate or materially
reduce the scale of its operation, the financial statements may need to be prepared on a different basis. If
the financial statements are prepared on a different basis, that basis is disclosed.
The Cost Constraint

In providing financial information to users, firms must keep in mind the costs of preparing and providing
the information, referred to as the cost-benefit relationship. Companies need to consider the costs of provid-
ing the information against the benefits that can be gained from using it. To justify providing a particular
disclosure, the benefits to be derived from using it must be greater than the costs associated with providing
it.
Costs and benefits of financial reporting are not always obvious and measurable. However, in considering
new accounting standards, the IASB does attempt to determine whether the costs associated with a new
standard are justified by the information provided by it.
Elements of the Financial Statements
Note: There are some subtle differences between IFRS and U.S. GAAP in the two bodies’ conceptual
frameworks with respect to their descriptions of the elements of financial statements, and in some cases,
those differences have led to different accounting treatments.
The elements are the building blocks of the financial statements, and it is these elements that make
up the financial statements of an enterprise. The IASB refers to five elements of financial statements.
The first three elements relate to resources and the claims on those resources at any moment in time (the
statement of financial position or balance sheet) and the last two elements are for financial performance
(income and expenses):
• Assets are resources controlled by the entity as a result of past events and from which future
economic benefits are expected to flow to the entity.
Note: In U.S. GAAP, assets are defined as probable future economic benefits that have been
obtained or are controlled by an entity as a result of past transactions or events. IFRS uses the
term “expected,” whereas U.S. GAAP uses the term “probable.” “Expected” includes things that
are probable, but it also includes things that are less certain. The difference is expressed in the
fact that IFRS allows entities to revalue assets upward in some situations, while U.S. GAAP
specifically prohibits doing so.
• Liabilities are present obligations of the entity arising as a result of past events, the settlement
of which is expected to result in an outflow from the entity of resources embodying economic
benefits.
Note: Again, IFRS uses the word “expected,” whereas U.S. GAAP uses the word “probable” in
its definition of liabilities.
Note: Valuation accounts are used for both assets and liabilities. These valuation accounts
are neither assets nor liabilities. An example of a valuation account is accumulated depreci-
ation or unamortized bond premium or discount.
• Equity or Net Assets is the residual interest in assets of the entity that remains after deducting
its liabilities. In a sense, equity is the liability that the entity has to the owners of that entity.
Note: Equity is found only in for-profit businesses.
The remaining two elements (income and expenses) relate to events and transactions that occur during a
period of time.
• Income is increases in economic benefits during an accounting period in the form of inflows or
enhancements of assets or decreases in liabilities that result in increases in equity, other than
contributions from owners. Income includes both revenue and gains.
o Revenues are inflows of assets or reductions of liabilities that arise in the course of the ordi-
nary activities of the entity. Revenues include sales, fees, interest, dividends, royalties, and
rental income.
o Gains are other items that meet the definition of income and may or may not arise in the
course of the ordinary activities of the entity. Gains also represent increases in economic ben-
efits and thus are no different in nature from revenue. It is expressly stated in the IASB’s
Conceptual Framework that gains are not regarded as an element separate from revenues.
Note: The FASB’s Concepts Statement No. 6 defines revenue and gains separately as elements
of financial statements. According to the FASB, revenues are inflows to an entity or other en-
hancements of an entity’s assets and/or settlements of its liabilities resulting from delivering or
producing goods, rendering services, or other activities constituting the entity’s ongoing major
operations. Gains are defined as increases in equity from peripheral or incidental transactions
of an entity and from all other transactions and other events except those that result from
revenues or investments by owners.
• Expenses include expenses and losses:
o Expenses are outflows of assets or the incurrence of liabilities that arise in the course of the
ordinary activities of the entity.
o Losses are other items that meet the definition of expenses and may or may not arise in the
course of the ordinary activities of the entity. They are decreases in economic benefits and are
no different in nature from other expenses. The IASB’s Conceptual Framework states that
losses are not regarded as an element separate from expenses.
Note: Again, unlike the IASB, the FASB’s Concepts Statement No. 6 defines expenses and
losses separately as elements of financial statements. Expenses are outflows or other using up
of assets or incurrences of liabilities from delivering or producing goods, rendering services, or
carrying out other activities that are the entity’s ongoing major or central operations. Losses
are decreases in equity from peripheral or incidental transactions of an entity and from all other
transactions and other events except those that result from expenses or distributions to owners.
Note: An example of a gain or loss is a gain or a loss on the sale of equipment or a gain or loss on the
sale of securities. A theft of inventory is an example of a loss.
Recognition of Financial Statement Elements

Recognition is the process of incorporating in the statement of financial position (balance sheet) or state-
ment of profit or loss an item that meets the definition of an element and satisfies the criteria for
recognition. Two fundamental criteria that relate to all items must be met before an item is recognized in
the financial statements:
• It is probable that any future economic benefit associated with the item will flow either to or
from the entity.
• It must have a cost or value that can be measured with reliability.
Note: The FASB’s Concepts Statement No. 5 includes the two requirements above plus two others: (1)
the item must have relevance, that is, the information is capable of making a difference in user decisions;
and (2) the information is reliable, meaning it is representationally faithful, verifiable, and neutral.
One of the most critical items in terms of recognition is when income should be recognized. According to
the IASB’s Conceptual Framework, income should be recognized when an increase in future economic ben-
efits related to an increase in an asset or a decrease in a liability has arisen and can be measured reliably.
Recognition of income occurs at the same time as increases in assets or decreases in liabilities occur. IFRS
15, Revenue from Contracts with Customers, is an application of these recognition criteria. According to
IFRS 15, revenue should be recognized in the accounting period in which the performance obligation is
satisfied. A performance obligation is satisfied when the customer obtains control of the asset, which is a
good or service transferred to the customer. The revenue should be recognized to depict the transfer of
goods or services to customers in an amount that reflects the consideration that the company expects to
be entitled to receive in exchange for those goods or services.
Expenses should be recognized when a decrease has arisen in future economic benefits related to a de-
crease in an asset or an increase in a liability and when it can be measured reliably. Recognition of expenses
occurs at the same time as the recognition of an increase in liabilities or a decrease in assets. Expenses
should be recognized on the basis of a direct association between the cost incurred and the recognition of
related income, known as the matching of costs with revenues.
An expense is recognized immediately when an expenditure produces no future economic benefits or when
future economic benefits do not qualify for recognition in the balance sheet as an asset. An expense is also
recognized when a liability is incurred without recognition of an asset, as when a liability arises under a
product warranty.
Expenses are also recognized on the basis of systematic and rational allocation, as when economic benefits
are expected to arise over several accounting periods and the association with income can be only indirectly
determined. Examples of such systematic and rational allocations are depreciation and amortization rec-
orded to recognize the using up of tangible and intangible assets.
Measuring Elements of Financial Statements

Measuring, that is determining the monetary amounts at which to recognize the elements of the financial
statements, involves the selection of the basis of measurement to be used. The measurement bases em-
ployed include the following:
• Historical cost. Assets are recorded at the monetary amount paid or the fair value of the consid-
eration given to acquire them. Liabilities are recorded at the monetary amount of proceeds received
in exchange for the obligation or at the amounts expected to be paid to satisfy the liability in the
normal course of business.
• Current cost. Assets are carried at the monetary amount that would need to be paid if the same
or equivalent asset were acquired currently. Liabilities are carried at the undiscounted monetary
amount that would be required to settle the obligation currently.
• Realizable or settlement value. Assets are carried at the monetary amount that could be ob-
tained currently by selling the asset in an orderly disposal. Liabilities are carried at the
undiscounted monetary amount expected to be paid to satisfy the liabilities in the normal course
of business.
• Present value. “Present value” uses time value of money concepts.25 Assets are carried at the
present discounted value of the future net cash inflows that the asset is expected to generate in
the normal course of business. Liabilities are carried at the present discounted value of the future
net cash outflows expected to be required to settle the liabilities in the normal course of business.
IFRS 13, Fair Value Measurement, adds fair value to the measurement bases.
• Fair value is the price that would be received to sell an asset or paid to transfer a liability in an
orderly transaction between market participants at the measurement date.
The selection of the appropriate measurement basis to use is dependent in part on the concept of capital
maintenance being used by the reporting entity.
25
Time value of money concepts are covered in Appendix A to this volume.
Capital and Capital Maintenance

The concept of capital adopted by an entity depends on the needs of the users of its financial statements.
• Under a financial concept of capital, “capital” means net assets or equity of the entity. A financial
concept of capital is adopted if the users of the financial statements are concerned mainly with
maintenance of nominal invested capital or the purchasing power of invested capital. The majority
of entities use the financial concept of capital in preparing their financial statements.
• Under a physical concept of capital, “capital” is the productive capacity of the entity such as units
of output per day. A physical concept of capital is chosen if the main concern of users is with the
operating capability of the entity.
Under both concepts, an entity has maintained its capital if it has as much capital—in whichever way it
defines capital—at the end of the period as it had at the beginning of the period. The difference between
the two concepts is in the treatment of the effects of changes in the prices of the entity’s assets and
liabilities and the meaning of “profit.”
Financial Capital Maintenance

Under financial capital maintenance, an entity earns a profit only if the monetary amount of its net assets
at the end of the period is greater than the monetary amount of its net assets at the beginning of the
period, excluding distributions to and contributions from owners during the period.
Thus, “profit” under financial capital maintenance is the increase in nominal money capital during the pe-
riod. Holding gains, or increases in the prices of assets held during the period, are conceptually profits,
although they may not be recognized as profits until the assets are disposed of.
Physical Capital Maintenance

Under physical capital maintenance, a profit is earned only if the entity’s physical productive capacity or
the resources or funds needed to achieve that capacity at the end of the period exceed the entity’s physical
productive capacity at the beginning of the period, excluding any distributions to and contributions from
the owners during the period.
Thus, “profit” under physical capital maintenance is the increase in physical productive capacity during the
period. Price changes affecting the assets and liabilities of the entity are treated as capital maintenance
adjustments that are part of equity.
Capital Maintenance and Measurement Basis

If the physical capital maintenance concept is in use, the current cost basis of measurement must be used.
If the financial capital maintenance concept is in use, no particular basis is required for measurement.
Under the financial capital maintenance concept, the selection of a measurement basis depends on the type
of financial capital the entity is seeking to maintain. Financial capital maintenance can be measured either
in nominal monetary units or units of constant purchasing power.
1 A 2. External Financial Statements

According to IAS 1, Presentation of Financial Statements, a complete set of financial statements includes:
1) A statement of financial position as of the end of the period (a balance sheet)
2) A statement of profit or loss and other comprehensive income for the period
3) A statement of changes in equity for the period
4) A statement of cash flows for the period
5) Notes to the financial statements, comprising a summary of significant accounting policies and
other explanatory information
1. The Statement of Financial Position (Balance Sheet)

The statement of financial position, also called the balance sheet, provides information about an entity’s
assets, liabilities, and owners’ equity as well as their relationships to each other at a point in time (usually
the end of a reporting period). The balance sheet shows the entity’s resource structure, or the major classes
and amounts of its assets, and its financing structure, or the major classes and amounts of its liabilities
and equity as of the reporting date.
Note: The statement of financial position, or balance sheet, helps users to assess the liquidity, financial
flexibility, solvency, and risk of a company.
In the balance sheet, assets and liabilities are classified as either current or non-current. Current assets
and liabilities are short-term and non-current assets and liabilities are long-term, but the more correct
terminology for both assets and liabilities is “current” and “non-current.” The distinction between current
and non-current depends on the time frame in which the entity expects an asset to be converted into cash
or a liability to be settled.
Note: The operating cycle is the average time between the acquisition of resources (or inventory) and
the final receipt of cash from their sale.
Assets
Assets are resources controlled by the entity as a result of past events and from which future economic
benefits are expected to flow to the entity. Assets are classified on the balance sheet according to the time
frame in which they are expected to be converted into cash.
• Operational assets are non-current assets that the company uses in the process of generating
revenues. These are not expected to be converted into cash in less than a year and include both
tangible assets such as property, plant and equipment and intangible assets such as a patent or
copyright.
• Contract assets under IFRS 15, Revenue from Contracts with Customers, represent an entity’s
right to receive consideration in exchange for goods or services that the entity has transferred to
a customer when that right is conditional on something other than the passage of time, for example
the entity’s future performance. Contract assets may be current assets or non-current assets or
both, depending on the facts and circumstances such as when payment is expected, based on the
agreement with the customer.
• Investments are assets that the entity holds in order to provide either a return or an increase in
value over time. Examples are investments in other companies, stocks, bonds, land held for future
use, and so forth. Investments may be classified as either current or non-current, depending upon
the intent of the company.
• Current assets are those that will be converted into cash or sold or consumed within one
year or within one operating cycle if it is longer than one year. Current assets are perhaps the
easiest to identify of the different sections of the balance sheet and include inventory, accounts
receivable, and cash, among other items.
• Valuation accounts are accounts that are used to adjust the value of the asset on the balance
sheet. A valuation account is neither an asset nor a liability, and an example would be accumulated
depreciation.
Note: Under IFRS, items on the statement of financial position are listed in the opposite order from the
way they are listed under U.S. GAAP. The general order followed in presenting assets is to list non-
current assets first, and then current assets. This format style differs from U.S. GAAP, where the most
liquid assets are presented first and the least, liquid last, and thus under U.S. GAAP, current assets are
presented first and then non-current assets are presented. Similarly, equity and liabilities under IFRS
are presented in the opposite order from that of U.S. GAAP. Owner’s equity is shown first, then non-
current liabilities, followed by current liabilities. The format of the statement of financial position under
IFRS is shown on the next page.
Owners’ Equity
Owners’ Equity is the remaining balance of assets after the subtraction of all liabilities. Equity is the amount
of the company’s assets that are owned by and owed to the owners. If the company were to liquidate,
the equity is the amount that would theoretically be distributable to the owners after the assets were
liquidated and the liabilities were paid in full.
Note: Shareholders are usually the last people to receive any distribution of assets in the case of a
liquidation of the company.
All business enterprises have owners’ equity, but the types of accounts in owners’ equity will differ depend-
ing on the type of the entity. This discussion will focus on corporations. Owners’ equity for corporations is
split into three main categories:
1) Capital contributed by owners from the sale of shares.
2) Retained earnings, profits of the company that have not been distributed as dividends.
3) Other comprehensive income items, specific items that are not included in the statement of
profit or loss but are included as Other Comprehensive Income items.
Liabilities
Liabilities are present obligations of the entity arising from past events, the settlement of which is expected
to result in an outflow from the entity of resources embodying economic benefits.
• Non-current liabilities are those liabilities that will not be settled within one year or the oper-
ating cycle if the operating cycle is longer than one year. Bonds, leases, pensions and notes payable
are common examples of non-current assets.
• Current liabilities are those liabilities that will be settled within one year or the operating cycle
if the operating cycle is longer than one year. Another way of looking at the classification of current
liabilities is that current liabilities will require either the use of current assets or the creation of
other current liabilities to be settled. Most payables are current liabilities.
• Contract liabilities may be non-current liabilities or current liabilities, depending on the terms of
the contract. Contract liabilities arise when a company receives consideration from a customer
before it fulfills its performance obligation to the customer. The payment is a contract liability
under IFRS 15, Revenue Recognition.
An example of the format of the Statement of Financial Position follows.
Format of Statement of Financial Position (Balance Sheet)
Name of Company
Statement of Financial Position
as of December 31, 20X3
31 Dec 20X3 31 Dec 20X2
ASSETS
Non-current assets:
Net property, plant and equipment X X
Goodwill X X
Investments in associates X X
Other financial assets X X
Total non-current assets XX XX
Current assets:
Inventories X X
Net trade and other receivables X X
Prepayments X X
Cash and cash equivalents X X
Total current assets XX XX
TOTAL ASSETS XX XX
EQUITY AND LIABILITIES

Owner’s equity:
Contributed capital X X
Retained earnings X X
Components of accumulated other comprehensive income X X
XX XX
Non-controlling interest (minority interest) X X
TOTAL EQUITY XX XX
Non-current liabilities:
Long-term borrowings X X
Deferred taxes X X
Long-term provisions X X
Total non-current liabilities XX XX
Current liabilities:
Trade and other payables X X
Short-term borrowings X X
Current position of interest-bearing borrowings X X
Current tax payable X X
Total current liabilities XX XX
TOTAL LIABILITIES XX XX
TOTAL EQUITY & LIABILITIES XX XX
Benefits of the Statement of Financial Position
• Because the statement of financial position provides information on assets, liabilities, and stockhold-
ers’ equity, it provides a basis for computing rates of return, evaluating the capital structure of the
business, and predicting a company’s future cash flows.
• The statement of financial position helps users to assess the company’s liquidity, financial flexibility,
solvency, and risk. The statement of financial position can also be used in financial statement anal-
ysis to assess the company’s ability to pay its debts when due and its ability to distribute cash to its
investors to provide them an adequate rate of return.
• Liquidity refers to the time expected to elapse until an asset is converted into cash or until a
liability needs to be paid. The greater a company’s liquidity is, the lower its risk of failure.
• Solvency refers to the company’s ability to pay its obligations when due. A company with a high
level of long-term debt relative to its assets has lower solvency than a company with a lower
level of long-term debt.
• Financial flexibility is the ability of a business to take actions to alter the amounts and timing
of its cash flows that enable the business to respond to unexpected needs and take advantage of
opportunities.
• Risk refers to the unpredictability of future events, transactions, and circumstances that can
affect the company’s cash flows and financial results.
Limitations of the Statement of Financial Position
• A statement of financial position provides only a partial picture of liquidity or financial flexibility
unless it is used in conjunction with at least a statement of cash flows.
• A statement of financial position reports a company’s financial position at one point in time, but it
does not report the company’s true value, for the following reasons:
• Many assets are not reported on the statement, even though they have value and will gen-
erate future cash flows, such as employees, human resources, internally generated intangible
assets, processes and procedures, and competitive advantages.
• Values of certain assets are measured at historical cost, or the price the company paid to
acquire the asset—not the asset’s market value, replacement cost, or value to the firm. For
example, property, plant, and equipment (PP&E) are reported on the balance sheet at historical
cost minus accumulated depreciation, although the assets’ value may be significantly greater.
• Judgments and estimates determine the value of many items reported in the statement
of financial position. For example, estimates of the balance of receivables the company will
collect are used to value accounts receivable; the expected useful life of fixed assets is used to
determine the amount of depreciation; and the company’s liability for future warranty claims is
estimated by projecting the number and the cost of the future claims.
• Most liabilities are valued at the present value26 of cash flows discounted at the rate
that was current when the liability was incurred, not at the present value of cash flows
discounted at the current market interest rate. If market interest rates increase, a liability with
a fixed interest rate that is below the market rate increases in its value to the company. If market
rates decrease, a liability with a fixed interest rate that is higher than the market interest rate
sustains a loss in value. Neither of these changes in values is recognized on the balance sheet.
26
Present value is a time value of money concept. For information on time value of money concepts, please see Appendix
A in this volume.
2. Statement of Profit or Loss and Other Comprehensive Income

The statement of profit or loss and other comprehensive income is a summary of all of the transac-
tions that a company was involved in during a period of time except for transactions with the owners
of the company (shareholders).
An entity may present a single statement of profit or loss and other comprehensive income, showing the
profit or loss in one section directly followed by the other comprehensive income section; or an entity may
present the profit or loss section as a separate statement of profit or loss. If the entity chooses the latter,
the statement of other comprehensive income shall immediately follow the statement of profit or loss and
shall begin with the profit or loss amount.27
The statement of profit or loss provides the results of operations for a period of time. When people talk
about net income, they usually mean the income for one year, but profit or loss statements are also pre-
pared on a quarterly basis and can be prepared on a monthly basis, as well.
The summary in the statement of profit or loss and other comprehensive income is done using accrual
accounting. The use of accrual accounting means that income can be recognized before the receipt of cash
and expenses may be recognized before the expenditure of cash. Events are recorded when they occur,
not when cash is transacted.
The accounts on the statement of profit or loss that are used to record revenues, expenses, gains, and
losses are temporary accounts. At the end of each fiscal year, the temporary accounts are closed to
retained earnings, which is a permanent account on the statement of financial position. Permanent
accounts are not closed at the end of each fiscal year and their balances are carried forward from one period
to the next. Retained earnings is presented on the statement of financial position as part of owners’ equity.
The other comprehensive income account is also a part of owners’ equity on the balance sheet.
Note: The expense recognition principle, commonly called the matching principle, states that ex-
penses should be recognized in the same period as the revenues generated by those expenses are
recognized. In other words, when a company recognizes revenues, the company should also recognize
the expenses that generated those revenues.
An example of the matching principle is depreciation. A fixed asset is depreciated to allocate its cost (as
depreciation expense) to the different periods in which that asset is expected to generate revenues.
The items that are considered other comprehensive income items are expressly stated in the standards.
Some of the transactions included in this group are:
• Gains and losses from translating the financial statements of a foreign operation.
• Gains and losses from investments in equity instruments designated at fair value through other
comprehensive income.
• Gains and losses on financial assets measured at fair value through other comprehensive income.
• The effective portion of gains and losses on hedging instruments in a cash flow hedge and gains
and losses on hedging instruments that hedge investments in equity instruments measured at fair
value through other comprehensive income.
• Increases in revaluation surplus from gains on property revaluations (revaluation decreases are
recognized in profit or loss unless they reverse a previous revaluation increase).
• Remeasurements of defined benefit pension plans.28
27
Per IAS 1, Presentation of Financial Statements, Paragraph 10A, as revised December, 2014.
28
Per IAS 1, Presentation of Financial Statements, Paragraph 7.
For the exam, it is not important for candidates to know the specific components of other comprehensive
income, just that the statement of other comprehensive income can be presented below net income on the
same statement with profit or loss or shown as a separate statement immediately following the statement
of profit or loss, called the statement of other comprehensive income.
Formats of Statement of Profit or Loss Presentation

There are two possible formats for presenting the statement of profit or loss.
In the single-step format, all revenues and gains are reported together and all expenses and losses are
reported together. This results in a two-line presentation of income from continuing operations. Though the
single-step method is very simple and concise, it does not provide very much detail or opportunity for
analysis of the elements of income from continuing operations. An example of a single-step format is:
Revenue X
Other income (such as gains on sales of assets) X
Total revenue XX
Cost of goods sold (X)

Selling expenses (X)
General and administrative expenses (X)
Other expenses (such as losses on sales of assets) (X)
Interest expense (X)
Income tax expense (X)
Total expenses (XX)
Income from continuing operations XX
Note: The calculation of cost of goods sold is discussed in topic 2.B.2. Cost of Goods Sold (COGS) and
Cost of Goods Manufactured (COGM) in Managerial Accounting.
In the multiple-step format, individual classes of operating revenues and expenses are reported and after
that, all other gains and losses are reported. Sales revenue is followed directly by the related cost of goods
sold, leading to the calculation of gross margin as the difference between sales revenues and the cost of
goods sold. After gross margin is calculated, selling, general and administrative expenses, and other oper-
ating expenses such as research and development expenses are deducted to calculate income from
operations.
The multiple-step format also enables the company to report its operating and non-operating activities
separately.
The multiple-step method obviously provides more information and enables a user to determine from where
the profit (net income) is coming. To a potential investor it is significant if all of the profit is coming from a
source other than the main operations. An example of a multiple-step format follows.
Revenue XXXXX
Cost of goods sold (XXXX)
Gross margin XXXX
Selling expenses (XXX)

General and administrative expenses (XXX)
Research and development expenses (XXX)
Other business income XX
Other business expense ( XX)
Income (loss) from operations XX
Financial income (such as gains on sales of assets and interest income) X
Financial expenses (such as losses on sales of assets and interest expense) ( X)
Income before taxes XX
Income tax expense, continuing operations ( X)
Discontinued operations, net of income taxes X
Net income XX
Revenue from Contracts with Customers (IFRS 15)

The core principle in IFRS 15 is that an entity recognizes revenue to depict the transfer of promised goods
or services to customers in amounts that reflect the consideration to which the entity expects to be entitled
in exchange for the goods or services.
The revenue recognition guidance in IFRS 15 is not limited to business transacted under formal written
contracts, nor is it limited to long-term contracts. A valid contract can be written, oral, or simply implied
by the entity’s customary business practices. The performance obligations in a contract can be satisfied at
a point in time or over time.
IFRS 15 applies to all revenue transactions as long as a valid contract exists, with the exception of several
items listed in Paragraph 5, including leases, insurance contracts, various types of financial instruments
such as investment securities and derivatives, and some nonmonetary exchanges. For all other sales trans-
actions, whether they involve a written contract or not, IFRS 15 applies.
The steps in revenue recognition include:

Revenue recognition will be discussed in more detail later in this volume.
Extraordinary Items
A reporting entity is specifically prohibited from presenting any items of income or expense as extraordi-
nary items in the statements of profit or loss and other comprehensive income or in the notes to the
financial statements.29 However, when items of income or expense are material, their nature and amount
are to be disclosed separately, as a separate line item.30
Example: Arsenal International is a holding company that has full ownership in a manufacturing com-
pany that experienced significant property damage due to a hurricane. This damage resulted in a
500,000 net loss on the 20X8 financials.
Based on IFRS, the manufacturing company would report this material loss separately from other gains
and losses, in the following manner.
Income (loss) from operations 1,250,000

Non-operating gains and losses
Net loss from hurricane (500,000)
Gain from sale of equipment 50,000
Total non-operating gains and losses (450,000)
Income before taxes 800,000
Discontinued Operations (IFRS 5)

According to IFRS 5, “a discontinued operation is a component of an entity that either has been disposed
of, or is classified as held for sale, and (a) represents a separate major line of business or geographical
area of operations, (b) is part of a single coordinated plan to dispose of a separate major line of business
or geographical area of operations or (c) is a subsidiary acquired exclusively with a view to resale.” 31 A
non-current asset or disposal group shall be classified “as held for sale if its carrying amount will be recov-
ered principally through a sale transaction rather than through continuing use.” 32
Assets classified as held for sale are measured at the lower of their carrying amount and fair value less
costs to sell, and depreciation on such assets ceases. Assets classified as held for sale are presented sepa-
rately in the statement of financial position, and the results of discontinued operations are presented
separately in the statement of profit or loss and other comprehensive income.33
A single amount is disclosed in the statement of profit or loss and other comprehensive income comprising
the total of (1) the post-tax profit or loss of discontinued operations and (2) the post-tax gain or loss
recognized on the measurement to fair value less costs to sell or on the disposal of the assets or disposal
group(s) constituting the discontinued operation. In addition, the single amount is analyzed into (1) the
revenue, expenses, and pre-tax profit or loss of discontinued operations; (2) the related income tax ex-
pense; (3) the gain or loss recognized on the measurement to fair value less costs to sell or on the disposal
of the assets or disposal groups; and (4) the related income tax expense. This analysis may be presented
in the notes or in the statement of profit or loss and other comprehensive income. If it is presented in the
statement of profit or loss and other comprehensive income, it is presented separately from continuing
operations in a section identified as relating to discontinued operations.34
29
Per IAS 1, Presentation of Financial Statements, Paragraph 87.
30
Ibid., Paragraph 97.
31
Per IFRS 5, Non-current Assets Held for Sale and Discontinued Operations, Paragraph 32.
32
Ibid., Paragraph 6.
33
Ibid., Paragraph 1.
34
Any gain or loss not previously recognized by the date of the sale is recognized at the date of derecogni-
tion.35
The following are additional disclosures regarding discontinued operations that should be made in the notes:
• A description of the non-current asset or disposal group.
• A description of the facts and circumstances of the sale, or leading to the expected disposal, and
the expected manner and timing of that disposal.
• The gain or loss recognized in any impairment loss for any write-down of the asset or disposal
group to fair value less costs to sell or any gain for a subsequent increase in fair value less costs
to sell (but not in excess of the cumulative impairment loss previously recognized). If the gain or
loss is not separately presented in the statement of comprehensive income, the caption in the
statement of profit or loss and other comprehensive income that includes that gain or loss is to be
disclosed.
• If applicable, the reportable segment in which the non-current asset or disposal group is presented.
• If changes are made to the classification of the non-current asset or disposal group, an entity shall
disclose, in the period of the decision to change the plan to sell the non-current asset or disposal
group, a description of the facts and circumstances leading to the decision and the effect of the
decision on the results of operations for the period and any prior periods presented.
Note: On past CIA questions, candidates have not needed to know how to calculate the numbers that
are to be reported, but have simply needed to be able to identify what distinguishes a discontinued
operation and the necessary disclosures.
Format of the Statement of Profit or Loss and Other Comprehensive Income

Following is a sample statement of profit or loss and other comprehensive income using the multiple-step
format.
35
Name of Company
Statement of Profit or Loss and Other Comprehensive Income
For the Year Ended December 31, 20X3
Revenue XXXXX
Cost of goods sold ( XXXX)
Gross margin XXXX
Selling expenses (XXX)

General and administrative expenses (XXX)
Research and development expenses (XXX)
Financial income (such as gains on sales of assets and interest income) X
Financial expenses (such as losses on sales of assets and interest expense) ( X)
Income before taxes XX
Income tax expense – continuing operations ( X)
Discontinued operations, net of income taxes X
Net income XX
Other comprehensive income:

Currency translation differences X
Income tax effect on currency translation differences (X)
Gains (losses) on cash flow hedges X
Income tax effect on gains (losses) on cash flow hedges (X)
Actuarial gains (losses) on defined benefit pension plan X
Income tax effect on actuarial gains (losses), pension plan (X)
Gain on property revaluations X
Income tax effect on property revaluations (X)
Other comprehensive income, net of income taxes XX
Total comprehensive income XX
Note: In addition to all of this information regarding income, information regarding basic and diluted
Earnings per Share (EPS) must also be disclosed. When the entity discloses profit or loss from contin-
uing operations and discontinued operations, basic EPS and diluted EPS must be presented for the
continuing operations and for the discontinued operation. The basic and diluted EPS in respect of con-
tinuing operations must be disclosed on the face of the statement of profit or loss and other
comprehensive income, and the basic and diluted amounts per share for the discontinued operation may
be disclosed either in the statement or in the notes.36
36
IAS 33, Earnings Per Share, Paragraphs 66-69.
Benefits of the Statement of Profit or Loss
The statement of profit or loss helps to predict future cash flows, as follows:
• It helps users to evaluate the company’s past performance and to compare it to the performance
of its competitors.
• It provides a basis for predicting future performance.
• It helps users assess the risk or uncertainty of achieving future cash flows.
Limitations of the Statement of Profit or Loss
Most of the limitations of the statement of profit or loss are caused by the periodic nature of the
statement. At any particular financial statement date, buying and selling will be in process and some
transactions will be incomplete. Therefore, net income for a period necessarily involves estimates that
affect the company’s performance for the period. Limitations that reduce the usefulness of the state-
ment of profit or loss for predicting amounts, timing, and uncertainty of cash flows include:
• Net income is an estimate that reflects a number of assumptions.
• Income numbers are affected by the accounting methods used. For example, differences in meth-
ods of depreciation can cause differences in the amount of depreciation expense during each year
of an asset’s life. A lack of comparability between and among companies results from these differ-
ences in accounting methods.
• Income measurement requires judgment. For example, the amount of depreciation expense rec-
ognized during a period is dependent on estimates regarding the useful lives of the assets being
depreciated.
• Items that cannot be measured reliably are not reported in the profit or loss statement. For in-
stance, increases in value due to brand recognition, customer service, and product quality are not
reflected in net income.
• The statement of profit or loss is limited to reporting events that produce reportable revenues and
expenses. Some transactions are not reported immediately on the profit or loss statement.
3. Statement of Changes in Equity

The statement of changes in equity shall present the following:
• For each component of equity, a reconciliation between the carrying amount at the beginning of
the period and at the end of the period, disclosing changes resulting from:
o Profit or loss
o Other comprehensive income
o Transactions with owners, showing separately contributions made by and distributions made
to owners and changes in ownership interests in subsidiaries that do not result in a loss of
control.
• Changes in other comprehensive income attributable to owners of the parent and to non-controlling
interests should be shown separately.
• For each component of equity, the effects of retrospective application or retrospective restatement
should be recognized.
• An analysis of other comprehensive income shall be presented by item, either within the statement
or in the notes.
• The monetary amount of dividends recognized as distributions to owners during the period and the
related amount of dividends per share shall be presented.37
37
Per IAS 1, Presentation of Financial Statements, Paragraphs 106 through 110.
4. The Statement of Cash Flows (IAS 7)

The primary purpose of the SCF is to provide information regarding receipts and uses of cash for the
company during a specified period of time. Among other things, the information on the SCF helps users of
the financial statements assess the ability of the company to generate positive cash flows in the future and
to meet obligations as they come due. This includes assessments of liquidity, solvency and financial flexi-
bility. This information also helps users to assess the company’s need for external financing.
Classifications within the SCF

The SCF presents all of the sources and uses of cash during the specified period. For the purposes of
presentation and usefulness, the cash activities are broken down into three main categories of activities
on the SCF. Every cash transaction is classified as one of these three categories of activities. These three
categories (Operating, Investing and Financing Activities) are listed and discussed below.
While both U.S. GAAP and IFRS have the same components of cash flows, IFRS offers more flexibility in
how certain types of cash flows are categorized. For example, under U.S. GAAP, interest paid and interest
and dividends received are classified as operating activities. Under IAS 7, these items may be classified as
operating activities because they enter into the determination of profit or loss. Alternatively, interest paid
and interest and dividends received may be classified as financing cash flows and investing cash flows
respectively because they are costs of obtaining financial resources or they are returns on investments.
As another example of the difference between U.S. GAAP and IFRS, dividends paid are classified as a
financing cash flow under U.S. GAAP because they are a cost of obtaining financial resources. Under IFRS,
dividends paid may be classified as a financing cash flow for the same reason, but alternatively, dividends
paid may be classified as an operating cash flow in order to help users determine the ability of the company
to pay dividends out of operating cash flows. 38
The following are examples of items of the SCF classifications under provisions of IAS 7.
Operating Activities
In general, any item that is not classified as an investing activity or financing activity is classified as an
operating activity. This definition is rather general, but that can be narrowed to say that cash flows from
operating activities are primarily derived from the principal revenue-producing activities of the entity. They
generally result from transactions and other events that generate revenues and expenses. Transactions
that cause gains or losses are generally not considered operating activities. Candidates should be aware of
the following specific items, which are, or in some cases may be, classified as operating activities:
• Cash receipts from the sale of goods or rendering of services.

• Cash receipts from royalties, fees, commissions and other revenue.
• Cash payments to suppliers for goods and other services.
• Cash payments to and on behalf of employees.
• Cash payments to the government for income taxes and cash received back as tax refunds
unless they can be specifically identified with financing and investing activities.
• Cash receipts and payments from contracts held for dealing or trading purposes, including securi-
ties and loans, when they are similar to inventory acquired specifically for resale.39
• Interest paid on bonds and other debt (loans, leases, mortgages, etc.) may be classified as
operating activities but may also be classified under financing activities.
• Interest received and dividends received from debt and equity investments may be classified
as operating activities but may also be classified as investing activities.
38
Per IAS 7, Statement of Cash Flows, Paragraphs 33 and 34.
39
Ibid., Paragraphs 14 and 15.
Investing Activities
Investing activities are those activities that the company undertakes to generate a future profit, or return.
Events that are investing activities include:
• Cash payments for purchasing and cash receipts from sales of property, plant, and equipment,
intangibles, and other long-term assets.
• Making and collecting loans to other parties.
• Acquiring and disposing of stock of other companies.
• Acquiring and disposing of debt instruments.
• Cash payments and cash receipts for futures contracts, forward contracts, option contracts, and
swap contracts except when the contracts are held for dealing or trading purposes or the payments
are classified as financing activities.40
Financing Activities
Financing activities are the activities that a company undertakes to raise capital to finance the business.
Events that are considered to be financing activities include:
• Cash proceeds from issuance of shares and other equity instruments.
• Cash payments to owners to acquire or redeem the entity’s shares.
• Paying interest and dividends. As noted above, interest and dividends paid can also be reflected
as an operating activity
• Issuing debt (bonds) and the repayment of debt obligations. This includes the principal
amount of a lease or mortgage for fixed assets.
• Obtaining and repaying a loan.
Note: Candidates are urged to know the specific items listed under each of the three categories. If you
know them, you will be able to answer exam questions very quickly.
Cash Equivalents
Note: Cash equivalents are defined as highly liquid, short-term investments that are easily converted
into a known amount of cash. The definition usually includes only those investments that have a ma-
turity of 3 months or less from the date the entity acquires the investment. This means that if a 20-
year bond is acquired two months before it matures, it will be classified as a cash equivalent for the
purposes of the SCF. Common examples of cash equivalents are money market funds, commercial paper
and treasury bills.
In the preparation of the statement of cash flows, cash and cash equivalents on the balance sheet are both
considered to be cash. The statement of cash flows must explain the amount of change during the period
in the total of cash and cash equivalents. The total of the two classifications should be used when recon-
ciling the beginning-of-period and end-of-period total amounts shown on the statement of cash flows.
Therefore, the purchase or sale of cash equivalents with cash will not be reported as a cash flow
from operating activities, investing activities, or financing activities in the statement of cash
flows, since those transactions simply exchange one form of cash for another form of cash.
40
Non-cash Investing and Financing Activities

As their name implies, non-cash investing and financing activities are transactions that are either investing
or financing in nature, but do not involve cash. Because they do not involve cash, they will not be presented
on the SCF.
However, according to IAS 7, non-cash investing or financing activities should be disclosed in the footnotes
to the financial statements in a way that provides all relevant information about these investing and financ-
ing activities. This disclosure is required because these non-cash activities may be very large and significant
and therefore very important for a potential investor (or other user of the financial statements) to know
about. For example, if the company acquires all of its fixed assets by issuing shares, this will let the potential
investors know that their ownership shares will be diluted as the company buys fixed assets.
Note: Another difference between the statement of cash flows under U.S. GAAP and the statement
under IFRS is in the area of non-cash transactions. In IFRS, investing and financing transactions that do
not require the use of cash or cash equivalents are excluded from the statement of cash flows, although
such transactions are to be disclosed elsewhere in the financial statements in order to provide all the
relevant information about such non-cash transactions.41
Under U.S. GAAP, non-cash investing and financing activities must be presented separately in a schedule
at the end of the statement of cash flows, as a part of the statement itself.
Examples of non-cash transactions are: converting debt to equity, buying or selling fixed assets for some-
thing other than cash (stock, for example), obtaining a building or other item by gift, exchanging non-cash
assets or liabilities for other non-cash assets or liabilities.
Preparing the Statement of Cash Flows

One of the good things about the SCF is that the net cash flow from all three sources combined—operating
activities, investing activities, and financing activities—is known before the statement is prepared. The total
of the cash flows from operating, investing and financing activities must be equal to the amount of change
in the balance of cash and cash equivalents from the beginning of the year to the end of the year. Because
the cash balances for the prior period and the current period are on the balance sheets, the total increase
or decrease in cash for the period can be easily calculated.
Cash flows from operating activities may be calculated and presented in two ways, and both ways are
acceptable under both IFRS and U.S. GAAP. However, the company must use the same method from year
to year for consistency. The two acceptable methods are called the direct method and the indirect
method.
• The direct method essentially adjusts each line on the statement of profit or loss to make it a
cash number instead of an accrual number. For example, revenue is adjusted to become cash
received.
• The indirect method begins with net income on the statement of profit or loss and adjusts the
net income figure to remove any income or expense items that are investing or financing activities
and to present the cash flows from operations instead of the accrual-basis net income.
Note: Net cash provided by operating activities is exactly the same under both of the above methods.
The only difference between the two methods is the way net cash provided by operating ac-
tivities is presented.
The investing and financing sections are prepared in only one way, so they look exactly the same regardless
of which method is used to present net cash provided by operating activities.
41
Brief Overview of the Two Methods of Presenting Cash Flow from Operating Activities
Under both the direct and the indirect method, the statement of profit or loss is adjusted to express profit
or loss statement amounts as cash amounts.
The Direct Method

The direct method shows separately each operating activity that caused cash to be spent or received,
such as cash paid for payables or cash collected from customers. The direct method presentation is very
similar to the statement of profit or loss, at least in the lines used in the presentation. Three sets of adjust-
ments are made to the line items on the statement of profit or loss.
1) Each line on the statement of profit or loss that represents an operating activity is adjusted to
reflect the cash flows of that item, instead of the accrual accounting amount. For example, revenue
is adjusted to be cash received from customers and cost of goods sold is adjusted to be cash paid
to suppliers.
2) Some profit or loss statement items are noncash revenues or expenses, and noncash items are
eliminated. Depreciation expense is an example of a noncash expense. Even though depreciation
expense is reported on the statement of profit or loss, the expense does not represent cash that
was paid out during the current period.
3) Some lines on the statement of profit or loss represent transactions for activities other than oper-
ating activities. For example, the gain or loss on the sale of fixed assets is related to an investing
activity. The cash received from the sale, which includes any gain or loss on the sale, will be shown
on the SCF as part of cash flow from investing activities. The gain or loss on the sale is eliminated
from the statement of profit or loss in calculating the net cash flow from operating activities using
the direct method so it is not included twice on the SCF.
The Indirect Method

Under the indirect method, all adjustments are made to the net income figure from the statement of
profit or loss. The adjustments for the indirect method are the same as those for the direct method, with
adjustments for changes in balance sheet accounts and the elimination of noncash and non-operating ac-
tivity transactions. However, the adjustments are made to the figure on the net income line instead of to
the figures on the various individual lines on the statement of profit or loss.
Direct versus Indirect

Both the direct method and the indirect method must give the same results for net cash provided by
operating activities because the same adjustments are being made to the statement of profit or loss. It is
just that under the direct method, each individual line in the statement of profit or loss is adjusted individ-
ually, whereas under the indirect method, the net income figure is adjusted.
Format of the Statement of Cash Flows

A sample format of the statement of cash flows is shown below.
Name of Company
Statement of Cash Flows
For the Year Ended XXXX XX, 20XX
Cash flows from operating activities

…… XXXX
…… XXXX
…… XXXX
Net cash provided by operating activities XXXXX
Cash flows from investing activities

…… XXXX
…… (XXXX)
Net cash used for investing activities (XXXXX)
Cash flows from financing activities

…… XXXX
…… XXXX
Net cash provided by financing activities XXXXX
Net increase in cash and cash equivalents XXXX
Cash and cash equivalents at beginning of year XXXXX
Cash and cash equivalents at end of year XXXXX
Footnote: Disclosure of noncash investing and financing activities:

• Conversion of bonds into common stock XXXXX
• Property acquired under finance leases XXXXX
Note: The above format is basically the same whether the direct or the indirect method is used to
present net cash provided by operating activities. Under the two different methods the only difference
will be in the presentation of the cash flows from operating activities.
Benefits of the Statement of Cash Flows
• The statement of cash flows provides the most information about cash and how the company re-
ceives and spends cash. It helps users to assess the ability of the company to generate positive
future cash flows to meet its obligations as they come due and to pay dividends.
• It helps users to assess the reasons for differences between net income and net cash inflows and
outflows.
• It helps users to assess the effect of investing and financing transactions on the company’s financial
position.
• It helps users to assess the company’s need for external financing. A negative operating cash flow
and a positive financing cash flow indicate the company is financing its operations with either debt
or equity. An examination of the financing section of the statement will reveal whether debt or
equity is being used.
• Lenders can use it to assess the ability of a company to repay a loan.
• Investors can use it to determine if the company will be able to continue to pay its current level of
dividends in the future or whether it might even be able to increase its dividend.
Limitations of the Statement of Cash Flows
• The statement of cash flows shows only how much cash was received and paid out for operating,
investing, and financing activities. In order for the information on a statement of cash flows to be
fully utilized, it often needs to be interpreted in the context of other information in the other financial
statements. For example, a positive operating cash flow may have been achieved by not paying the
payables when due. In order to recognize past due payables, the balance sheet and statement of
profit or loss are also needed.
• The indirect method of preparing the operating cash flows section of the SCF does not show the
sources and uses of operating cash individually but shows only adjustments to accrual-basis net
income, a limitation that can cause a user to have difficulty in using the information presented
5. Notes to the Financial Statements

In addition to the presented financial statements, complete financial reports also require notes to the fi-
nancial statements in order to get a more complete picture of a company’s financial position and the results
of operations. The notes provide explanations of the principles of accounting applied and the methods used
to determine the amounts reported in the financial statements. The notes can also provide further break-
down and analysis of certain accounts that are deemed important. For example, if a company listed a loss
in its statement of profit or loss due to a fixed asset impairment, the note is a way to corroborate the
impairment by providing a specific explanation for how the asset became impaired.
Disclosures in the notes can provide additional relevant information that can be important to fully under-
standing the financial statements. For example, if just prior to the end of the period a company signed a
long-term lease for the rent of new, larger office space, the statement of financial position will report the
right-of-use asset and the lease liability.42 However, someone considering a potential investment in the
company would also be interested to know the terms of the lease and the amount of the future lease
payments. These future payments could significantly impact future cash flows, which could impact the
investor’s decision to invest.
42
Per IFRS 16, Leases, effective January 1, 2019.
Notes and disclosures can be financial or non-financial. Some of the more common notes to the financial
statements include:
• Accounting principles
• Contingent liabilities
• Inventory
• Capital stock disclosures
• Changes in the accounting policies

• Pension plans
• Investments in affiliated companies
• Related party transactions
1 A 3. Intermediate Concepts of Financial Accounting

This topic includes:
• Bonds
• Leases
• Pensions
• Intangible assets
• Research and development
These topics need to be known only at the awareness level so the discussion of them does not get into the
details of accounting for these items. The focus is on knowing what these are and the main issues connected
with these topics.
Bonds
Bonds are a means of financing in which a company borrows money by selling debt securities (bonds) to
investors. The bonds represent a loan by the bondholders (investors) to the issuing company. By selling
the bond, the company is making a promise to pay the investors a certain amount of interest every period
until the bond matures. On the maturity date, the company promises to pay the face amount of the bond
to the investor. The interest that will be paid each period, the face (or maturity) value and the maturity
date are all printed on the face of the debt certificate, the financial instrument that evidences the debt.
A bond’s indenture is the legal, binding contract between a bond issuer—the borrower—and the bondhold-
ers—the lenders. It states the interest rate the bond will pay per year (also called its coupon rate), the
bond’s maturity date, information about when interest is paid, and any covenants, collateral, or additional
information about the bond. The maturity date is the date on which the issuer will “retire” the bond by
paying the face amount of the bond to the bondholders.
Bonds are valued at and sold at the present value (PV) of all of the future cash payments the company is
expected to make, including the interest payments and the final principal repayment, discounted at the
market rate of interest for bonds of similar terms and risk.
After their issuance, bonds can be traded in the secondary bond markets. The market value of a bond will
increase when the market rate of interest for bonds of similar terms and risk decreases and will decrease
when the market rate increases.
The amount of cash interest paid each interest period is an annual percentage of the bond’s par value.
A bond sold at a price higher than its par value is sold at a premium. A bond sold at a price lower than its
par value is sold at a discount. When a bond is sold at a premium, the issuing company records the par
value of the bond in the bonds payable account and records the premium received in the bond premium
account. Both accounts are liability accounts, and the bond premium account increases the bond’s book
value on the books of the issuer. When a bond is sold at a discount, the issuing company records the par
value of the bond in the bonds payable account and records the discount amount in the bond discount
account, which is a contra-liability account that reduces the bond’s book value on the books of the issuer.
The issuing company amortizes the bond premium or discount to interest expense over the term of the
bond using the effective interest method. Amortization of a bond premium reduces the interest expense
recorded each interest period by the issuer, while amortization of a bond discount increases the interest
expense recorded each interest period.
At the bond’s maturity date, the balance in the bond premium or bond discount account is zero, and the
bond’s book value for the issuer is the par value that will be repaid to the investors.
Leases (IFRS 16)

A lease is a contract that conveys the right to control the use of an identified asset for a period of time in
exchange for consideration. Effective January 1, 2019, lessees are required to recognize most leases on
their statements of financial position as assets and liabilities. The information that follows is for 2019.
Lessee
A lessee (the entity leasing the asset for its use) classifies each of its leases as either a finance lease or
an operating lease.
Essentially all leases are finance leases, although the lessee may make an accounting policy election, by
class of underlying assets, to classify short-term leases as operating leases. Lessees may also elect, on a
lease-by-lease basis, to classify leases of low-value assets as operating leases.
Finance Leases for the Lessee

The lessee in a finance lease recognizes a right-of-use asset—its right to use the leased item for the lease
term—and a lease liability—its obligation to make lease payments—as of the commencement date of the
lease. The asset and the liability are measured initially at the present value of the lease payments, using
the interest rate implicit in the lease if that can be determined. If the rate cannot be readily determined,
the lessee uses its incremental borrowing rate to calculate the present value of the lease payments.
If the lease transfers ownership of the asset to the lessee by the end of the lease term or if the lessee
expects to exercise a purchase option at the end of the lease, the lessee depreciates the right-of-use asset
from the commencement date of the lease to the end of the useful life of the asset. Otherwise, the lessee
depreciates the right-of-use asset to the end of the lease term or to the end of its useful life if that is earlier.
As payments are made on the lease, the lessee reduces the lease liability by a portion of the payments
made.
Note: The amount of interest on the lease expensed on the lessee’s statement of profit or loss is calcu-
lated based on the outstanding balance of the lease obligation that is still outstanding at the beginning
of each period. Thus, each time a periodic payment is made, part of the payment is a payment of interest
and part of it is a reduction of the lease obligation.
Operating Leases for the Lessee

IFRS 16 includes two exemptions from the requirement to recognize leases on the balance sheet as assets
and liabilities: short-term leases and leases of low-value assets. A lessee may elect to report short-term
leases and leases of low-value assets as operating leases without recognizing a right-of-use asset or lease
liability in its statement of financial position.
• A short-term lease is defined as a lease that has a lease term of 12 months or less at its com-
mencement date and that does not contain a purchase option.
• Low-value items might be small items of office equipment such as a fax machine.
The lessee recognizes the lease payments associated with operating leases as expenses on either a straight-
line basis over the lease term or on another systematic basis if another basis is more representative of the
pattern of the lessee’s benefit.
The election to classify short-term leases as operating leases is to be made by class of underlying asset,
that is, a grouping of assets of a similar nature and use in the lessee’s operations. The election to classify
leases of low-value assets as operating leases can be made on a lease-by-lease basis.
Lessor
The lessor (the entity providing the lease financing to the user of the asset) classifies each lease as either
a finance lease or an operating lease.
Finance Leases for the Lessor

A finance lease transfers to the lessee substantially all the risks and rewards of ownership of the asset.
Examples of situations that would normally lead to a lease being classified as a finance lease by the lessor
are:
• The lease transfers ownership of the leased asset to the lessee by the end of the lease term.
• The lessee has the option to purchase the asset at a price sufficiently lower than the asset’s fair
value at the exercise date, so that it is reasonably certain at the inception date that the option
will be exercised.
• The term of the lease is for the major part of the asset’s economic life, even if title is not trans-
ferred.
• The present value of the lease payments at the inception date is substantially all of the fair value
of the underlying asset.
• The underlying asset is of such a specialized nature that only the lessee can use it without major
modification.
• If the lessee can cancel the lease, the lessee will bear the lessor’s losses associated with the
cancellation.
• Gains or losses caused by fluctuations in the fair value of the residual accrue to the lessee.
• The lessee may continue the lease for a secondary period at a rental that is substantially lower
than market rent.
At each lease’s inception date, a lessor that is providing financing only (that is, the lessor is a financial
institution, not a manufacturer or a dealer) recognizes a lease receivable for each asset leased under a
finance lease. The lessor’s lease receivable for each lease is an amount equal to its net investment in the
lease. The net investment in the lease is the gross investment in the lease discounted at the interest rate
implicit in the lease.
Finance Leases for Manufacturer or Dealer Lessors

A manufacturer or a dealer acting as the lessor is essentially selling the asset in addition to providing the
financing for it in the form of a lease. On the commencement date of a finance lease, the manufacturer or
dealer recognizes revenue equal to the fair value of the underlying asset or the present value of the lease
payments accruing to the lessor, discounted using a market rate of interest, if that is lower. The manufac-
turer or dealer derecognizes the asset, and the cost of the sale is the carrying amount of the underlying
asset minus the present value of the unguaranteed residual value.
The manufacturer or dealer lessor therefore recognizes profit or loss on the sale. The profit or loss is equal
to the profit or loss that would result from an outright sale of the underlying asset at normal selling prices.
Over the term of the finance lease, a manufacturer or dealer lessor also recognizes finance income.
Operating Leases for the Lessor

An operating lease does not transfer substantially all the risks and rewards of ownership of the leased asset
to the lessee. Whether the lessor is a manufacturer or dealer or is only providing the operating lease
financing, the lessor recognizes the asset on its statement of financial position and depreciates it consistent
with its normal depreciation policy for similar assets. A manufacturer or dealer lessor does not recognize
selling profit at the commencement of an operating lease because an operating lease is not the equivalent
of a sale.
The lessor recognizes lease payment revenue from operating leases as income on either a straight-line or
on another systematic basis, if another basis is more representative of the pattern in which benefit from
the use of the underlying asset is diminished.
Benefits of Leasing
 Convenience of short-term leases. If a company needs an asset for only a short period of time,
it makes more sense to lease it than to buy it and then have to sell it a year or so later.
 100% financing at fixed rates. Leases often do not require any money down from the lessee,
which helps to conserve scarce cash. In addition, lease payments often remain fixed, which protects
the lessee against inflation and increases in the cost of money.
 Protection against obsolescence. In many cases leasing passes the risk of residual value to the
lessor. Under a lease agreement, the lessee may be permitted to turn in older leased equipment for
a new model at any time, canceling the old lease and writing a new one. The cost of the new lease
is added to the balance due on the old lease, less the old piece of equipment’s trade-in value.
 Flexibility. Lease agreements may contain less restrictive provisions than other debt agreements.
Rental payments can be structured to meet the timing of cash revenues to be generated by the
equipment so that payments are made when the equipment is productive.
 Depreciation tax shields43 can be used. A company that is operating unprofitably may lease as
a way of receiving tax benefits that might otherwise be lost, because any depreciation deductions
allowable for income tax purposes may offer no benefit to a company that has little if any taxable
income. Through leasing, the tax benefits from the depreciation tax shield could be used by the
leasing company, and the leasing company could pass some of the tax benefits back to the user of
the asset in the form of lower rental payments, thus benefitting the lessee currently.
• Cancellation options have value. If a lease agreement contains an option to cancel, the option
can add value to the lease agreement.
43
Depreciation expense is a tax-deductible expense. The amount of tax-deductible depreciation will cause an equal
reduction in the company’s taxable income. That will, in turn, cause a reduction in the amount of income tax that will be
due. The amount of tax savings that results is called the depreciation tax shield. However, a company cannot pay less
than zero income tax. Thus, if a company has a loss on its tax return for the current tax year, the increase in expense
caused by the depreciation expense would not lower the company’s tax bill for the current tax year.
Limitations of Leasing
 Cost. Leasing an asset may be costlier than purchasing the same asset and financing it with a term
loan. Over the life of the asset, the total cash outlay associated with a lease may be greater than
that associated with borrowing and purchasing the same asset. However, every situation is different,
so leasing may or may not be costlier in a given situation.
• Lack of flexibility if the lease is non-cancelable. Many leases are non-cancelable. A non-can-
celable lease can restrict the firm. If the capital project for which the leased item was acquired turns
out to be unsatisfactory, the company can abandon the project and sell any of the equipment that
it owns. However, it cannot sell the leased equipment and is obligated to continue making lease
payments on it.
Pensions
A pension is an employee benefit that is given in the form of a payment to the employee after the employee
has retired. For example, in some pension plans the amount of the payment is calculated as a certain
percentage (for example, 2%) of the employee’s highest salary for each year that the employee worked for
the company. This would mean that if an employee worked for 32 years, he or she would receive 64% of
his or her highest salary every year after retirement until death.
When a company offers a pension to its employees, the employer has made a promise to pay some amount
in the future to its employees. The amount that the company promises to pay in the future is really nothing
more than deferred compensation. For the work that they perform each year, the employees will receive
their salary, other benefits like medical insurance, vacation benefits, and their pension. Because of the
nature of the pension, they will not receive the cash from the pension portion until they retire. The employer
makes contributions to a pension fund that is usually managed by an outside trustee, and this pension fund
is used to make the pension payments to employees who have retired.
Types of Pension Plans

The two major types of pension plans are defined contribution plans and defined benefit plans.
Defined Contribution Plans

Defined contribution plans are retirement benefit plans under which amounts to be paid as retirement
benefits are determined by contributions to a fund together with investment earnings thereon.
Defined contribution plans require the employer to contribute a certain amount of money each period to
the plan, based on a formula. Employees do not receive a guaranteed income from the plan. Instead, the
total amount of benefits paid to an employee is limited to the amount that has been contributed, the
accumulated income on the amounts contributed, and the treatment by the plan of forfeitures of funds
caused by other employees who have left their employment before contributions in their accounts are
vested.
In a defined contribution plan, the employees receive the benefit of any gains on assets in the plan and
they also bear the risk of any losses on assets in the plan.
The employer’s responsibility is only to make the contributions as called for by the plan. If the employer
does not contribute the full amount required, the employer reports a liability for the amount of the shortfall
in the actual amount contributed. If the employer contributes more than is required, the employer reports
an asset in the amount of the excess contribution.
Defined Benefit Plans

Defined benefit plans are retirement benefit plans under which the amount to be paid as retirement benefits
is determined by reference to a formula usually based on employees’ earnings and/or years of service (such
as the 2% of their highest salary for each year that they worked for the company, as in the example above).
To meet the benefit commitment, the employer must make contributions of an amount that will provide
enough money to meet the requirements of commitment made to the employees at retirement.
The pension fund is a separate legal entity from the employer, usually overseen by an independent trustee.
The trustee’s responsibility is to safeguard and invest the plan assets. The employer’s responsibility is to
make adequate contributions to the plan using assumptions about future benefits to be paid and future
growth in the plan assets. The employer bears the risk for a defined benefit plan.
Because the employer bears the risk, accounting for a defined benefit plan is complex. The pension expense
recognized each period does not necessarily equal the amount of the contribution to a defined benefit plan.
Main Accounting Questions for Pensions

Under both defined contribution and defined benefit plans, the company has two main accounting issues
with pensions:
1) How much pension expense should the company recognize each period?
2) What should be reported on the company’s financial statements in respect to pensions?
Pension Expense
The pension expense recognized each period for a defined benefit plan should be equal to the present value
of the expected future pension benefits that the employees have earned by working during the current
year. The company must estimate this amount of pension benefit that was earned this period. To do this,
they must estimate what the employee’s highest salary will be (in order to calculate a percentage of it) and
also when they expect the employee to retire and die.
Example: In a pension plan that pays a pension equal to 2% of the employee’s highest salary for each
year that they have worked for the company, the company make the following estimates:
• The employee’s highest salary will be 50,000,
• The employee will retire at age 65, and
• The employee will die at age 85.
To calculate the pension expense to recognize in the period when the employee is 50 years old, the
company will calculate the present value of 1,000 (50,000 × 0.02, the future pension amount that is
expected to have been earned by the employee for working this year), being paid for 20 years (how long
the company expects to pay the pension), starting in 15 years (when the employee is expected to retire).
Reporting Defined Benefit Pensions on the Statement of Financial Position

The employer records a liability on the balance sheet to recognize in the financial statements the obligation
to pay future benefits.
Each period when the employer recognizes a pension expense, it will recognize a corresponding pension
liability. Usually, the company will choose to make contributions to its pension plan each period so that it
can build up the value of the plan assets to be able to pay the pensions when employees retire.
The measure of the amount that the company owes for pensions is called the Projected Benefit Obligation,
or PBO. The PBO is the actuarially determined liability owed to plan participants over the life expectancy of
the beneficiaries for benefits earned up to the date of the financial statement. It includes effects of com-
pensation increases, inflation, life expectancy, expected retirement dates, and so forth.
The funds the company has set aside to be used to pay the future pension amounts are the plan assets.
Plan assets are stated at their fair value as of the date of measurement, usually at the fiscal year end.
Intangible Assets (IAS 38)

According to IAS 38, an intangible asset is defined as an “identifiable, non-monetary asset without phys-
ical substance.” An asset is identifiable if it either:
• Is separable, or
• Arises from contractual or other legal rights.
For an item to be considered separable, it must have the capability of being separated or divided from the
entity and sold, transferred, licensed, rented or exchanged by itself.
The most typical types of intangible assets are:
• Licenses
• Patent rights
• Franchises
• Trademarks and trade names
• Copyrights
• Customer lists
Intangible assets that are purchased are measured at cost, which includes the initial purchase price and
any directly attributable expenditures to prepare the asset for its intended use by the purchaser, such as
legal fees.
Internally Generated Intangibles

Generally, internally generated intangible assets are not recognized on the balance sheet because they are
not able to be measured. Because there is no external transaction for the acquisition, there is no amount
at which to record the internally generated intangible asset.
IAS 38 prohibits the recognition of the following internally generated items:
• Goodwill (purchased goodwill, or the amount by which the cost of an acquisition exceeds the fair
value of net assets acquired, may be recognized as an asset, but internally generated goodwill
may not be recognized as an asset)
• Brands
• Mastheads (a masthead is a statement printed in all issues of a newspaper, magazine, or the like,
usually on the editorial page, giving the publication's name, the names of the owner and staff,
etc.)
• Publishing titles
• Customer lists
These internally generated items are not recognized as intangible assets because expenditures for these
items cannot be distinguished from the cost of developing the business as a whole. Therefore, such items
are not recognized as intangible assets.
Note: In certain specific cases, internally generated intangible assets may be recognized.
Goodwill
Goodwill is one of the most common examples of intangible assets and is the one item that lacks specific
identification. Goodwill is defined by IFRS 3 as “future economic benefits arising from assets that are not
capable of being individually identified and separately recognized.” Goodwill must be reported as a sepa-
rate line item on the balance sheet. Generally, other intangibles are combined and reported as one
figure on the balance sheet.
Goodwill may be acquired or developed internally, but the only goodwill that may be recognized in the
accounting records is purchased goodwill. Purchased goodwill is calculated as:
Cost of acquisition X
Less: Fair value of net assets acquired (X)
Goodwill XX
Goodwill should be recorded on the books as an asset. Goodwill is not amortized, but it should be reviewed
for impairment on an annual basis.
Bargain Purchases
If the purchase price is less than the value of the net identifiable assets acquired, the acquirer has a
bargain purchase. A bargain purchase is very unusual, but if it occurs:
• Before recognizing any gain due to the bargain purchase, the acquirer shall review whether it has
correctly identified all of the acquired assets and assumed liabilities and shall recognize any addi-
tional assets or liabilities identified in that review. The calculation of fair value of the net identifiable
assets should be confirmed to be correct (since a bargain purchase should arise only rarely).
• After the review, if the acquirer still has a bargain purchase amount on the acquisition, the bargain
purchase amount should be reported as a gain on the consolidated statement of profit or loss as
of the acquisition date. The gain is attributed to the acquirer.44
The amount of a bargain purchase cannot be shown on the balance sheet.
Amortization and Impairment of Intangible Assets

Amortization of an asset begins when the asset is available for use. The useful life of an intangible should
be assessed as to whether it is:
• Finite
• Indefinite
If the useful life is assessed to be indefinite, then the intangible has no foreseeable limit to its useful
life. If the useful life is assessed to be indefinite:
• The intangible should not be amortized.
• Impairment reviews should be carried out annually.
If the useful life is assessed to be finite:
• The intangible should be amortized over its useful life (presumed to be no more than 20 years).
• The residual value is usually assumed to be zero.
• The amortization charges should be expensed on the statement of profit or loss.
• If there is any indication of impairment, then an impairment review should be carried out.
44
Per IFRS 3, Business Combinations, Paragraph 36.
If it is determined that an intangible asset is no longer an asset (for example, a company loses a patent
lawsuit), the asset should be written down to the amount of its expected future benefit, if any. Any loss
that is recorded must be recognized in the period when the asset is determined to be impaired.
Research & Development

The primary internally generated intangible expenditure (as recognized under IAS 38) is research and
development (R&D). Under IAS 38, internally generated research and development is split into two
phases: research phase and development phase.
• Research is an “original and planned investigation undertaken to gain new scientific knowledge
and understanding.”
• Development is the “application of research findings or other knowledge to a plan or design for
the production of new or substantially improved materials, devices, products, processes, systems
or services before the start of commercial production or use.”
Expenditures on research activities are expensed as they are incurred. Development activities con-
ducted for the benefit of the reporting entity are expensed as they are incurred, unless the entity can
demonstrate all of the following:
1) The technical feasibility of completing the intangible asset so that it will be available for use or
sale.
2) Its intention to complete the intangible asset and use or sell it.
3) Its ability to use or sell the intangible asset.
4) How the intangible asset will generate probable future economic benefits.
5) The availability of adequate technical, financial and other resources to complete the development
and to use or sell the intangible asset.
6) Its ability to measure reliably the expenditure attributable to the intangible asset during its devel-
opment.45
1 B. Advanced Concepts of Financial Accounting

This topic includes:
• Fair value
• Business combinations and consolidations
• Partnerships
• Investments in financial instruments
• Investments in associates
• Foreign currency transactions
These topics need to be known only at the awareness level so the discussion of them does not get into the
details of accounting for these items. Candidates should focus on knowing what these are and the main
issues connected to these topics.
45
IAS 38 Intangible Assets, Paragraph 57.
Fair Value (IFRS 13)

Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly
transaction between market participants at the measurement date under current market conditions, re-
gardless of whether the price is directly observable or estimated using another valuation technique. A fair
value measurement assumes that the sale or transfer takes place either
1) In the principal market for the asset or liability, or
2) In the absence of a principal market, in the most advantageous market for the asset or liability.
For non-financial assets, a fair value measurement takes into account the asset’s ability to generate eco-
nomic benefits in its highest and best use.
However, fair value estimates can be subjective if, for instance, an active market does not exist for a
financial asset or liability. The IASB has established a fair value hierarchy to provide priority for fair value
valuation techniques to be used.
The fair value hierarchy as set forth in IFRS 13, Fair Value Measurements, is as follows:
Level 1: Quoted prices in active markets, such as a closing stock price, that the entity can access at the
measurement date are Level 1 values and are the most reliable evidence of fair value.
Level 2: In the absence of quoted market prices, Level 2 estimates use observable inputs other than
quoted prices for the asset or liability. Level 2 inputs include quoted prices for similar assets or
liabilities in active markets or in markets that are not active or inputs other than quoted prices
that are observable for the asset or liability such as interest rates.
Level 3: If observable information is not available, Level 3 estimates permit the use of unobservable
inputs such as a company’s own data or assumptions. Level 3 estimates are the most subjective,
and much judgment is needed to arrive at a relevant fair value measurement. Values may be
developed using expected cash flow and present value techniques.
Accounting for Business Combinations (IFRS 3)

A business combination occurs when an acquirer obtains control of one or more businesses. A “business”
in this context is an integrated set of activities and assets that can be conducted and managed for the
purpose of providing directly to investors or other owners, members, or participants a return in the form of
dividends, lower costs, or other economic benefits.46
The method used under IFRS and U.S. GAAP to account for a business combination is the acquisition
method. The basic principles are:
• An acquirer of a business measures the cost of the acquisition at the fair value47 of the consider-
ation paid.
• The acquirer allocates the cost to the identifiable assets and liabilities acquired on the basis of their
fair values.
• Any consideration paid over and above the fair value of the net assets acquired48 is allocated to
goodwill.
• If the consideration paid is less than the fair value of the net assets acquired, the excess of acquired
assets less assumed liabilities over the consideration paid is recognized immediately as a gain in
the statement of profit or loss.
46
Per IFRS 3, Business Combinations, Appendix A (definitions).
47
Per IFRS 13, Fair Value Measurement, Paragraph 24, “Fair value is the price that would be received to sell an asset
or paid to transfer a liability in an orderly transaction in the principal (or most advantageous) market at the measurement
date under current market conditions (i.e., an exit price) regardless of whether that price is directly observable or
estimated using another valuation technique.”
48
“Net assets acquired” is assets acquired less liabilities assumed.
Recording Assets and Liabilities

Under the acquisition method, the acquiring corporation records the acquired identifiable assets and
liabilities on its books at the fair values of the assets acquired and the liabilities assumed. The values of
the assets on the books of the acquired company are not relevant because the acquiring company records
them at their fair values as of the date of the combination.
Recording Income or Loss and Equity

The income or loss of the combined company is calculated by including the income or the loss of the
purchased company only for the period after the purchase. This also means that revenues and expenses
of the acquired company are included in the combined financial statements, again, only for the period after
the acquisition.
If the consolidation is being done on worksheets only rather than in the accounting system of the acquirer,
the retained earnings of the acquired company are eliminated from the consolidated financial state-
ments along with the rest of the acquiree’s equity by an offset with the investment account of the acquiring
company. Thus, the retained earnings of the consolidated company will be the retained earnings of the
acquirer only.
Note: If the acquiring company does not own 100% of the acquired company (but does own a controlling
interest), it cannot offset all of the acquiree’s equity accounts against its investment account. It cannot
to do this because it does not “own” all of the equity of the acquired company. Therefore, the equity that
does not belong to the acquirer is reported in an equity account on the consolidated statement of financial
position called non-controlling interests. The non-controlling interests account represents the claims
that other, minority, shareholders have in the equity of the subsidiary.
The total stockholders’ equity of the combined company will be equal to the parent company’s stock-
holders’ equity. The stockholders’ equity of the acquired company is not included in the consolidated
This means that the balance in the common stock and in the additional paid-in capital accounts for the
consolidated company will be equal to the balances in the acquiring company’s accounts. These balances
will need to be increased for any stock that is issued as part of the acquisition.
Goodwill
As discussed previously in Intangible Assets, goodwill exists when the acquisition price paid (the fair value
of everything given up in the transaction) exceeds the fair value of the net identifiable assets received. This
goodwill is recognized as an asset and will need annual review to make sure that its value is not impaired.
Bargain Purchase
When a business is acquired at a price lower than the fair value of its net assets, the transaction is
called a bargain purchase. The amount by which the price is lower than the fair value of the net assets is
recognized as a gain on the statement of profit or loss, but only after the acquirer first reassesses whether
it has correctly identified all of the assets acquired and all of the liabilities assumed and recognizes any
additional assets or liabilities identified in that review. The acquirer then must review the procedures it used
to measure the fair values it has used to ensure that the measurements appropriately reflect all available
information as of the acquisition date.49
49
Per IFRS 3, Business Combinations, Paragraphs 34 through 36.
Consolidation of Financial Statements (IFRS 10)

When one company has control over another company, the controlling company must prepare consolidated
financial statements. The parent company—the controlling company—will present the financial statements
of the consolidated companies as if the two (or more) companies were a single economic entity.
An investor controls an investee if and only if the investor has all of the following:
1) Power over the investee
m
2) Exposure, or rights, to variable returns from its involvement with the investee
o
il.c
3) The ability to use its power over the investee to affect the amount of the investor’s returns 50
Power over the investee may be demonstrated by holding more than half of the voting rights of the inves-
a
gm
tee. However, it is possible for there to be control with a smaller ownership percentage or no control with
a higher percentage.51
@
An investor is exposed, or has rights, to variable returns when the investor’s returns from its involvement
with the investee have the potential to vary as a result of the investee’s performance. 52
01
An investor controls an investee if it not only has power over the investee and exposure or rights to variable
e1
returns from the investee, but it also must have the ability to use its power to affect its returns (for
example, declare a dividend) from its involvement with the investee.53
lin
on
Note: A majority-owned subsidiary should not be consolidated if control does not rest with the ma-
jority owner. This can happen if the subsidiary is in legal reorganization or bankruptcy, or if it operates
do
under foreign exchange restrictions, controls or other governmentally imposed uncertainties so strict
that they cast significant doubt on the parent's ability to control the subsidiary.
ar
on
If a business combination involves the acquired company being legally dissolved and merged into the ac-
quiring company, a permanent consolidation is produced on the acquisition date by entering all account
- le
balances into the financial records of the surviving company.
If the acquired company continues to exist as a separate entity after the acquisition, the fair value of the
n
net assets acquired is carried in the investment account on the acquirer’s books and each entity continues
me
to keep a separate set of books. Whenever financial statements are to be prepared, though, the financial
statements must be consolidated as though the books had been consolidated on the acquisition date by
ar
entering all the account balances into the financial records of the surviving company. The consolidation is
lC
simulated through the use of worksheets that are used to produce consolidated financial statements. Con-
solidation worksheet entries are used to adjust and eliminate subsidiary company accounts. Consolidation
De
journal entries are not recorded in the books of either company, but the consolidation entries are made on
the worksheets only. The final consolidated financial statements are equivalent to the financial statements
that are produced when permanent consolidation is effected on the acquisition date as occurs in a merger.
Jr
The same reporting standards apply to both types of consolidations.

do
The Consolidation Process

ar
At the end of each period, a consolidation worksheet is prepared. The balance sheets and profit or loss
on
statements of the parent and the subsidiary are prepared in a columnar format and an additional column
is created for adjusting/eliminating entries. The main exercise in the consolidation is the elimination of
Le
intercompany transactions. An event that gives rise to an asset for one company and a liability for the
other company must be eliminated in order to prevent double counting of an event. Similarly, profit or loss
statement events that are carried out between two consolidated companies need to be eliminated.
50
IFRS 10, Consolidated Financial Statements, Paragraph 7.
51
Ibid., Paragraphs 10 through 14, B34 through B54.
52
Ibid., Paragraphs 15 and 16, B55 through B57.
53
The main adjustments that need to be made are:
• The elimination of intercompany receivables and payables.
• The elimination of the effect of intercompany sales of inventory.
• The elimination of the effect of intercompany sales of fixed assets.
• The elimination of the carrying amount of the parent’s investment in each subsidiary and the
parent’s portion of equity of each subsidiary.
The Elimination of Intercompany Receivables and Payables

Because it is not possible for a company to owe money to itself, when the consolidated financial statements
are prepared, any consolidated payables or receivables between the companies need to be eliminated.
If intercompany payables and receivables were not eliminated, the balance sheet would be “grossed up”
because both payables and receivables for the consolidated company would be overstated. The amounts of
intercompany payables and receivables to eliminate should be equal to each other since if one of the con-
solidated parties has a related party receivable, then another of the consolidated parties must have a
related party payable.
The Elimination of the Effect of Intercompany Sales of Inventory

When an inventory sale takes place between consolidated companies, several adjustments need to be
made.
• The inventory sold by one consolidated company to another consolidated company must be re-
ported in the consolidated financial statements at the value recorded by the original purchaser
of the inventory. If the inventory sold to the related party included some profit for the seller, the
buyer of the inventory will have recorded it at an amount higher than the seller’s purchase price.
Because it is necessary to show all of the companies as if they were one company, the inventory
must be reported at the value at which it was purchased by the original purchaser. If the inventory
is still on the books of the company that purchased it from the original purchaser, the inventory
account must be written down to the cost that was paid when the consolidated group of companies
first acquired the inventory.
• Furthermore, any profit recognized by one member of the consolidated group on intercompany
sales of inventory not yet sold to an unrelated third party by the group must be eliminated because
the company cannot make a profit simply by selling inventory to itself.
• If the buyer of the inventory has sold it to an unrelated third party, the consolidated reported profit
will be the sale price received by the company that ultimately sold the inventory to the unrelated
third party minus the inventory’s cost to the original purchasing company.
The Elimination of the Effect of Intercompany Sales of Fixed Assets

The following adjustments must be made if an intercompany sale of fixed assets has taken place:
• The carrying value of the asset needs to be adjusted to be what it would have been if the fixed
asset had never been sold within the group. The historical cost on the consolidated balance sheet
needs to be the amount the selling company paid for the asset.
• The intercompany gain on the sale is unrealized until the asset is sold to an outside party, so the
gain recorded by the seller must be eliminated. This adjustment must be made every year.
• Since the unrealized gain is eliminated from the valuation of the asset, the gain element must be
eliminated from the related depreciation expense in the consolidated statement of profit or loss.
The depreciation expense on the consolidated statement of profit or loss should be what it would
have been if the asset had not been sold to the related party.
• The accumulated depreciation needs to be the amount it would have been if the asset had not
been sold. This adjustment must be made every year.
• The retained earnings of the selling company need to be reduced in order to eliminate the gain
that was recognized by the selling company on the sale of the fixed asset.
The Elimination of the Parent’s Investment Account

Because the parent company owns shares of the subsidiary, it has an account titled investment in sub-
sidiary on its balance sheet that represents its investment in the subsidiary. Because the subsidiary’s
balance sheet is added to the parent’s balance sheet in the process of the consolidation, the parent would
be double counting that investment unless an adjustment is made. The adjustment eliminates the invest-
ment account on the parent’s books against the equity accounts on the subsidiary’s books. Candidates do
not need to worry about the details of the elimination, other than to know that it happens.
Other Eliminations
Any other intercompany transactions also need to be eliminated. Intercompany transactions could be re-
lated to bonds, loans, notes payable or anything similar.
Non-controlling Interests
Non-controlling interests are the claims to the net assets of the subsidiary that are held by investors other
than the parent company. Non-controlling interests arise when the parent does not own 100% of the sub-
sidiary. If the parent owns 100% of the subsidiary, then no non-controlling interests can exist.
In the consolidation, the balance sheet of the subsidiary is added to the balance sheet of the parent. For
example, if the parent owns only 90% of the subsidiary, technically it should include only 90% of the assets
and liabilities of the subsidiary, because that is all it owns. However, the parent will prepare the consolida-
tion worksheet as though it owned 100% of the subsidiary. The parent then sets up a balance sheet account
titled non-controlling interests that represents the claims on the subsidiary’s net assets by the non-
controlling shareholders.
• In the consolidated balance sheet, the offsetting credit amount for the portion that does not belong
to the parent company is shown as a separate caption in the stockholders’ equity section.
• Accumulated other comprehensive income of the subsidiary is also apportioned between the parent
and the non-controlling interest and the amounts are shown separately in the equity section.
• In the statement of profit or loss, the amount of net income belonging to the parent and to the
non-controlling interests are consolidated, but they must be separately identified.
Investments in Financial Instruments (IFRS 9)

IFRS 9, which became effective on January 1, 2018, applies to investments in financial instruments includ-
ing debt and equity securities where the holder does not have significant influence or control, whether they
are publicly held and traded in the secondary markets or privately held.
Debt securities are bonds or notes issued by corporations or governmental authorities that represent
loans made to the issuer by investors in the securities.
Equity securities represent ownership interests in other companies.
Three different methods are used to account for investments in financial instruments. Such debt and equity
securities are measured at amortized cost, fair value through other comprehensive income, or fair
value through profit or loss. Measurement of debt securities is determined on the basis of:
• The entity’s business model for managing the financial assets, and
• The contractual cash flow characteristics of the financial asset.
Two additional methods are used to account for equity securities when the investor has significant influence
over or controls the other entity: the equity method or consolidation. Those are not within the scope of
IFRS 9 and they are covered elsewhere in these materials.
Method Guideline – Used for:
1. Amortized Cost Investments in debt securities if both of the following conditions are met:
(a) The financial asset is held within a business model whose objective is to
hold financial assets in order to collect contractual cash flows, and
(b) The contractual terms of the financial asset give rise on specified dates
to cash flows that are solely payments of principal and interest on the
principal amount outstanding.
2. Fair Value Through Investments in debt securities if both of the following conditions are met:
OCI (FVTOCI) (a) The financial asset is held within a business model whose objective is
achieved by both collecting contractual cash flows and selling fi-
nancial assets, and
(b) The contractual terms of the financial asset give rise on specified dates
to cash flows that are solely payments of principal and interest on the
principal amount outstanding.
3. Fair Value Through Investments in financial assets unless the assets are measured at amortized
Profit or Loss (FVTPL) cost or at fair value through other comprehensive income (that is, unless the
assets are debt securities). Generally, this classification will include all equity
securities (except for equity securities when the investor has significant in-
fluence over or controls the other entity). Dividends are recognized in profit
or loss unless they represent recovery of a part of the cost of the investment,
in which case they are included in OCI.
However, an entity may make an irrevocable election at initial recognition
for specific investments in equity instruments to measure them at fair value
through other comprehensive income. Changes in fair value that have
been recognized in OCI are never transferred to the statement of profit
or loss even if the asset is sold or is impaired.54
54
In its separate document, Basis for Conclusions, IFRS 9 Financial Instruments, the IASB noted that an entity is not
prohibited from presenting information in its financial statements as a separate line item in other comprehensive income
to disclose realized gains or losses that have remained in OCI after derecognition of the associated equity instrument
(Paragraph BC4.153[a].)
Note: Measuring privately-held equity instruments at cost because the instruments are not traded on
secondary markets and thus a market price is not available, which was permitted under IFRS 39, is no
longer an option. IFRS 9 requires all equity investments to be measured at fair value.55
Investments in Associates – The Equity Method (IAS 28)

The equity method can be called a “one-line consolidation,” because the net result on the investor’s
income of accounting for an investment using the equity method is the same as the result of using full
consolidation. However, instead of reporting its share of each separate component of income (sales, cost
of sales, operating expenses, and so forth) in its statement of profit or loss, the investor includes only its
share of the investee’s net income in a single line on its statement of profit or loss.
When to Use the Equity Method
An associate is an entity over which the investor has significant influence. Owning between 20% and
50% of the outstanding voting stock of an associate usually indicates significant influence. The equity
method is used when the investor has significant influence over operating and financial policies of the
associate, usually as a long-term investor.
Note: It is important to remember that the rules governing the equity method and consolidation
are based on influence and control, not the percentage of ownership. The percentages of ownership
are only guidelines. If a company owns 80% of another company but does not have significant influ-
ence over the other company, the investment is accounted for using the fair value through profit or loss
(FVTPL) method or at fair value through OCI (FVTOCI) if the reporting entity has made an irrevocable
election at initial recognition to do so for a specific equity investment.
IAS 28, Investments in Associates and Joint Ventures, provides indicators of “significant influence,” in ad-
dition to the percentage of ownership, as follows:
• The investor is represented on the board of directors or equivalent governing body of the investee.
• The investor participates in the policy-making processes of the investee, including participation in
decisions about dividends or other distributions.
• There are material intra-entity transactions.
• There is an interchange of managerial personnel between the investor and the investee.
• There is provision of essential technical information.
Acquisition of an Equity Method Investment

An investment in an associate or a joint venture is initially recognized at cost. Any difference between the
entity’s cost for the investment and the entity’s share of the net fair value of the investee’s identifiable
assets and liabilities is accounted for as follows:
• If the investor’s cost exceeds its share of the net fair value of the investee’s identifiable assets and
liabilities, the difference is goodwill. However, the goodwill is not recognized as a separate line
item. It is included in the carrying amount of the investment, and amortization of the goodwill is
not permitted.
• If the investor’s share of the net fair value of the investee’s identifiable assets and liabilities is
greater than the cost of its investment, the difference is included as income in the determination
of the investor’s share of the investee’s profit or loss in the period the investment is acquired.
55
However, IFRS 9 does state in Paragraph B5.2.3 that in limited circumstances, cost may be an appropriate estimate
of fair value, specifically if sufficient recent information to measure fair value is unavailable or if there is a wide range of
possible fair value measurements and cost represents the best estimate of fair value within that range.
Post-Acquisition Events
Subsequently, the investment’s carrying amount is increased or decreased to recognize the investor’s share
of profit or loss of the investee and to include that share of the investee’s profit or loss in the investor’s
profit or loss.
If the investor’s share of losses of an investee equals or exceeds its interest in the investee, the investor
stops recognizing its share of further losses once the investor’s interest has been reduced to zero. Additional
losses are provided for and a liability is recognized only to the extent that the investor has obligations for
or has made payments on behalf of the investee. However, the investor continues to keep records of the
amount of investee losses not reflected in its financial statements. If later the investee recovers and returns
to profitability, the investor will ignore its share of the future earnings until the amount of ignored losses
have been completely offset. After the investor’s ignored losses (its proportionate share of past losses)
have been completely offset by its share of future earnings, the investor resumes recognizing its share of
those profits.
Distributions received from an investee reduce the carrying amount of the investor’s investment. Other
adjustments to the carrying amount may also be needed for changes in the investor’s proportionate interest
in the investee arising from changes in the investee’s other comprehensive income. The investor’s share of
changes in the investee’s other comprehensive income is recognized in the investor’s other comprehensive
income.
Intercompany Profits and Losses

The investor’s pro rata share of profits or losses on transactions between the investor and the investee
should be eliminated for any items not yet sold to an outside party at the financial statement date. These
profits or losses, which are still inside the companies, are eliminated through the investment and investment
income accounts.
Partnerships
A partnership consists of two or more individuals or entities, formed to carry on a business with the goal of
earning a profit. A partnership is unincorporated, but it is a separate entity from the partners. The partners
have unlimited liability, so if the partnership is unable to pay its liabilities, the partners may be required to
pay the unpaid liabilities from their personal assets.
A partnership is governed by the terms of its partnership agreement.
The equity section of a partnership balance sheet consists of partnership accounts for each of the partners.
Although partnership accounting records could be maintained with only one ledger account for each partner,
usually several accounts are maintained for each partner. The partnership accounts consist of
• Separate capital accounts for each partner
• Separate drawing accounts (also called current accounts) for each partner
• Separate accounts for loans to and from each partner
Partners’ total capital is the sum of their capital and drawing accounts.
The original investments of the partners are recorded as credits to the capital accounts. If investments by
partners consist of nonmonetary assets, the nonmonetary assets should be valued at their fair values, and
the partners need to agree on the fair values to use.
Withdrawals of cash or other assets by partners in anticipation of net income or drawings that are salary
allowances are recorded as debits to the partners’ drawing accounts. At the end of an accounting period,
the debit balances in the partners’ drawing accounts are closed to their capital accounts.
The distribution of net income to the partners’ capital accounts is done in accordance with the partnership
agreement. The “profit and loss sharing ratio” governs the allocation. However, the amount distributed
under the profit and loss sharing ratio is not the net income of the partnership for the period. Several
adjustments, called appropriations, are made to the partnership’s net income to arrive at the profit or loss
to be distributed, as follows:
• The amount paid to each partner during the year is not an expense to the partnership. Since the
partners are the owners of the business, any amounts paid to them as “salaries” during the year
under the terms of the partnership agreement are part of their share of the profit. The amount
paid to each partner as “salary” is a guaranteed amount, and it is accounted for through a credit
entry in the partner’s account, usually the drawing account before the residual profit is shared.
The other side of the credit entry is a debit to the appropriation account.
• Interest on partners’ capital is usually paid on the partners’ capital balances. The interest is a
means of rewarding the partners for having invested their funds in the partnership. The interest
paid reduces the amount of profit available for distribution under the profit and loss sharing ratio.
The interest is paid with a credit entry to the drawing account of each partner and a debit to the
appropriation account.
• Interest may be charged on drawings to discourage partners from withdrawing excessive amounts.
If interest is charged on drawings, the interest is debited to the partners’ drawing accounts and
credited to the appropriation account.
The net profit after adjusting for the items above is a residual amount that is then allocated to the partners’
capital accounts using the profit and loss sharing ratio. The appropriations are made whether or not there
is enough profit before the appropriations to cover them. If the net of the appropriations exceeds the net
profit, then a loss is distributed to the partners’ capital accounts using the profit and loss sharing ratio. The
net income (loss) is debited (credited) to the Income Summary to bring its balance to zero; the balance in
the appropriations account (usually a debit balance) is credited to the appropriations account to bring its
balance to zero; and the residual amount is credited (if a profit) or debited (if a loss) to the partners’ capital
accounts under the terms of the sharing ratio.
If a new partner joins the partnership or an existing partner leaves the partnership, the business carries
on. However, the existing partnership is dissolved and a new partnership is formed. The new partners
effectively buy the assets of the old partnership from the old partners.
Accounting for Foreign Currency Denominated Transactions

Foreign currency transactions are individual transactions that are denominated in a currency other than the
entity’s functional currency.
Note: An entity’s functional currency is the currency of the primary economic environment in which
the entity operates, that is, the environment in which it primarily generates and expends cash. Any other
currency is a foreign currency.
When a firm enters into a transaction in a foreign currency, the transaction is recorded in the firm’s books
in the firm’s functional currency in an amount equivalent to the foreign currency amount at the spot ex-
change rate in effect on the transaction date. The spot rate is the rate of a foreign exchange contract to
purchase or sell currency for immediate delivery. Thereafter, at each financial statement date, the monetary
amount of the outstanding receivable or payable on the firm’s books denominated in the foreign currency
but recorded in the firm’s functional currency is adjusted using the spot exchange rate in effect at the end
of the reporting period. On each reporting date during the period the receivable or payable remains out-
standing, any gain or loss caused by changes in the exchange rate since the previous reporting date is
recorded as an adjustment to the affected balance sheet account and as a gain or loss on the statement of
profit or loss.
When the receivable or payable is settled, another gain or loss is recorded to recognize the gain or loss
caused by the change in the exchange rate since the most recent financial statement date.
Example: A U.S. company makes a sale for £10,000 to a U.K. company denominated in British pounds.
The U.S. company issues the invoice in the amount of £10,000. However, the functional currency of the
U.S. company is U.S. dollars, so the invoice will be recorded in the U.S. company’s accounting records
at the equivalent amount of U.S. dollars. Assuming the U.S. company has not hedged the transaction
using a foreign exchange forward or futures contract, the transaction is treated as follows.
On the date the customer is billed and the revenue is recognized, the spot exchange rate between British
pounds and U.S. dollars is £1 = $1.38. The U.S. company records the revenue and the receivable in its
functional currency (U.S. dollars) using the currency exchange spot rate on that date. The equivalent
amount in U.S. dollars converted at the spot rate is the amount of U.S. dollars the U.S. company would
receive if the foreign receivable amount were settled that day in pounds and then converted into U.S.
dollars at that day’s spot rate. At a spot rate of £1 = $1.38, £10,000 equals $13,800 US.
On every financial statement date prior to settlement of the receivable, the U.S. company adjusts the
balance in its receivable account to the functional currency equivalent of the 10,000 British pounds
receivable at the closing spot exchange rate on the statement date. The exchange rate gain or loss
is recorded in the current period statement of profit or loss. The foreign currency gain or loss will be
equal to the amount of change in the receivable as a result of the change in the spot rate since the last
statement date (or, on the first statement date following the sale, the amount of change in the receivable
due to change in the spot rate since the date of the sale).
On the first financial statement date following the sale, the spot rate is £1 = $1.40. The U.S. dollar value
of the sale is now 10,000 × $1.40, or $14,000. The U.S. company records a gain of $200 and increases
its account receivable in U.S. dollars from $13,800 to $14,000.
The British customer pays the invoice 10 days following the first financial statement date following the
sale. On that date, the spot exchange rate is £1 = $1.36. On the date payment is received, the U.S.
company uses the £10,000 it receives to buy U.S. dollars at the spot rate. The U.S. company receives
$13,600 for the £10,000 (10,000 × $1.36). The value of the receivable has decreased from $14,000 at
the last statement date to $13,600, a $400 decrease. The U.S. company records a $400 loss in the
current period and decreases the balance of the receivable from $14,000 US to $13,600 US. The U.S.
company then applies the U.S. dollars received to the receivable by debiting cash for $13,600 and cred-
iting the receivable for $13,600.
The U.S. company’s net currency exchange loss has been $200: a $200 gain less a $400 loss.
1 C. Financial Analysis
Note: CIA exam candidates are expected to demonstrate knowledge of financial analysis at the pro-
ficient level. They must be able to apply concepts, processes, or procedures; analyze, evaluate, and
make judgments based on criteria; and/or put elements or material together to formulate conclusions
and recommendations.
In studying for the following section, make certain to know all of the ratios listed, what each one means,
and what each one is used for. Candidates need to be able to interpret the ratios, not just calculate them.
Use of Financial Analysis by Internal Auditors

Analytical procedures are one type of audit evidence used by all auditors. For example, calculation of ratios
and observations of the same ratio over time are analytical procedures that can alert an auditor that some-
thing does not look right.
Example: The cost of items in inventory flows to cost of goods sold as sales are made. If someone is
recording fraudulent sales and receivables that have no corresponding cost, then the gross margin per-
centage (sales revenue less cost of sales divided by sales revenue) may increase unaccountably (that
is, not explainable by cost-cutting procedures, for example). If inventory theft is occurring, the gross
margin percentage may be inexplicably low (due to costs without corresponding sales revenue). Internal
auditors should be comfortable with the use of financial ratios as analytical procedures.
Basic Financial Statement Analysis

Earnings before interest and taxes (EBIT) and earnings before taxes (EBT) are terms frequently used in
financial statement analysis, although they do not appear as summations on a statement of profit or loss.
EBIT and EBT can be calculated in a format similar to a standard multiple-step statement of profit or loss
but with certain changes, as follows:
Revenue XXXXX
Cost of goods sold (XXXX)
Gross margin XXXX
( XXX)
Selling expenses
General & administrative expenses ( XXX)
Research & development expenses ( XXX)
Financial income (such as gains on sale of assets and interest income) X
Financial expenses (such as losses on sale of assets but not interest expense) ( X)
Earnings before interest & taxes (EBIT) XXX
Interest expense ( X)
Earnings before taxes (EBT) XXX
Income tax expense, continuing operations ( XX)
Note that interest expense has been pulled out of financial expenses to calculate earnings before interest
and taxes (EBIT). Interest expense appears on the line below EBIT. Thus, earnings before interest and
taxes (EBIT) is not the same as income from operations nor is it the same as income from contin-
uing operations. EBIT is equivalent to income from operations adjusted for financial income and financial
expenses but without including interest expense in financial expenses.
In a statement of profit or loss, interest expense is reported in financial expenses along with losses on the
sale of assets. EBIT and income from operations would be the same only if financial income and financial
expenses (other than interest expense) were zero.
Exam Tip: Despite the fact that income from operations and EBIT are not the same thing, they may be
used interchangeably, even on an exam, under the assumption that the statement of profit or loss
contains no financial income or financial expenses other than interest expense.
Comparative Financial Statement Analysis

One of the main difficulties in the comparison of financial statements between companies or between peri-
ods of time for the same company is the difference in size.
• When comparing two companies, one company may have a higher net income simply because it
is bigger and not because it is more efficient, effective or sells a better product.
• When comparing financial statements for the same company over several accounting periods, the
statements of profit or loss may report significant sales growth during one of the periods, making
comparison difficult.
One of the ways to deal with these size differences is through comparative financial statement analysis.
Comparative financial statements state each item of the financial statement not as a numerical amount,
but rather as a percentage of a relevant base amount.
Comparative financial statements can be either vertical or horizontal.
• Vertical analysis, also called common-size financial statements, makes it possible to com-
pare the performance of companies of different sizes during the same period of time.
• Horizontal or trend analysis, also called common-base year statements, enables comparison
of data for a single company or a single industry over a period of time.
Vertical Common-Size Financial Statements

A simple vertical common-size financial statement covers one year’s operating results and expresses each
component as a percentage of a total.
• Line items on the statement of profit or loss are presented as a percentage of sales revenue
• Line items on the balance sheet are presented as a percentage of total assets
For example, fixed assets will not be stated as a dollar amount but rather will be stated as a percentage of
total assets. Each expense item will be stated as a percentage of total revenue.
However, common-size financial statements do not need to relate each balance sheet item to total assets
only. For example, the analysis might focus on the company’s inventory and calculate percentages of raw
materials, work in process, and finished goods in total inventories. Or the analysis might focus on the
composition of the company’s investments, both non-current and current.
A vertical common-size statement of profit or loss might state each classification of sales revenue or ex-
penses as a percentage of total revenues. Alternatively, it might state general and administrative expenses
and selling expenses each as a percentage of total operating expenses. A common-size financial statement
can be anything the analyst wants to see or analyze.
The internal auditor might also compare a company’s common-size statement of profit or loss with industry
common-size profit or loss statements to potentially reveal a problem. For instance, if cost of goods sold
as a percentage of total sales revenue is significantly higher than the norm for other firms in the same line
of business, it could indicate that “inventory shrinkage” (in other words, theft) is taking place.
In addition, common-size financial statements for one company can be arranged side by side for a period
of several years to reveal trends over time in individual line items as percentages of sales revenue. Large
unexplained changes over time indicate a need for further investigation.
Common-size financial statements by industry are available in published form from several sources. Two
of them are:
• A book called Annual Statement Studies is published by the Risk Management Association (formerly
Robert Morris Associates), a bankers’ trade association. The statement studies information is pro-
vided by RMA member banks from the financial statements of their small and medium-size
business customers. The information covers more than 300 industries and is broken down by asset
size and sales size, so that a particular company’s common-size statement can be compared with
those of businesses in its industry that are approximately its own size. The Annual Statement
Studies can be purchased either in hard copy or as online access through RMA’s website at
www.rmahq.org. The book is also available in most public libraries.
• Dun & Bradstreet® Key Business Ratios on the Web (KBR), published by Mergent, Inc., provides
industry benchmarks compiled from Dun & Bradstreet's database of public and private companies.
KBR provides common-size financial statements and 14 key ratios developed from actual company
The sources above contain data on both public and nonpublic companies, though the vast majority of the
information in the Annual Statement Studies is on nonpublic companies.
Much more information is available for public companies than for nonpublic companies. Various Internet
sites provide data on public companies that is already in a form that can be easily analyzed. Some of this
information is free and some is on a subscription basis. In the U.S., information on any company that files
reports with the SEC (U.S. Securities and Exchange Commission) is available for free on the SEC’s website
at www.sec.gov.
Horizontal Trend Analysis

Horizontal trend analysis is used to evaluate trends for a single business over a period of several years. In
analyzing the statement of profit or loss, changes in revenues or expenses over time can indicate, for
example, the effectiveness of a company’s change in pricing strategy or its efforts to improve operations.
Horizontal trend analysis can be in the form of common-base year financial statements or as a variation
analysis, a presentation of the annual growth rates of line items.
Common-base year financial statements use the first year as the base year. Financial statement amounts
for subsequent years are presented not as dollar amounts but as percentages of the base year amount,
with the base year assigned a value of 100% or 100. For example, each year’s inventory balance is stated
as a percentage of the base year’s inventory and each year’s fixed assets are stated as a percentage of the
base year’s fixed assets.
New Line Item Amount

Common Base Year Statements = × 100
Base Year Line Item Amount
Example: A common-size vertical statement. Following is a statement of financial position and a statement of
profit or loss for a company with the actual monetary amounts (in thousands, 000 omitted) in the first column and
the common size vertical statement percentages in the second column. Each individual statement of financial position
item has been divided by the total assets and each individual profit or loss statement item has been divided by net
revenues.
20X3 Actual 20X3 Common Size

Statement of Financial Position:
ASSETS
Non-current Assets:
Property, plant & equipment, net 2,400 9.1%
Intangible assets 4,500 17.0%
Other non-current assets 1,200 4.5%
Total non-current assets 8,100 30.6%
Current Assets:
Inventories 400 1.5%
Marketable securities 14,100 53.2%
Other current assets 300 1.1%
Accounts receivable, net 700 2.7%
Cash & cash equivalents 2,895 10.9%
Total current assets 18,395 69.4%
Total assets 26,495 100.0%
SHAREHOLDERS’ EQUITY
Preferred stock 100 0.4%
Common stock 1,685 6.4%
Paid-in capital 5,780 21.8%
Retained earnings 6,830 25.8%
Total shareholders’ equity 14,395 54.3%
LIABILITIES
Non-current Liabilities:
Long-term debt 5,000 18.8%
Other non-current liabilities 4,300 16.2%
Total Non-current liabilities 9,300 35.1%
Current Liabilities:
Accounts payable 600 2.3%
Accrued liabilities 500 1.9%
Other current liabilities 1,700 6.4%
Total current liabilities 2,800 10.6%
Total liabilities 12,100 45.7%
Total liabilities and shareholders’ equity 26,495 100.0%
Statement of Profit or Loss:
Revenues:
Net revenues 10,400 100.0%
Cost of goods sold 3,200 30.8%
Gross margin 7,200 69.2%
Operating expenses:
Selling expenses 600 5.8%
General and administrative expense 900 8.7%
Research and development expense 3,000 28.9%
Total operating expenses 4,500 43.3%
Income from operations 2,700 25.9%
Non-operating income and expenses:
Financial income 177 1.7%
Financial expense (other than interest expense) ( 344) ( 3.3%)
Earnings before interest and taxes (EBIT) 2,533 24.3%
Interest expense ( 400) ( 3.8%)
Earnings before taxes (EBT) 2,133 20.5%
Income tax expense ( 533) ( 5.1%)
Net income 1,600 15.4%
Example: A common-base year statement. Below are the same company’s profit or loss statements for three
years. The statements appear first, and below them the common-base year statements follow. In the common-base
year statements of profit or loss, amounts from 20X1 are expressed as 100%, and on each line, amounts from 20X2
and 20X3 are expressed as percentages of the 20X1 values. The same type of analysis can be done using balance
sheet amounts.
Statements of Profit or Loss:
20X3 20X2 20X1
Net revenues 10,400 11,100 9,900
Cost of goods sold 3,200 3,400 3,000
Gross margin 7,200 7,700 6,900
Selling expense 600 900 500
General and administrative expense 900 800 900
Research and development expense 3,000 1,800 1,200
Income from operations 2,700 4,200 4,300
Financial income 177 617 710
Financial expenses (other than interest expense) ( 344) ( 150) ( 210)
Earnings before interest and taxes (EBIT) 2,533 4,667 4,800
Interest expense ( 400) ( 400) ( 400)
Earnings before taxes (EBT) 2,133 4,267 4,400
Income tax expense (25%) ( 533) (1,067) ( 1,100)
Net Income 1,600 3,200 3,300
Common-Base Year Statements:
Note: The percentages below do not represent percentages of increase or decrease from one year to another year.
Instead, they represent the proportional amounts for 20X2 and 20X3 compared to 20X1. They were calculated by
dividing each amount for the year in question by the same amount for 20X1 (from the profit or loss statements above)
and multiplying by 100.
20X3 20X2 20X1
Net revenues 105.1% 112.1% 100.0%
Cost of goods sold 106.7% 113.3% 100.0%
Gross margin 104.3% 111.6% 100.0%
Selling expense 120.0% 180.0% 100.0%
Research and development expense 250.0% 150.0% 100.0%
General and administrative expense 107.1% 121.4% 100.0%
Income from operations 62.8% 97.7% 100.0%
Financial income 24.9% 86.9% 100.0%
Financial expenses (other than interest expense) 163.8% 71.4% 100.0%
Earnings before interest and taxes (EBIT) 52.8% 97.2% 100.0%
Interest expense (100.0%) (100.0%) (100.0%)
Earnings before taxes (EBT) 48.5% 97.0% 100.0%
Income tax expense ( 48.5%) ( 97.0%) (100.0%)
Net income 48.5% 97.0% 100.0%
Analysis and interpretation:

In the common-base year statement, each year’s financial results are compared with results for the base year. The
analysis does not end with developing the percentages. An analysis like the one above can be used to determine both
the causes and to see the effects of shifts that have taken place over time.
Net revenues increased in 20X2 to 112% of 20X1’s revenues but then decreased in 20X3 to just 105% of 20X1’s
revenues. The economy went into a recession in 20X3, and that probably accounts for most of the sales decrease.
Gross margin, of course, was lower as well in 20X3 compared with 20X2.
It is worth noting that much of 20X3’s net income decrease was due to increased R&D expense. In a year when
revenues and gross margin decreased, the company chose to increase its R&D expense. The company being analyzed
above is a strong company in the technology industry, and its management was taking advantage of the slower selling
period during the recession to position itself for a very strong upward movement in sales when the economy recovered
by having new products available to sell as a result of its increased R&D activity.
Horizontal analysis can also be done in the form of a variation analysis by calculating the annual growth
rate of each individual line item. For each line item, the percentage of change year-over-year is calculated.
Each year’s value is compared with that of the previous year.
New Line Item Amount

Annual Growth Rate of Line Items = −1
Old Line Item Amount
The percentage of change year-over-year can also be calculated as follows:
New Line Item Amount − Old Line Item Amount

Annual Growth Rate of Line Items =
Old Line Item Amount
An example of a variation analysis follows.
Example: A variation analysis showing growth rates of individual line items on the statement of financial position
and statement of profit or loss. Below are financial statements for the same company for two years showing the
growth rate in each balance sheet and profit or loss statement item from 20X2 to 20X3 (in thousands, 000 omitted).
(Note that growth rates can be negative.)
20X3 20X2 Growth Rate
Statement of Financial Position:
ASSETS
Non-current Assets:
Property, plant & equipment, net 2,400 2,100 +14.3%
Intangible assets 4,500 4,600 − 2.2%
Other non-current assets 1,200 1,200 0.0%
Total non-current assets 8,100 7,900 + 2.5%
Current Assets:
Inventories 400 500 −20.0%
Marketable securities 14,100 9,300 +51.6%
Other current assets 300 800 −62.5%
Accounts receivable, net 700 3,675 −81.0%
Cash & cash equivalents 2,895 1,800 +60.8%
Total current assets 18,395 16,075 +14.4%
Total assets 26,495 23,975 +10.5%
SHAREHOLDERS’ EQUITY
Preferred stock 100 100 0.0%
Common stock 1,685 1,670 0.9%
Paid-in capital 5,780 5,570 + 3.8%
Retained earnings 6,830 5,735 +19.1%
Total shareholders’ equity 14,395 13,075 +10.1%
LIABILITIES
Non-current Liabilities:
Long-term debt 5,000 5,000 0.0%
Other non-current liabilities 4,300 3,500 +22.9%
Total non-current liabilities 9,300 8,500 + 9.4%
Current Liabilities:
Accounts payable 600 500 +20.0%
Accrued liabilities 500 400 +25.0%
Other current liabilities 1,700 1,500 +13.3%
Total current liabilities 2,800 2,400 +16.7%
Total liabilities 12,100 10,900 +11.0%
Total liabilities and shareholders’ equity 26,495 23,975 +10.5%
Statement of Profit or Loss:
Revenues:
Net revenues 10,400 11,100 − 6.3%
Cost of goods sold 3,200 3,400 − 5.9%
Gross margin 7,200 7,700 − 6.5%
Operating expenses:
Selling expense 600 900 −33.3%
Research and development expense 3,000 1,800 +66.7%
General and administrative expense 900 800 −12.5%
Total operating expenses 4,500 3,500 +28.6%
Income from operations 2,700 4,200 −35.7%
Non-operating income and expenses:
Financial income 177 617 −71.3%
Financial expenses other than interest expense ( 344) ( 150) +129.3%
Earnings before interest and taxes (EBIT) 2,533 4,667 −45.7%
Interest expense ( 400) ( 400) 0.0%
Earnings before tax (EBT) 2,133 4,267 −50.0%
Income tax expense ( 533) (1,067) −50.0%
Net income 1,600 3,200 −50.0%
Financial Ratio Analysis

Ratio analysis examines relationships among financial statement items at a specific point in time.
By looking at these relationships, financial statement users or internal auditors can see if they indicate
positive or negative trends within the company. Ratio analysis can be used to analyze income and balance
sheet items and the relationships between them.
Ratios are based on accounting data. Therefore, they often do not reflect the current values of the items
they are measuring because the accounting system uses historical costs rather than current fair values.
While using current fair values would usually be a more accurate approach, current fair values of some
assets are not readily determinable.
A calculated ratio is only a number. In order for the number to be meaningful, it must be put into a context
by comparing it to another number. These comparisons can be made through:
• Trend analysis of a single company over time by comparing its current financial ratios to previ-
ous year’s results.
• Comparison with other companies in the same industry or with industry averages after any
necessary adjustments have been made to assure that the financial statements are comparable.
• Comparison with management’s expectations, for example comparison of the accounts receiv-
able number-of-days-receivables-held ratio (the average collection period) with the usual terms
given to customers.
Example: Assume that 34 days are needed on average to collect accounts receivable. Without context,
it is impossible to know whether or not 34 days is an acceptable collection period. If the number of days
the company gives customers to pay is 20 days, then 34 days is not acceptable. If customers have 45
days to pay, though, then 34 days is more acceptable. If customers have 20 days but last year the
collection period was 52 days, then 34 days may not be acceptable by itself, but compared to a previous
period, 34 days may signal an improvement.
Ratios can be identified and classified as to whether they measure liquidity, solvency, activity, leverage,
or profitability. The next section looks at a number of ratios and discusses their meaning and also their
interpretation.
Note: Two rules should always be followed when calculating ratios that include items from both the
statement of financial position (balance sheet) and the statement of profit or loss:
1) Average balances of balance sheet items are used instead of ending balances whenever a ratio
calculation is relating a profit or loss statement amount to a balance sheet amount. The average
balance amount should be the average balance of the balance sheet item during the same period
of time as is covered by the profit or loss statement item. Using the average balance of the
balance sheet item over the same period of time as is covered by the profit or loss statement item
makes the relationship of the two amounts meaningful. The average balance is usually calculated as
the average of the beginning and ending balances of the period.
If a year-end balance sheet amount were used in the ratio, that amount would represent the balance
sheet item’s balance only as of one moment in time, and thus it would not be comparable to a profit
or loss statement figure covering a range of “moments in time.”
Note: If both the numerator and the denominator of a ratio are balance sheet amounts, year-end
balances can be used instead of average balances for both the numerator and the denominator of
the ratio.
(Continued)
2) When the time period represented by a profit or loss statement amount in a ratio is less than one
year, the profit or loss statement amount should be annualized to present the amount as if the
same level of income or expense had been experienced for a full year. Annualize an income or
expense amount that is for less than a full one-year period as follows.
 If the income or expense amount is for one quarter, multiply it by 4 to annualize it.
 If the income or expense amount is for one month, multiply it by 12 to annualize it.
 If the income or expense amount is for 5 months, divide it by 5 and then multiply the result (one
month’s income) by 12 months.
 If the income or expense amount is for an uneven number of days, for example 54 days, divide
the income amount by the number of days and then multiply the result (one day’s income) by
365 days.
However, the average balance used for the balance sheet amount in the ratio should be for only
the period of time covered by the partial-period statement of profit or loss, not for a full
year.
A fundamental analyst uses the information from a company’s financial statements to determine the
financial strengths and weaknesses of a corporation. This analysis also compares the company’s perfor-
mance to other companies within the same industry.
To conduct fundamental analysis, a fundamental analyst will use various calculations and ratios. These
formulas will reveal information regarding the company’s liquidity, capitalization, ability to meet fixed
costs, and profitability.
Liquidity Ratios
Liquidity reflects the ability of a firm to meet its short-term obligations by using assets that are most
readily converted into cash without significant loss in value or the necessity of making significant price
concessions. A firm’s liquidity also refers to its ability to sell assets quickly in order to raise cash.
Assets that can be converted into cash within a short period of time without significant loss are referred to
as liquid assets, and they are identified in financial statements as current assets. Current assets repre-
sent the resources needed for the day-to-day operations of the firm's long-term, capital investments.
Current assets should be used to satisfy current liabilities.
A company needs current assets to cover its current obligations for daily operations. A company should
maintain a level of current assets sufficient to pay its current obligations. At the same time, the company
should not have a greater amount of current assets than necessary because current assets do not provide
as much return on investment as can generally be earned from investing in long-term, productive assets.
Liquidity ratios measure a firm’s short-term viability, meaning its ability to continue to operate in the
short term by paying its short-term obligations.
Net working capital is total current assets less total current liabilities. A company needs working capital
(that is, current assets minus current liabilities) to finance its daily operations. Working capital bridges the
gap between production and sales. Maintaining a comfortable level of working capital is important, because
doing so will enhance the company’s ability to meet its current liabilities, expand its production, and take
advantage of opportunities.
Working capital is a measure of the ability of the company to meet its liabilities as they come due. It is
calculated as follows:
Net Working Capital = Current Assets – Current Liabilities
Exam Tip: Working capital and net working capital are often used interchangeably to refer to cur-
rent assets minus current liabilities. Net working capital can be referred to as working capital, and
working capital can be referred to as net working capital.
Since the term “working capital” may be used to refer either to current assets or to current assets minus
current liabilities, some interpretation may be necessary if the term “working capital” appears in an exam
question.
Current assets include: Current liabilities include:

• Inventories • Accounts payable
• Marketable securities • Notes payable
• Prepayments56 • Current maturities of long-term debt
• Net accounts receivable • Contract liabilities that are short-term
• Contract assets that are short-term • Taxes payable
• Cash and cash equivalents • Wages payable
• Other accruals
It is possible for a company’s working capital to be too high. Current assets do not earn much return for
the company because of their short-term nature and do not appreciate in value over time in the same way
as shares and long-term assets do. Therefore, while a company needs to have adequate working capital, if
its working capital exceeds the amount needed, it could be giving up the greater return it could be earning
on longer-term investments.
The Current Ratio

The current ratio is the most commonly used measure of near-term liquidity as it relates current assets
to the claims of short-term creditors. In other words, it measures the company’s ability to pay its short-
term obligations with short-term assets. The current-ratio calculation is very similar to the working-capital
calculation, except that in this instance the relationship between current assets and current liabilities ap-
pears as a ratio.
The formula is:
Current Assets
Current Ratio =
Current Liabilities
Companies with an aggressive financing policy will have lower current ratios, while conservative financing
policies result in higher current ratios.
A high current ratio is not always a good thing. Short-term assets are not productive assets to a company,
since these assets do not provide much return. An overly high ratio indicates that management may not be
investing idle assets productively. Therefore, a high current ratio may indicate that the company should
convert some of its short-term assets into longer-term assets.
On the other hand, a low ratio indicates a possible liquidity problem, and this is also a risk that should be
avoided if possible. Effective working capital management requires that working capital be kept as low as
possible, given a particular management’s threshold for risk.
56
When a company makes a prepayment, that is, pays a liability before it has been incurred, the amount that is prepaid
is recorded as an asset on the balance sheet of the company that paid.
The general principal is that a firm’s current ratio should be proportional to its operating cycle (dis-
cussed in more detail below). Thus, a shorter cycle may justify a lower ratio. The quality of accounts
receivable and merchandise inventory should also be considered when evaluating the current ratio. Accord-
ingly, a low receivables turnover (net credit sales ÷ average accounts receivable) and a low inventory
turnover (cost of sales ÷ average inventory) indicate a need for a higher level of cash and cash equivalents.
The Quick or Acid Test Ratio

A more conservative version of the current ratio is the quick ratio (or acid test ratio). The quick ratio
measures the firm’s ability to pay its short-term debts from its most liquid assets. Liquidity is a tradeoff for
profitability, as liquid investments do not provide as high a return as productive assets.
Quick Ratio Cash + Marketable Securities + Net Accounts Receivable

=
(or Acid Test Ratio) Current Liabilities
Cash equivalents are, of course, included in the numerator of the ratio. Cash equivalents are considered a
part of “cash” for this purpose. Cash equivalents are very liquid, short-term investment instruments with a
maturity date of less than 90 days when they were acquired that are easily converted into known amounts
of cash without significant loss in value. Cash equivalents are the short-term investments a company makes
in order to earn a return on excess cash for short periods until the cash is needed for operations.
Inventory is not included in the numerator of the quick ratio. If a company uses liquidation of its inventory
to pay its liabilities without replacing the inventory, the company will have no means of generating future
cash flows. Therefore, inventory should not be used to pay off short-term liabilities.
Note that prepaid expenses are also not included in the numerator of the quick ratio. Prepaid expenses are
not current assets that can be liquidated to pay current liabilities, so they should not be included.57
Accounts receivable are included in the numerator, for two reasons:
• Receivables are only one step away from conversion to cash in contrast to inventory, which is two
steps away.
• A company can almost always collect its receivables immediately by factoring58 them (as long as
the receivables have not been previously pledged as collateral on borrowings).
The standard for the quick ratio is 1:1.
57
Sometimes the numerator of the quick ratio is given as current assets minus inventory. That is incorrect because it
could include prepaids if the balance sheet includes prepaids. Including prepaids—or any other current asset that cannot
be liquidated to pay current liabilities—in the numerator of the quick ratio is incorrect. The only situation in which the
numerator of the quick ratio would be current assets minus inventory would be if the only items in current assets are
cash, A/R and inventory. In that case, no current asset items other than inventory would need to be excluded.
58
When a company factors its receivables, the company sells the receivables. A commercial finance company called a
“factor” buys the receivables and charges a commission, or factoring fee. The proceeds of the sale are deposited to the
seller’s account at the factor. If the seller of the receivables withdraws the proceeds of the factoring immediately, the
factor is essentially making a loan to the seller. However, the primary source of the factor’s repayment is its collection
of the receivables it purchased, not repayment from the seller of the receivables. The factor notifies the seller’s customers
to remit their payments directly to the factor. As the receivables are collected, the factor applies the money received to
repay the seller’s obligation.
The Defensive Interval Ratio

The defensive interval ratio estimates the number of days that the company can meet its basic opera-
tional costs with the cash, cash equivalents, marketable securities, and receivables on hand.
Defensive Interval Cash + Net Receivables + Marketable Securities

=
Ratio Average Daily Operating Cash Outflow
The average daily operating cash outflow can be approximated by reducing total expenses for the year by
noncash charges (for example, depreciation, amortization of intangibles) and dividing the result by 365.
Again, the company must be able to meet its needs for the near future. However, if this number gets too
high, it indicates that the company is not utilizing all of its assets to their maximum advantage.
Financial Leverage Ratios

Financial leverage ratios measure a firm’s use of debt to finance assets and operations and increase
earnings. Leverage (that is, trading on the equity) is advantageous when the company earns more on
money that it has borrowed than it costs to borrow that money. Risk increases as interest rates to borrow
increase and returns on borrowed funds decrease. Therefore, as the company becomes more leveraged
(that is, saddled with more debt), the risk to creditors also increases because there is a greater chance that
the company will not be able to meet its interest obligations. However, because interest is tax deductible
for corporations, leverage increases the return when the company is profitable.
Benefits of Using Financial Leverage
• If financial leverage is used successfully, the interest expense paid on the debt capital will be less
than the return earned from investing it, and the excess return will benefit the equity investors.
• Interest paid on debt is tax-deductible, and its tax deductibility effectively reduces interest as an
expense.
Limitations of Using Financial Leverage
• The financial leverage may be used unsuccessfully, and if so, the return earned from investing the
debt capital will be less than the interest expense paid on it, which will hurt the value of the equity
investors’ investments.
• Too much financial leverage causes the cost of all of the company’s capital to increase because
investors will perceive greater risk and will require a greater return on their investment.
Debt-to-Equity Ratio
The debt-to-equity ratio compares the resources provided by creditors with resources provided by share-
holders. The debt-to-equity ratio determines a firm’s long-term debt payment ability. A high ratio means
high risk because there are more liabilities and less of owners’ equity with which to offset those liabilities.
The conservative approach to this ratio’s calculation is to include all long-term liabilities and near-term
liabilities in the numerator, making it total liabilities rather than simply total debt.
Total Debt
Debt-to-Equity Ratio =
Shareholders’ Equity
Debt Ratio
The debt ratio measures the percentage of funds provided by creditors. Like the debt-to-equity ratio, it
determines long-term debt payment ability and the degree to which creditors are protected from the firm’s
insolvency. Creditors prefer this ratio to be low as a cushion against losses because it indicates a lower
chance of default on the interest payments that the company will owe. Therefore, the higher this ratio is,
the higher the company’s cost of debt will be, because creditors will demand compensation for the increased
risk they are bearing.
"The numerator of the debt ratio includes all liabilities, including current liabilities such as accounts payable
that probably do not require interest payments and those that may or may not require principal payments
such as contingencies and deferred taxes. If the company has redeemable preferred stock, the redeemable
preferred stock should also be included in the numerator. If there is a non-controlling interest, that should
be included, as well. Including those items in the numerator makes the ratio more conservative."
Total Debt
Debt Ratio =
Total Assets
Times-Interest-Earned Ratio
The times-interest-earned ratio, also known as the interest coverage ratio, indicates the margin of safety
in funds available to pay interest (earnings before interest and taxes) over fixed interest charges, so a
consistently high ratio is desirable. This ratio is a profit or loss statement approach to evaluating debt
payment ability.
Times-Interest-Earned Ratio Earnings Before Interest and Taxes (EBIT)

=
(or Interest Coverage Ratio) Interest Expense
Interest is tax deductible, so interest must be added to net income to determine the amount available to
pay interest. If earnings decline sufficiently, the company will owe no income tax expense; but because
interest is a fixed charge, the company will still need to pay interest, even in periods of no (or negative)
income.
The most accurate calculation of the numerator includes only earnings that are expected to recur. Unusual
or infrequent items, discontinued operations, and the effects of accounting changes should be excluded.
Any declared dividends should also be excluded because they are not available to cover interest.
Note: The non-controlling interest income exclusion should be added back to earnings before interest
and taxes. Interest expense of a consolidated entity is included in consolidated income, so all the income
of that entity should be included.
Fixed Charge Coverage Ratio

The fixed charge coverage ratio is an extension of the times-interest-earned ratio; it includes all fixed
charges in the denominator. For example, principal payments on loans and finance leases and operating
lease obligations are fixed charges that will need to be paid in the future. Other items, such as preferred
dividends, pension payments or depreciation may be included.
The denominator should include capitalized interest, as well.
Earnings Before Interest and Taxes +

Operating Lease Payments Expensed
Fixed Charge Coverage Ratio =
Total Payments on Loans (Interest and
Required Principal) + Total Payments on
Finance and Operating Leases
Asset Management Ratios (or Activity Ratios)

Asset management ratios measure the firm’s use of assets to generate revenue and income. Thus, they
also relate to liquidity.
Inventory Turnover Ratio

The inventory turnover ratio measures how many times during the year the company sells the average
level of inventory it holds. An average inventory (that is, the average of beginning and ending inventory)
figure should be used in the denominator. If annual inventory is highly cyclical, a monthly average should
be used.
Annual Cost of Goods Sold (COGS)

Inventory Turnover Ratio =
Average Inventory
A high turnover implies that a firm does not hold excessive stocks of unproductive inventory, which would
lessen profitability. A high turnover also implies that the inventory is truly marketable and does not contain
obsolete goods. However, if the inventory turnover is too high then the company might not be holding
enough inventory. As a result, it may be losing sales because consumers cannot buy products that are out
of stock.
If the cost of goods sold figure to be used in the numerator is for a period of less than one year, the cost
of sales should be annualized (one quarter’s cost of sales should be multiplied by 4, and so forth). The
average used for average inventory should represent the average during the period represented by the cost
of goods sold being analyzed, even if it is less than a one-year period.
Number-of-Days-Inventory-Is-Held Ratio
The number-of-days-inventory-is-held ratio measures the average number of days that inventory is held
before sale and it reflects the efficiency of inventory management. The lower the figure, the better the
firm’s management of its inventories. However, if the number is too low it may indicate that not enough
inventory is being held.
Number-of-Days- 365, 360, or 300

=
Inventory-Is-Held Ratio Inventory Turnover Ratio
(Annual COGS / Average Inventory)
The number of days can be calculated using actual days (365), bankers’ days (360), or the number of
business days (300).
Accounts Receivable Turnover Ratio

The accounts receivable turnover ratio is used to measure the number of times receivables “turn over”
during a year’s time and tracks the efficiency of a firm’s accounts receivable collections. Comparing a
company’s accounts receivable turnover ratio from one year to the next shows how the company’s collection
efforts perform over time. Net annual sales could be substituted for net annual credit sales, but such a
substitution could dramatically alter the ratio. However, if a company has very few cash sales, then it may
be easier to use the net annual sales figure as long as it is used consistently.
Net Annual Credit Sales

Accounts Receivable Turnover Ratio =
Average Accounts Receivable
A company should extend credit until the marginal benefit (or profit) of extending credit is zero. The point
at which the marginal benefit is zero is the point at which the cost of extending additional credit and the
benefit of extending additional credit are equal. The calculation of this point should take into consideration
the opportunity costs of other investment options available to the company. In economics terms, the mar-
ginal cost of a credit and collection policy should not exceed the marginal revenue (actually, the marginal
increase in the contribution margin) that it generates.
If the net credit sales figure to be used in the numerator is for a period of less than one year, the credit
sales should be annualized (one quarter’s credit sales should be multiplied by 4, and so forth). The average
used for average accounts receivable should represent the average during the period represented by the
credit sales being analyzed, even if it is less than a one-year period.
Number-of-Days-Receivables-Held Ratio (Average Collection Period)

The number-of-days-receivables-held ratio, also called the average collection period, indicates the average
number of days it takes the company to collect its receivables.
365, 360, or 300

Number-of-Days- =
Receivables-Held Ratio Accounts Receivable Turnover Ratio
(Net Annual Credit Sales ÷
Average Accounts Receivable)
The number-of-days-receivables-held ratio can be compared with the seller’s credit terms to determine if
most customers are paying on time.
This ratio may also be computed by dividing average accounts receivable by the average daily net credit
sales, because these are effectively net credit sales divided by the number of days in a year.
Number-of-Days- = Average Accounts Receivable

Receivables-Held Ratio Average Daily Net Credit Sales
(Net Annual Credit Sales ÷ 365)
Accounts Payable Turnover Ratio

The accounts payable turnover ratio represents the number of times payables “turn over,” or are paid and
new ones are generated by new purchases, during a year’s time.
Annual Credit Purchases

Accounts Payable Turnover Ratio =
Average Accounts Payable
Note that the numerator of this ratio represents a full year’s credit purchases. As with accounts receivable
and inventory, if the credit purchases figure to be used in the numerator is for a period of less than one
year, the credit purchases should be annualized (one quarter’s credit purchases should be multiplied by 4,
and so forth). The average used for average accounts payable should represent the average during the
period represented by the credit purchases being analyzed, even if it is less than a one-year period.
A decrease in the accounts payable turnover ratio over time means the company is paying its payables
more slowly, an indication of possible liquidity problems.
Days Purchases in Accounts Payable

The days purchases in accounts payable represents the average number of days the company takes to pay
its payables. The days purchases in accounts payable is calculated as follows:
Average Accounts Payable

Days’ Purchases in Payables =
Average Daily Credit Purchases
(Annual Credit Purchases ÷ 365)
Days purchases in accounts payable can also be calculated as:
365
Days’ Purchases in Payables =
Accounts Payable Turnover Ratio
(Annual Credit Purchases ÷ Average
Accounts Payable)
Fixed Asset Turnover Ratio

The fixed asset turnover ratio measures the amount of sales revenue the company is generating from each
monetary unit of only its fixed assets.
Sales
Fixed Asset Turnover =
Average Net Property, Plant, and Equipment
“Net property, plant, and equipment” means net of accumulated depreciation.
Total Asset Turnover Ratio

The total asset turnover ratio is an overall activity ratio relating total sales to average total assets:
Sales
Total Asset Turnover =
Average Total Assets
The total asset turnover ratio measures the amount of sales revenue the company is generating from the
use of each monetary unit it has in total assets. The total asset turnover ratio provides a means of meas-
uring the overall efficiency of the company’s use of all its investments, including both non-current assets
and current assets.
The Operating Cycle

The operating cycle is the length of time it takes to convert an investment of cash in inventory back into
cash through collections of sales.
Number-of-Days- Number-of-Days-
Operating Cycle = +
Inventory-Held Receivables-Held
The cash cycle is the length of time it takes to convert an investment of cash in inventory back into cash,
while recognizing that some purchases are made on credit. Therefore, the cash cycle (also known as
the net operating cycle) is the number of days in the operating cycle minus the number of days’
purchases in payables.
Therefore, the cash cycle represents the number of days a company’s cash is tied up by its current oper-
ating cycle. The shorter the cycle, the more efficient the firm’s operations and cash management. Longer
cycles may lead to cash shortfalls and increased financing costs.
Number-of-Days- Number-of-Days- Days’ Purchases

Cash Cycle = + −
Inventory-Held Receivables-Held in Payables
Note: In a large company, a small reduction in the cash cycle can increase pretax profits significantly
because of the lowered costs of financing. Some companies may actually have negative cash cycles.
Profitability Ratios
Profitability ratios measure earnings relative to some base, such as productive assets, sales, or capital.
Increased profits benefit shareholders because they make additional funds available for dividend payments
and because they may result in the appreciation of the firm’s stock price. Profits also provide a cushion for
debt coverage. Hence, investors, creditors, and others use profitability rations to evaluate management’s
stewardship of the firm’s assets.
Profit Margin
The profit margin measures the percentage of the company’s sales that becomes net income after interest
and taxes.
Net Income after Interest and Taxes

Profit Margin =
Net Sales
The numerator may also be stated in terms of the net income available to common shareholders. Another
form of this ratio excludes nonrecurring items from the numerator, such as unusual or infrequent items,
discontinued operations, and the effects due to accounting changes. Still other numerator refinements
exclude equity-based earnings and items in the “other income” and “other expense” categories.
These adjustments may be made for any ratio that includes net income.
Operating Profit to Sales

In operating profit to sales, the use of operating income emphasizes operating results and more nearly
approximates cash flows than other income measures.
Income from Operations

Operating Profit to Sales =
Net Sales
The operating profit to sales margin measures the percentage of its sales revenue that the firm keeps as
income from operations.
Income from operations includes revenues and expenses of the company’s principal operations. It does not
include revenues and expenses that result from secondary or auxiliary activities of the company, gains and
losses from investments, or gains and losses from discontinued operations.
Return on Total Assets

In the return on total assets (or return on investment) ratio, the numerator may again be defined in various
ways. One possibility is to use the net income available to common shareholders; another method is found
in the basic earning power ratio (EBIT ÷ Average Total Assets). This ratio enhances comparability of
firms with different capital structures and tax planning strategies.
The denominator may be defined to include only operating assets. Thus, investments, intangibles, and
the other asset category would be excluded.
Return on Total Assets or Net Income

=
Return on Investment Average Total Assets
Return on Common Equity

The return on common equity ratio measures the company’s return on the book value of its common equity.
The average common shareholders’ equity includes total equity minus the preferred shareholders’ capital
and any minority interest.
Return on Net Income − Preferred Dividends

=
Common Equity Average Book Value of Common Equity
Return on Total Equity

The return on total equity ratio measures the return of the company on all forms of equity, common and
preferred.
Net Income
Return on Total Equity =
Average Total Equity
Benefits and Limitations of Ratio Analysis

Although ratio analysis provides useful information pertaining to the efficiency of operations and the stability
of financial condition, it has inherent limitations.
Benefits of Ratio Analysis

• Ratio analysis can help in understanding financial statements by showing the relationships between
various items in the financial statements.
• Ratios enable comparisons of the performance of different companies and industries with each other
by providing standardized measures. Companies can be compared with each other on the basis of
their financial performance, regardless of their relative sizes or market shares.
• Average ratios in an industry or ratios of the best performers within an industry can be used as
benchmarks against which a company’s performance can be measured.
• Ratios can reveal trends and strengths and weaknesses. Internal ratio trend analysis may reveal
deterioration in liquidity or profitability ratios, signaling future problems that may be averted by
timely action.
• Ratios can be used to evaluate a specific aspect of a firm’s performance.
• Trends in sales, costs, and profits as they relate to other quantitative measures over time can be
useful in budgeting, forecasting, and planning.
• Ratio analysis can be used to indicate operational efficiency or the lack of it.
• Ratios can be used to compare the performances of different segments of a company and for control.
• Ratio analysis of potential customers can help with making credit decisions. Banks use ratio analysis
in making decisions on commercial loan requests and credit managers of companies use it to decide
whether to extend credit to a customer and if so, how much.
Limitations of Ratio Analysis

• A ratio by itself is not significant. It must be interpreted in comparison with prior periods’ ratios,
predetermined benchmarks, or ratios of competitors.
• A firm’s management may have an incentive to window dress the financial statements to improve
results, and financial statement analysis may not detect it. In other words, management may make
short-term accounting decisions (or operational decisions) that cause the company’s financial state-
ments to look better, even though there is no long-term financial justification for such decisions.
The result can be ratios that are misleading.
• Financial statement analysis cannot give definite answers. It can point out where further investiga-
tion is warranted; but it is a mistake to place too much importance on a simple analysis of financial
statement numbers.
• The usefulness of ratios depends on the quality of the numbers used in their calculation. If a com-
pany’s financial statements are not credible because of poor internal controls or fraudulent financial
reporting, then the resulting ratios will be just as unreliable and misleading as the financial state-
ments. However, a critical analysis of ratios can alert an analyst to the possibility of problems in the
financial reporting, because he or she may see that the ratios do not make sense.
(continued)
• The ability to make use of ratios is dependent upon the analyst’s ability to adjust the reported
numbers before calculating the ratios and then to interpret the results.
• Accounting and the preparation of financial statements require judgment in making assumptions
and estimates. The more frequent the publication of financial statements, the more frequent will be
the need to make these estimates, and the greater will be the uncertainty inherent in the financial
statements and thus the ratios calculated from them, because many transactions require several
quarters or several years for completion. The longer the time it takes to complete a transaction, the
more tentative will be the estimates relating to it that affect the financial statements. The short-
term incentives, agendas, and personal interests of those who prepare them may affect estimates
relating to long-term events.
• Current performance and trends may be misinterpreted if sufficient years of historical analysis are
not considered.
• The numbers constitute only one part of the information that should be considered when evaluating
a company. Qualitative aspects such as employee morale, new products under development, the
company’s reputation, customer loyalty, or the company’s approach to its social responsibilities are
also important.
• When one company is compared with other companies, the various companies’ financial statements
will probably classify items differently. To the extent possible, the analyst should adjust the financial
statements in order to make them as comparable as possible. However, making such adjustments
may not always be possible, and that can make it difficult to draw conclusions from the comparisons.
• Many companies are conglomerates and are made up of many different divisions operating in dif-
ferent, unrelated industries. This diversification59 can make it difficult to compare any two
companies, because while they may share some markets, they seldom share all of the same mar-
kets.
• Companies can choose different accounting policies such as valuation of inventories and computing
depreciation expense. These variations in reporting also affect the comparability of companies’ fi-
nancial ratios.
• A company may have poor operating results that are caused by several different, small factors. If
an analyst focuses on trying to find one major problem, he or she may miss the confluence of many
factors.
• Traditional ratio analysis focuses on the statement of financial position and the statement of profit
or loss, and therefore cash flow ratios may be overlooked.
• The goal of financial analysis is to make predictions about how a company will do in the future. In
contrast, ratio analysis is performed on historical data and may have little to do with what is going
on currently at the company. In addition to the historical information, current information such as
news releases from the company must be included in the analysis.
• Many financial statement items are based on historical cost values. Ratios based on those historical
cost values may be less relevant to a decision than current market values.
• To be meaningful, a ratio must measure a relationship that is meaningful. For example, the rela-
tionship between sales and accounts receivable is meaningful, so the ratios that relate those items
are significant. However, there is no meaningful relationship between freight costs and the average
balance of total long-term debt, so a ratio relating those items to one another would be useless.
• Financial statements consist of summaries and simplifications for the purpose of classifying eco-
nomic events and presenting the information in a form that can be utilized. In some cases, the
details behind the summarized transactions are recoverable, but in other cases they are not.
(continued)
59
Diversification is the practice of manufacturing a variety of products, investing in a variety of securities, or selling a
variety of merchandise, so that a failure in or an economic slump affecting one of them will not be disastrous .
• Financial statements deal only with monetary amounts and do not reflect the decrease in the pur-
chasing power of money that occurs with inflation. Therefore, comparing values over a long period
of time may be misleading.
• Fixed standards for ratios do not exist. A target ratio depends on conditions within each firm and
must be established by management, making it somewhat subjective.
• Liquidity and activity ratios calculated for seasonal businesses may be misleading unless they are
interpreted in light of the seasonality of the business.
• Ratios are based on accounting data. Because the accounting system uses historical costs rather
than current fair market values, ratios often do not reflect the current values of the items they are
measuring.
• Whether or not a certain ratio is favorable depends on the underlying circumstances. For example,
a high quick ratio indicates high liquidity, but it may also imply that excessive cash is being held.
• In interpreting one firm’s financial ratios, an analyst must consider external factors such as economic
or political conditions that may have affected all firms or all firms in the firm’s specific industry.
• Different ratios may yield opposite conclusions about a firm’s financial health. Thus, the net effects
of a set of ratios should be analyzed.
1 D. The Revenue Cycle and Working Capital Management

The topic that follows includes a discussion of the revenue cycle and the impact of the new revenue recog-
nition standard, IFRS 15, Revenue from Contracts with Customers, on revenue cycle activities. Working
capital management, including management and valuation of current assets such as inventory and accounts
receivable, as well as cash, current liabilities such as accounts payable, and supply chain management are
also discussed.
The Revenue Cycle

The revenue cycle begins when an order is received from a customer and ends when the seller receives
payment in full from the customer. The major activities in the revenue cycle vary from business to business,
but they may include:
• Receipt of the order
• Determination of the price and sale terms
• Approval of the order
• Credit authorization if the customer will pay in any manner other than at the point of sale
• Order entry
• Preparation of a packing list, or for a service, preparation of a work order
• Picking and packing of the ordered items
• Shipment of the goods, or for a service, scheduling and performance of the service
• Recognition of revenue, issuance and submission to the customer of an invoice or invoices
• Collection of the payment or payments from the customer
IFRS 15, Revenue from Contracts with Customers

The core principle in IFRS 15 is that an entity recognizes revenue to depict the transfer of promised goods
or services to customers in amounts that reflect the consideration to which the entity expects to be entitled
in exchange for the goods or services.
The revenue recognition guidance in IFRS 15 is not limited to business transacted under formal written
contracts, nor is it limited to long-term contracts. A valid contract can be written, oral, or simply implied
by the entity’s customary business practices. The performance obligations in a contract can be satisfied at
a point in time or over time.
• A valid contract can be represented when a customer approaches a cashier in a retail establishment
and pays for a purchase. The performance obligation in such a contract is satisfied at a point in
time.
• A valid contract can be represented by an order for goods to be shipped that is received from a
customer through any of a variety of means and includes payment by credit card, on account after
receiving the invoice, or by some other method such as cash. If only one shipment takes place,
the performance obligation in the contract is satisfied at a point in time. If more than one shipment
takes place, the performance obligations in the contract are satisfied over time.
• A valid contract can be represented by a long-term contract, which can be satisfied at a point in
time or over time. Long-term contracts can be construction contracts but can also be, for example,
contracts to provide services for an extended period. If the customer obtains control of the asset
as the asset is being constructed or as the services are being performed, the performance obliga-
tions in the contract are satisfied over time. If the customer obtains control of the asset only at
the completion of the contract, the performance obligation is satisfied at a point in time.
IFRS 15 applies to all revenue transactions as long as a valid contract exists, with the exception of several
items listed in Paragraph 5 of the standard, including leases, insurance contracts, various types of financial
instruments such as investment securities and derivatives, and some nonmonetary exchanges. For all other
sales transactions, whether they involve a written contract or not, IFRS 15 applies.
The steps in revenue recognition include (and they need not take place in the order listed):


• The receipt of an order begins the revenue cycle. The first step in the process of revenue recog-
nition is to identify the contract(s) with the customer.
• Identification of the contract includes approval of the order and credit authorization. An im-
portant part of these activities includes determining whether a valid contract exists.
Under IFRS 15, a valid contract exists only when the contract
1) Creates enforceable rights and obligations and
2) Meets all of the following criteria:
a. The parties have approved the contract. The approval may be oral, in writing, or in accordance
with other customary business practices.
b. The rights of each party regarding the goods or services to be transferred can be identified.
c. The payment terms for the goods or services to be transferred can be identified.
d. The contract has commercial substance (that is, the risk, timing, or amount of future cash
flows of the company will change as a result of the contract).
e. It is probable that the company will be able to collect the consideration that it will be entitled
to receive for the goods or services that will be transferred to the customer. The assessment
of collectibility must include an assessment of the customer’s credit risk—the customer’s ability
to pay and intent to pay. The assessment of the customer’s credit risk is an important part of
determining whether a contract is valid.60
• If collateral is being pledged by the customer to secure the receivable, assessment of the credit
risk includes evaluation of the secondary repayment source. Documentation is prepared for the
customer’s signature.
Note: The credit authorization step is very important because if collection is not considered probable,
then under IFRS 15, no contract exists and no revenue may be recorded, even if a portion of the
consideration has been received from the customer, because the contract with the customer does not
meet the collectibility criterion for a valid contract.
In addition, if control of the goods or services has already been transferred to the customer, the company
may not be able to defer its costs, including costs incurred before collectibility is probable. Thus, the
company may need to recognize costs without recognizing revenue.
If the company has received a portion of the consideration due but the contract is not a valid contract, any
consideration received is accounted for as a contract liability.
2) Identify the performance obligations in the contract

All promises in the contract, whether written, oral, or implied are identified, and the entity determines
which of the promises are performance obligations that should be accounted for separately.
3) Determine the transaction price

The transaction price is the amount of consideration that the company expects to be entitled to receive in
exchange for transferring the promised goods or services to the customer, and it can include fixed amounts,
variable amounts, or both. The transaction price may be significantly different from the contractual price.
The transaction price excludes any amounts that the company collects on behalf of other parties (for ex-
ample, sales tax).
60
Per IFRS 15, Revenue from Contracts with Customers, Paragraphs 9 and 10.
Determination of the sale price includes determination of the sale terms, such as how long the customer
will be given to pay for the promised goods or services after they have been provided.
4) Allocate the transaction price to the performance obligations in the contract

Allocation of the transaction price is based on the fair value of each performance obligation, usually each
obligation’s standalone selling price. If a discount is offered to the customer such as when a bundle of goods
or services is sold at a lower price than the total price of the individual items, the discount is allocated
proportionally based on the relative standalone selling prices of the items.
• Entry of the order into the accounting system can take place after the contract has been identi-
fied, the performance obligations in the contract have been identified, the transaction price has
been determined, and the transaction price has been allocated to the performance obligations in
the contract.
• If the ordered items are to be shipped, a packing list is prepared or, if the performance obligation
is a service, a work order is prepared.
• The ordered items are picked and packed for shipping, if applicable. For a service, the service is
scheduled.
• Shipment of the goods takes place, or for a service, the service is performed.
5) Recognize revenue when each performance obligation has been satisfied

A performance obligation has been satisfied when a promised good or service has been transferred to the
customer.
• Revenue is recognized when each performance obligation has been satisfied, not necessarily when
the customer is invoiced.
When revenue is recognized, it becomes a contract asset. Contract assets can be an unconditional or
conditional.
Unconditional contract assets are unconditional rights to receive consideration because the company
has satisfied its performance obligation to a customer and thus recognizes revenue. Unconditional rights to
receive consideration should be reported as receivables in the statement of financial position. The cus-
tomer is invoiced coincident with (occurring at the same time as) the recording of the receivable and the
recognition of the revenue.
Dr Accounts receivable ........................................ Amount of sale
Cr Sales revenue ...................................................Amount of sale
Conditional contract assets are conditional rights to receive consideration because the company has
satisfied one of, or some of, the performance obligations in the contract and thus recognizes revenue for
the performance obligations that are satisfied, but it must satisfy another performance obligation or obli-
gations before it can invoice the customer. Conditional rights to receive consideration should be reported
in the statement of financial position as contract assets. The revenue is recognized before the customer
is invoiced.
Dr Contract asset ............................ Price of obligation A satisfied
Cr Sales revenue ............................... Price of obligation A satisfied
When the company satisfies its complete performance obligation, invoices the customer, and reports the
remainder of the performance obligation satisfied as revenue, it also reduces the contract asset and reports
the full contract obligation as a receivable:
Dr Accounts receivable ....................... Price of obligations A and B
Cr Contract asset ........................................... Price of obligation A
Cr Sales revenue ............................................ Price of obligation B
Completion of the Revenue Cycle

The revenue cycle is complete when the customer makes payment in full of the consideration due to the
seller for the satisfaction of the performance obligation. Collection includes all collection activities necessary
to collect the receivable. Collection activities are part of working capital management, the next topic.
Working Capital Management

Working capital management involves making sure a company has enough cash to pay for its expenditures
as they come due. Working capital management involves the management of current assets (inventory,
receivables, and cash) and current liabilities (accounts payable and short-term financing).
Collecting the cash owed to the company as quickly as possible and paying the cash owed to others as
slowly as possible are both part of working capital management. Candidates need to know the ways cash
collections can be speeded up and cash disbursements can be slowed and be able to calculate the effective
interest rate imputed by not paying an invoice within a discount period and thus not receiving the discount.
The amount of liquidity and the level of working capital a company needs depends on the length of its
operating cycle. A firm that produces and sells goods has an operating cycle that consists of four phases:
1) Purchase raw material and produce goods, investing in inventory.
2) Sell goods, generating sales, which may or may not be for cash.
3) Extend credit, creating accounts receivable.
4) Collect accounts receivable, generating cash.
Working capital, or net working capital, is measured as follows:
Net Working Capital = Current Assets – Current Liabilities
The objective of working capital management is to minimize the cost of maintaining sufficient liquidity
(access to cash) while at the same time guarding against the possibility of financial insolvency (lack of
money and inability to pay liabilities as they become due) by having enough current assets on hand.
Working capital management is a process of balancing different goals.
• On one hand, management must be certain that the company has enough cash to be able to settle
its liabilities as they come due. While not being able to pay liabilities as they come due (occasionally
paying late, for example) does not force a company into bankruptcy, it does place the company in
a position of technical insolvency. If technical insolvency is not remedied, a repeated pattern of
not paying liabilities as they come due may lead to bankruptcy proceedings being started against
the company. At the very least, a pattern of late paying will cause the company to lose its credit
privileges with its vendors and it will then be forced to pay cash in advance for purchases.
• On the other hand, the short-term assets (inventory, receivables, cash) the company holds provide
very little return, if any.
Therefore, the more short-term assets held by the company, the lower will be its chance of insolvency, but
also the lower will be the overall return it earns on its assets.
Types of Working Capital

Because a company may have different cash needs throughout the year, the company may maintain dif-
ferent levels of working capital at different times of the year. The minimum amount of working capital
maintained at all times to support the firm’s day-to-day sales and activities is called permanent working
capital, and the increases that occur from time to time are called temporary working capital.
For example, a company in a seasonal business will build up inventory in advance of its big selling season.
During and following the selling season, accounts receivable will increase until the customers pay their
invoices. After the selling season is over and the additional accounts receivable have been collected, the
balances of current assets will revert to their permanent levels.
Levels of Working Capital

Management’s decisions about the company’s level of working capital constitute a risk-return trade-off.
• A company that adopts a conservative working capital policy seeks to minimize liquidity risk
by increasing the amount of working capital it holds. As a result, the company gives up the poten-
tially higher returns available from using the additional working capital to acquire long-term assets,
but it is in a safer position with respect to liquidity and possible insolvency because of the greater
amount of working capital.
• An aggressive working capital policy reduces the amount of working capital and the current
ratio (calculated as current assets divided by current liabilities). A company pursuing an aggressive
working capital policy maintains a low level of working capital and so accepts a higher risk of short-
term cash flow problems in exchange for a greater return on investment.
It is even possible for a company to have negative working capital where current liabilities are greater
than current assets. A company can have negative working capital if it maintains minimal accounts receiv-
able and inventory while receiving terms from its suppliers that allow it to delay payment of its accounts
payable. For example, a company that sells its product for cash and produces the product on demand to
fulfill orders after they have been received will have very little in inventory and accounts receivable.
Components of Working Capital

The main classifications of current assets are:
• Inventory
• Accounts receivable
• Marketable securities
• Cash and cash equivalents
Note: Prepaid expenses are also classified as current assets. A prepaid expense is money the company
has paid for something it has not yet received. Prepaid expenses are not covered in specific detail as a
part of working capital because a prepaid cannot be liquidated to pay current liabilities. However, prepaid
expenses are current assets and therefore they are a part of the calculation of working capital.
The main classifications of current liabilities are:
• Trade credit, or accounts payable
• Warehouse financing and inventory financing
• Short-term bank financing, including seasonal lines of credit which may be unsecured or secured
by inventory and receivables
• More permanent sources of financing such as a revolving line of credit secured by receivables
• Commercial paper, primarily used by large corporations
• Repurchase agreements, used by large corporations and financial institutions
• Bankers’ acceptances, used as a source of financing for international trade transactions
Inventory Management
Inventory management is a critical part of working capital management for any company that produces or
sells a product. If a company is a seller of finished goods or a producer of goods, inventory may well be the
largest, or one of the largest, items in the company’s statement of financial position. Because inventory is
such a large item, a small percentage increase or decrease in the cost of inventory can cause a large
increase or decrease in cost of goods sold and a large decrease or increase in net income.
Reasons for Holding Inventory

A company that resells goods needs to hold inventory if it needs to have goods available for customers to
purchase. Resellers have various business models. A reseller might choose to place orders for goods only
on demand, when a customer places an order. A reseller who orders only on demand might have the order
“drop-shipped” to the customer by the supplier, meaning the supplier will ship directly to the reseller’s
customer. When goods are shipped directly to customers by suppliers, the reseller can keep its inventory
very low or eliminate it entirely. However, a retailer with a physical location where customers make pur-
chases or an Internet retailer that fulfills orders by shipping goods to customers from its warehouse must
keep inventory on hand in order to have it available for purchase.
A company that manufactures products has additional types of inventory. In addition to its finished goods
inventory, it must also maintain a certain amount of inventory that is in production (called work-in-progress
inventory) as well as raw materials inventory. Work-in-progress inventory is inventory that is being worked
on, and a manufacturer cannot avoid having inventory that is being worked on. Raw materials inventory
allows the firm to be flexible in its purchasing. Without a raw materials inventory, the firm would need to
buy raw materials on an as-needed basis according to its production schedule. If something were to happen
that required a change in the production schedule and the firm did not have the necessary raw materials,
the firm might not be able to respond to the need in a timely manner.
However, holding inventory creates costs for the firm. Well-managed inventory ties up a minimum of a
firm’s funds.
Costs of Inventory
Because of the potential impact of inventory costs on cost of goods sold, a firm should minimize its total
inventory costs by minimizing its levels of inventories. Inventory costs, including the cost of the inventory
itself and the costs associated with holding inventory, are classified as follows.
1) Purchasing Costs
Purchasing costs are the cost of goods purchased from suppliers. For a manufacturer, goods purchased
from suppliers are the raw materials used in manufacturing. For a retailer, goods purchased are the finished
goods purchased for resale. Purchasing costs can be affected by discounts for size of purchases, by missed
discounts for not ordering enough to qualify for the discount, and by suppliers’ credit terms, such as dis-
counts for early payment.
The purchasing cost of inventory includes the cost of the inventory itself plus landing costs. Landing
costs include:
• Incoming freight costs
• Insurance on the inventory while in transit
• Taxes, tariffs, and duties
• Any other costs without which the company could not receive the inventory
2) Ordering Costs
Ordering costs include the costs of:
• Placing an order (obtaining purchase approvals, preparing and issuing purchase orders)
• Receiving orders and inspecting items received
• Matching invoices received with purchase orders and receiving reports to make payments
• Any other special processing associated with ordering
3) Carrying Costs
Carrying costs are costs of holding inventory, such as:
• Rental of or depreciation on facilities used for storing the inventory
• Insuring and securing the inventory
• Inventory taxes
• Obsolescence and spoilage of the inventory
• The opportunity cost of the investment in inventory, or the cost of capital, representing the amount
of return lost by investing cash in inventory instead of in some other longer-term investment that
would provide a return such as dividends or interest. If the inventory has been financed, the op-
portunity cost is the cost of the interest on the borrowed funds.
4) Stockout Costs
Stockout costs are the costs that that result from lost sales when a company does not have inventory
available to sell when customers want to buy it. Stockout costs can include:
• Costs for placing an expedited order in an attempt to meet customer demand when the inventory
is out of stock. Ordering costs can be increased as can shipping costs for overnight or other expe-
dited types of shipment.
• The revenue and profit lost if the inventory cannot be received in time to make an individual sale.
• The cost of customer ill will. The cost of customer ill will is potentially very large as it can cause
the customer to not return for future purchases. Once a customer has found another source, that
customer could be gone permanently. Ill will is almost impossible to measure.
5) Inventory Shrinkage
Inventory shrinkage is the difference between the cost of the inventory as recorded on the books and the
cost of inventory when it is counted physically. Inventory shrinkage can be caused by:
• Theft by outsiders or embezzlement61 by employees.
• Clerical errors in recording and tracking the inventory.
61
Embezzlement is a person’s unlawfully taking assets that have been entrusted to that person, for example an employee
or an investment manager.
Other Inventory Management Terms
Lead Time
The lead time is the amount of time a company must wait to receive the next shipment of inventory after
it places an order. The longer the lead time is, the greater is the company’s risk of stockouts while it is
waiting to receive the order.
Safety Stock
The level of safety stock a company carries is one of its protections against stockouts. Safety stock is the
amount of inventory the company plans to have on hand when the next shipment of inventory is due to
arrive. Therefore, safety stock is a quantity of inventory that is held at all times. A high level of safety stock
means that even if the inventory is delayed in its receipt, the company will have sufficient levels of inventory
to continue to operate while it waits for the shipment to arrive.
The amount of safety stock a company needs to hold will be affected by:
• The variability of the lead time.
• The variability of the demand for the product.
• The cost of a stockout.
The more that either the lead time or the demand varies, the more safety stock the company will need to
carry to guard against stockouts in the case of an unusually high demand or an unusually long lead time.
If the lead time and the demand are consistent and predictable, the company can reduce the amount of its
safety stock because the chance will be less that the company will need a lot of items in stock to prevent a
stockout.
The higher the cost of a stockout to the company, the more inventory the company will need to keep on
hand in order to reduce the chances of a stockout. As an extreme example, if the company has no costs
when it experiences a stockout, the company does not need to carry any safety stock, because even if it
runs out of inventory completely, it will not lose anything.
The company needs to balance the probability of a stockout and the cost of a stockout against the cost
of carrying enough safety stock to avoid a stockout. The bottom line is that management needs to decide
how much probability of an inventory stockout it is willing to accept. Generally, the probability of a stockout
decreases at a decreasing rate as the level of safety stock increases. For example, a company may be able
to reduce the probability of a stockout’s occurring by 25% if it adds 150 units to its safety stock; but if it
adds another 150 units, the probability can be reduced by only an additional 10%. So, at some point, it will
cost more in terms of added carrying costs than it is worth to further reduce the probability of a stockout
because the incremental cost will become greater than the incremental benefit.
Reorder Point
The reorder point is the level of remaining inventory that indicates when the company needs to place the
order for inventory. The reorder point is calculated as follows:
Expected demand during the lead time (average daily usage × average lead time in days)
+ Amount of safety stock
= Reorder point
Average Inventory
The average inventory the company holds is the number of units ordered each time an order is placed
divided by two, plus the safety stock, which is assumed to be there all the time. The number of units
ordered each time will usually be determined by the Economic Order Quantity.62
Number of units ordered

Average In- each time an order is placed
= + Safety Stock
ventory 2
Example: The average lead time is 10 days and the average daily usage of widgets is 20. The company
has determined that safety stock should be 100 units. The reorder point will be when inventory on hand
gets down to 300 units, as follows:
Reorder point = (Average daily usage × Average lead time) + Safety Stock
Reorder point = (20 × 10) + 100 = 300 units
The average inventory level will be:

Number of units ordered
each time an order is placed
Average Inventory = + Safety Stock
2
If the company orders a 15-day supply each time it places an order, it will order 300 units each time (15
days × 20 units per day). Therefore, its average inventory level will be
300
Average Inventory = + 100 = 250 units
2
Note: Each unit of the company’s safety stock will increase its average inventory by one unit because
both the maximum and minimum number of units that the company holds will be increased by one unit
for each unit of safety stock held.
62
The Economic Order Quantity (EOQ) is the most advantageous number of units to order each time an order is placed.
The EOQ will be covered next.
A graph of the inventory on hand for the example company will look like the following, if everything is as
planned.
400
300  Reorder Point  Reorder Point
200
100
Safety Stock
0
0 5 10 15 20 25 30
Days
However, everything will not always be as planned. There will be times when the company will need to use
some inventory from its safety stock while waiting to receive a new order, and there will be times when the
inventory on hand will not get down to the safety stock level before the new order is received.
Economic Order Quantity (EOQ)

The Economic Order Quantity (EOQ) is the optimal number of units that a company should order of a
given product each time it orders that item. The EOQ is calculated using a decision model. It is a traditional
inventory management approach, and if it is used correctly it can help minimize the company’s costs of
ordering and holding inventory.
The three factors incorporated into the EOQ model are:

• The annual demand for inventory.
• The cost to carry one unit of inventory for one year (including interest on the funds invested in
inventory).
• The cost of placing an order.
For the EOQ calculation to work, the following six assumptions are made:
• The same quantity is ordered each time an order is placed.
• The annual demand for the item is known and constant.
• The unit ordering and carrying costs are assumed to be known and constant throughout the period.
• Purchase order lead time—the time between placing an order and receipt of the order—is known
and is constant.
• Purchasing cost per unit is not affected by the quantity ordered, which makes purchasing costs
irrelevant since they will be the same for all units acquired.
• There are no stockout costs included in the EOQ model because it is assumed that demand can be
determined and planned for.
Obviously, these assumptions limit the usefulness of EOQ because they are not always true in reality.
However, the model can provide a useful starting point for a company.
The Economic Order Quantity is calculated as follows:
2aD
EOQ =
k
Where: a = Variable cost of placing an order

D = Demand in units for a given period
= Carrying cost of one unit for the same
k
time period used for D
Example: Medina Co. makes footballs and is trying to determine the quantity of leather it should order
every time an order is placed. The relevant information is as follows:
 Over the course of a year 12,000 square meters of leather will be needed.
 The cost of storing one square meter of leather is 3.
 The cost of placing an order is 450.
The EOQ for inventory is calculated as follows:
EOQ = √(2 × 450 × 12,000)/3 = 𝟏, 𝟖𝟗𝟕. 𝟒

Every time Medina orders leather, it should order 1,898 square meters in order to minimize its costs of
ordering and carrying the leather inventory.
Furthermore, the EOQ can be used to determine the number of times that Medina will need to order
inventory per year. Given a demand for leather of 12,000 square meters per year and an EOQ of 1,898
square meters per order, Medina will need to order inventory 7 times per year in order to have enough
leather for production during the year (12,000 ÷ 1,898 = 6.3).
Economic Lot Size

A variation of the Economic Order Quantity formula, called the Economic Lot Size, is used in production
planning. It is used by manufacturers to determine how many units to manufacture in each production run
in order to balance setup costs with the carrying cost of the completed inventory. The goal is to minimize
both the setup costs and the carrying cost while still meeting customer demand. The calculation of the
Economic Lot Size is based on the same equation as is used for the Economic Order Quantity, except it
uses the setup cost to manufacture a batch of the product in place of the variable cost of placing an order.
Just-in-Time (JIT) Inventory Management

Modern inventory management has departed from the EOQ approach in favor of the JIT approach. JIT
inventory systems are based on a manufacturing philosophy that combines purchasing, production, and
inventory control into one function.
The goal of a JIT system is to minimize the level of inventories held in the plant at all stages of production,
including raw materials, work-in-progress and finished goods inventories, while meeting customer demand
in a timely manner with high-quality products at the lowest possible cost.
Just-in-time purchasing is timing the purchase of raw materials (or finished goods, for a reseller) so that
the items ordered will be delivered just as needed. Raw materials are purchased more frequently and in
smaller quantities and no sooner than absolutely necessary in order to get the materials delivered just at
the time they are needed for production. For a reseller, inventory is ordered to fulfill actual customer orders.
Just-in-time (JIT) production is a manufacturing system in which nothing is produced until the next
process in the assembly line needs it. Manufacturing activity at each workstation is governed by the need
for that workstation’s output at the next workstation on the production line. Demand controls each step of
the production process, beginning with the customer demand for the finished product. Since demand pulls
each order through the production line, JIT is called a “demand-pull” system. In a demand-pull system such
as JIT, essentially nothing is produced until a customer orders it, and then it is produced very quickly.
In contrast, when a “push” inventory management system is being used, each department produces all it
can and sends those units to the next step in the process for further processing. Under a push system, the
company manufactures parts and products without knowing whether they are actually needed or not, which
can result in large, useless stocks of inventory that cannot be used or sold in a timely manner or possibly
not all.
The advantage of a JIT system is reduction in the cost of carrying the inventory. JIT reduces the level of
inventory held by the company at all stages of production, and the reduction in the level of inventory
reduces the cost of carrying the inventory. The cost savings include reduction in the risk of damage, theft,
loss, or a lack of ability to sell the finished goods.
Close coordination is required between and among workstations to keep the flow of goods smooth in spite
of the low levels of inventory. To implement the JIT approach to manufacturing and to minimize inventory
storage, the factory must be reorganized to permit what is known as lean production. The plant is ar-
ranged by manufacturing cells in order to enable workers to pass a part or product through every needed
process with a minimum of wasted motion and distance. Material handling costs are minimized because all
of the work on each product is accomplished within a small area.
Workers are trained to operate all the machines in the cell and to perform supporting tasks such as doing
minor repairs and routine maintenance on the equipment. Being able to do their own maintenance when
needed reduces the downtime resulting from breakdowns. Since all the employees in a given cell can op-
erate all the machines in the cell, downtime caused by employee absences is minimized.
Because of the close coordination required between and among workstations and the minimum inventories
held at each workstation, defects in manufacturing must be aggressively eliminated. A defect occurring at
one workstation quickly impacts the next workstations in the line. JIT creates the need to solve problems
as soon as they arise and eliminate the causes of defects as soon as possible.
Setup time in a JIT manufacturing system is reduced. Setup time is the time required to get everything
ready to begin production of a component or a product. Equipment needs to be set and calibrated, tools
needed must be gathered, and raw material needed must be requisitioned. Because the employees in each
manufacturing cell work closely, the time and thus costs for these setup activities can be minimized.
Companies that use JIT manufacturing usually also implement JIT purchasing and thus purchase raw ma-
terials more frequently and in smaller quantities and no sooner than absolutely necessary in order to get
the materials delivered just at the time they are needed for production.
Because inventory levels are kept low in a JIT system, the company must have a very close relationship
with its suppliers and make certain that the suppliers can make frequent deliveries of smaller amounts of
inventory in a timely manner. Furthermore, the inventory must reliably be of the required quality because
the company does not have extra inventory items on hand that can be used in place of any defective
inventory items received. Therefore, a company that uses JIT purchasing must choose its suppliers carefully
and maintain long-term supplier relationships.
Inventory Valuation
Inventory can be one of the most important, and possibly largest, items in the statement of financial posi-
tion for any company that sells goods, whether it resells purchased inventory or produces the inventory
and sells it.
Inventory is defined by IAS 2, Inventories, as an item that is “held for sale in the ordinary course of
business; in the process of production for such sale; or in the form of materials or supplies to be consumed
in the production process or in the rendering of services.”63
Inventories include
• Goods (merchandise or other property) purchased for resale
• Finished goods produced
• Work in progress of being produced
• Materials and supplies awaiting use in the production process
Inventory is an asset that not only is presented on the statement of financial position, but it is also used
on the statement of profit or loss in calculating the cost of goods sold. Cost of goods sold is usually one of
the main expense items on the statement of profit or loss of a manufacturing or merchandising company
and therefore inventory is a critical account in the accounting process.
Inventory Measurement
Under IFRS, all inventories are measured at the lower of cost and net realizable value.
• Cost includes all costs of purchase, costs of conversion, and other costs incurred in bringing the
inventories to the needed location and to the needed condition.
• Net realizable value is the estimated selling price of the inventory in the ordinary course of
business less the estimated costs to complete and the estimated costs necessary to make the sale.
A specific cost is attributed to each specific item of inventory. When that item is sold, its assigned
cost is charged to cost of goods sold and the cost of the item is removed from inventory.
Cost Flow Assumptions – Determining Which Item is Sold

• When inventory items are not ordinarily interchangeable, such as when serialized inventory is
carried or when specific items have been segregated for specific projects, the cost assigned to
each sale is determined by means of specific identification. The cost of each unit of inventory is
individually tracked and when it is sold, its specific cost becomes the cost of the sale.
• When the inventory constitutes large numbers of interchangeable items, the first-in, first-out
(FIFO) or the weighted average cost method should be used to determine the cost of items
sold and the cost of unsold items remaining in inventory.
o When FIFO is used, the assumption is made that the items of inventory that were purchased
or produced first are sold first. Thus, the cost of each sale is the cost of the oldest item in
inventory. The cost of the items remaining in inventory at the end of the period is the cost of
those most recently purchased or produced.
o When the weighted average method is used, the cost of each item is the weighted average of
the cost of similar items at the beginning of a period and the cost of similar items purchased
or produced during the period. The total cost paid for all units held during the period is divided
by the number of units held during the period. Ending inventory and cost of goods sold are
then priced at this average cost. The average cost may be calculated on a periodic basis or as
each additional delivery is received.
63
IAS 2, Inventories, Paragraph 6.
Note: Last-in, first-out (LIFO) is a method permitted under U.S. GAAP and on U.S. business income tax
returns, but it is not acceptable under IFRS. Under LIFO, the assumption is made that each item sold
was the most recently purchased or produced (the newest) unit in inventory. Thus, the cost of each sale
is the cost of the newest item in inventory while the items remaining in inventory at the end of the period
are the earliest units purchased or produced.
Benefits of FIFO
• In a period of rising prices, cost of goods sold will be lower with FIFO than with average cost because
the oldest, lowest-cost inventory will be assumed sold for each sale. Consequently, reported net
income will be higher than it would be with the average cost assumptions, which may be of benefit
to some companies.
• When FIFO is used, inventory on hand will reflect more-current market prices than would be the
case under other average cost because the ending inventory will be reported at the cost of the most
recently purchased items.
Limitations of FIFO
• Although reported net income is higher under FIFO than under average cost in a period of rising
prices, net cash flow will probably be lower. Taxable income will be higher, and higher taxable
income means higher income taxes paid, which decreases net cash flow.
• Use of FIFO when prices are rising creates short-term, overstated operating income that is not
sustainable due to lower-cost units purchased at lower prices in the past being the ones expensed
as cost of goods sold.
Valuing Inventory at the Lower of Cost or Net Realizable Value

Because inventory is an asset, it is important that it is not overvalued on the statement of financial position.
Therefore, at the end of each period a company must evaluate its inventory to make sure that the recorded
amount is actually less than or equal to the amount of benefit that will accrue to the company in the future.
This valuation is accomplished by comparing the cost of the inventory (its recorded cost on the company’s
books) to the net realizable value of the inventory. The inventory will then be recorded on the balance sheet
at the lower of these two amounts.
Net Realizable Value (NRV) = Selling Price – Costs to Complete – Costs to Sell
If the NRV calculated above is lower than the cost of the inventory, the difference between the carrying
amount of the inventory and its net realizable value must be written off to a loss account that will be
reported on the statement of profit or loss as a reduction of income in that period.
The journal entry will be:

Dr Inventory Loss .................................................................. X
Cr Inventory ........................................................................... X
A writedown of inventory is considered a material item that must be disclosed separately, that is, on a
separate line in the statement of profit or loss.64
Write-downs are usually done item by item, although in some circumstances, similar or related items may
be grouped together. For example, items of inventory relating to the same product line with similar pur-
poses that are produced and marketed in the same geographical area and that cannot be practicably
64
IAS 1, Presentation of Financial Statements, Paragraphs 97-98(a).
evaluated separately may be marked down together. However, it is not appropriate to write inventories
down on the basis of a whole classification of inventory such as finished goods or all inventories in a par-
ticular division.65
Gross Margin and Inventory Estimation

A company’s historical gross margin can be used to estimate its ending inventory under limited circum-
stances such as for interim financial statements. Appendix C to IAS 34, Interim Financial Reporting, states,
“Full stock-taking and valuation procedures may not be required for inventories at interim dates, although
it may be done at financial year-end. It may be sufficient to make estimates at interim dates based on sales
margins.”66 Thus, if the gross margin on sales is relatively stable and constant, a company can use its gross
margin percentage to estimate its ending inventory for interim financial reporting.
The same process may also be used to estimate the amount of inventory damaged or destroyed or as a
check on the accuracy of the physical year-end inventory count, but estimation is not an acceptable valu-
ation method for year-end financial reporting under either IFRS or U.S. GAAP. An example follows.
Example: Estimation of ending inventory using the gross margin percentage for SYZ Company, a com-
pany that needs to estimate its ending inventory in order to prepare its first quarter interim financial
statements.
Gross margin is the amount of sales revenue remaining after cost of goods sold has been deducted from
it. The averages of SYZ’s quarterly sales revenue, cost of goods sold, and gross margin for the last four
quarters is:
Sales revenue 1,000,000
Less: Cost of goods sold 750,000
Gross margin 250,000
The gross margin percentage is the percentage of sales revenue represented by gross margin. It is the
gross margin divided by sales revenue. SYZ’s average gross margin percentage is 25%:
Percentage
of Sales
Sales revenue 1,000,000 100%
Less: Cost of goods sold 750,000 75%
Gross margin 250,000 25%
When cost of goods sold for the period is not known, it can be estimated by multiplying the current sales
revenue by (1 – the historical gross margin percentage). Current period sales revenue for SYZ Company
is 1,200,000. Using the historical average gross margin percentage of 25%, cost of goods sold can be
estimated as 900,000:
Sales revenue 1,200,000
× (1 – 0.25) × 0.75
= Estimated cost of goods sold 900,000
After cost of goods sold has been estimated, SYZ company can calculate the estimated cost of the ending
inventory using an adaptation of the formula used for calculating cost of goods sold.
(Continued)
65
IAS 2, Inventories, Paragraph 29.
66
Per Appendix C to IAS 34, Interim Financial Reporting, Paragraph 6.1.3.1, Inventories.
The formula for cost of goods sold is:

Cost of beginning inventory
+ Cost of inventory added during period*
= Cost of goods available for sale
− Cost of ending inventory
= Cost of goods sold
* For a reseller, the cost of inventory added is the net cost of purchases made during the period,
or purchases minus returns plus landing costs. For a manufacturer, the cost of inventory
added is the cost of goods manufactured during the period. The calculation of cost of goods
manufactured is covered later in this text.
The adapted formula solves for a different variable—estimated cost of ending inventory. The estimated
cost of goods sold is deducted from the cost of goods available for sale, as follows:
Cost of beginning inventory
+ Cost of inventory added during period
= Cost of goods available for sale
− Estimated cost of goods sold
= Estimated cost of ending inventory
SYZ’s cost of beginning inventory is 75,000, cost of inventory added during the period is 910,000, and
its estimated cost of goods sold, as calculated previously, is 900,000. Therefore, the estimated cost of
SYZ’s ending inventory is 85,000, as follows:
Cost of beginning inventory 75,000

+ Cost of inventory added during period 910,000
= Cost of goods available for sale 985,000
− Estimated cost of goods sold 900,000
= Estimated cost of ending inventory 85,000
Supply Chain Management

Nearly every product that reaches an end user represents the coordinated efforts of several organizations.
Suppliers provide components to manufacturers, who in turn convert them into finished products that they
ship to distributors for shipping to retailers for purchase by the consumer. All of the organizations, re-
sources, activities, and technologies involved in moving a product or service from suppliers to the end-user,
the customer, are referred to collectively as the supply chain. A supply chain begins with the delivery of
materials by a supplier to a manufacturer and ends with the delivery to the end consumer of the completed
product or service.
Supply chain management is the active management of supply chain activities by the members of a supply
chain with the goals of maximizing customer value and achieving a sustainable competitive advantage.
Firms endeavor to develop and run their supply chains in the most effective and efficient ways possible.
Supply chain activities cover product development, sourcing, production, logistics, and the information sys-
tems needed to coordinate the supply chain activities.
Supply chain management is a particularly important part of just-in-time inventory management, and just-
in-time purchasing and inventory management are important parts of supply chain management.
The organizations that make up the supply chain are linked together through physical flows of products
and through flows of information. Physical flows involve the movement, storage, and transformation of
raw materials and finished goods. The physical flows are the most visible part of the supply chain, but the
information flows are just as important. Information flows allow the various supply chain partners to fore-
cast demand, coordinate their long-term plans and to control the day-to-day flow of goods and material up
and down the supply chain.
By sharing information and by planning and coordinating their activities, all the members of the supply
chain can be in a position to respond quickly to needs while at the same time reducing excess inventory.
Retailers share daily sales information and forecasts with distributors and manufacturers, so that the man-
ufacturer knows how much production to schedule and how much raw material to order and when, and the
distributors know how much to order. The trading partners share inventory information. The sharing of
information reduces uncertainty as to demand.
The result of effective supply chain management is fewer stockouts at the retail level, reduction of excess
manufacturing by the manufacturer and thus reduction of excess finished goods inventories, and fewer rush
and expedited orders. Each company in the supply chain is able to carry lower inventories, thus reducing
the amount of cash tied up in inventories for all.
Some supply chain management goes so far as the retailer allowing the distributor or the distributor allow-
ing the manufacturer to manage its inventories, shipping product to it automatically whenever its inventory
of an item gets low. Such a practice is called supplier-managed or vendor-managed inventory.
Along with the benefits of supply chain management, issues and problems can arise because of communi-
cations problems, trust issues, incompatible information systems, and the required increases in personnel
resources and financial resources.
Accounts Receivable Management

Accounts receivable represent money that customers owe to the company for goods or services they have
received on credit. Companies carry accounts receivable because it is not realistic to expect customers
always to pay cash for their purchases. In addition, companies need to match what their competitors are
doing. If all the companies in an industry carry accounts receivable and give terms of, for instance, 2/10,
net 30, a company requiring cash payment would not do much business. Thus, most firms must carry
accounts receivable in order to maintain their sales in a competitive environment.
Accounts receivable are assets to the company, and they have value. On the other hand, receivables have
costs. Managing and monitoring the accounts receivable and following up on delinquent accounts is one
cost of carrying accounts receivable. Cash not received for a period of time represents an opportunity cost,
because the firm is not able to invest the cash or use the money owed it until it receives payment from its
customers. Furthermore, the firm may incur not only an opportunity cost but also a direct cost if it grants
credit to a customer who does not pay at all.
To manage accounts receivable, a company must balance the level of receivables outstanding and the
amount of bad debts resulting from the receivables that it will be unable to collect. The company must
balance the trade-off between the rewards of credit sales (additional sales that would not be made if only
cash sales were accepted) and the costs of carrying and collecting the corresponding accounts receivable
(collection costs, foregone interest on outstanding balances, bad debt costs). Obviously, it would be pref-
erable for a company to never have bad debts, but the only way to never have a bad debt is to never make
a credit sale.
The question the manager must answer is “how much credit should the firm grant and to whom”? Relaxing
credit standards will cause sales to increase, which is a benefit. But relaxing credit standards also increases
costs because more accounts will become uncollectible. The decision is a cost/benefit tradeoff. The goal is
to extend credit as long as the benefits outweigh the costs. Financial managers must manage accounts
receivable carefully to make sure that the asset adds to the firm’s profits rather than reducing profits
because the costs have become greater than the benefits.
Therefore, a balance between accounts receivable and bad debt expense must be reached. If a company
does not make any credit sales it will not have any bad debts. However, if it makes no credit sales, the
company may be losing revenue because of lost sales.
Three elements that constitute the credit policy of a company are:
• Credit standards determine to whom the company grants credit. Relaxed terms mean that the
company gives credit to more customers that may carry a higher risk of default, whereas strict
terms mean that the company gives credit to only those with a very low risk of default.
• Credit terms include the terms of sale, including the payment period allowed, discount for early
payment or penalty for late payment, and the size of any discount or penalty.
• Collection efforts are the amount of time and money spent on trying to collect past due accounts
before writing them off as bad debts.
Any action that changes any of the three elements above will have both costs and benefits. The benefits
may be in the form of increased sales revenues (as would result from the relaxation of credit standards),
the reduction of opportunity costs due to lower accounts receivable balances, fewer bad debts, or lower
collection expenses (resulting from tighter credit standards). The costs may include lost sales revenue (from
tighter credit standards), increased discounts taken (a cost of collecting the receivables sooner), the op-
portunity cost of higher accounts receivable balances, higher bad debts, or higher collection expenses
(resulting from relaxation of credit standards). The cost of collection efforts may exceed the potential ben-
efit where very low-value accounts are concerned, as well.
Some companies use a system of credit scoring in an attempt to manage their credit policies and extend
credit only to creditworthy customers. In a credit scoring system, a potential customer is graded against
specific criteria and the customer is assigned points for meeting certain criteria. The “score” that a potential
customer receives then determines whether or not the customer will receive credit.
Impact of a Change in Credit Policy Variables

If the credit standards are relaxed (changed so that more people are able to obtain credit), sales will
increase, but bad debts and collection costs will increase because more credit sales will be made to cus-
tomers with worse credit histories (that are therefore a higher risk). In other words, as the credit terms are
relaxed and more people obtain credit, the default risk increases. The default risk is the risk that one or
more of the debtors will not make the necessary payments, defaulting on their payables to the firm.
Conversely, a change to stricter (or tighter) credit policies will have the opposite effect: lower levels of
accounts receivable and fewer bad debts but also lower levels of credit sales.
Changes in credit terms and/or interest charged on unpaid balances (if the firm charges interest on unpaid
receivable balances, and some do) will also impact the number of customers who will apply for credit to
make purchases. A lower interest rate on the credit or a longer time to pay will cause more customers to
buy on credit, increasing sales. However, if the interest rate is low, it is possible that some customers who
would have purchased an item for cash will instead choose to purchase the item on credit. If that occurs,
the level of sales may not change, but the amount of bad debts will increase—not a very good situation for
the company as risk is increased without a corresponding reward.
Thus, the terms under which credit is granted will greatly impact the level of sales (including the balance
between cash and credit sales), bad debts, interest revenue, cash flows and other determinants of the
company’s financial picture.
All of this also affects the cash position of the firm. If the company allows a longer credit payment period,
the company is giving up cash (and the earnings potential of cash) by allowing its customers to keep the
cash for a longer time before paying it to the company. Similarly, by encouraging customers to pay early
with cash discounts, the company can gain the benefits of receiving the cash sooner—though it must give
up some of the cash it would have received because it must offer a discount to get the money earlier.
Monitoring Accounts Receivable

An aging schedule is a common analytical tool used in conjunction with receivables and their evaluation.
An aging schedule is developed from a company’s accounts receivable ledger and classifies the accounts
according to the amount of time each has been outstanding. Those that are current (not past due) are
listed in one column, those less than 30 days’ past due are in another column, and so forth.
An aging schedule can be used to determine the allowance for uncollectible accounts (covered in the next
topic) that should be established and/or the amount of bad debt expense that should be booked. In the
calculation of bad debt expense and the allowance for uncollectible accounts, the amount in each category
can be multiplied by an estimated bad debt percentage that is based on a company's credit experience and
other factors. The theory is that the oldest receivables are the most likely to become uncollectible.
Accounts Receivable Valuation

According to IFRS 9, Financial Instruments (effective January 1, 2018), trade receivables that do not contain
a significant financing component (assumed to be any receivables with an expected term of less than one
year) are initially measured at the transaction price, that is, the invoice amount excluding items collected
on behalf of third parties such as sales taxes.
According to IFRS 9, subsequent valuation of trade receivables that are within the scope of IFRS 15, Rev-
enue from Contracts with Customers, is to be performed using calculation of an “expected loss” over the
lifetime of the receivables. The expected credit losses are to be measured in a way that reflects an unbiased
and probability-weighted amount determined by evaluating a range of possible outcomes and the time
value of money, that utilizes information about past events, current conditions, and forecasts of future
economic conditions that is available without undue cost or effort.67 The company may use practical expe-
dients if they are consistent with those principles. IFRS 9 gives an example of using historical credit loss
experience for trade receivables by using fixed percentages depending on the number of days a trade
receivable is past due. However, IFRS 9 states that the percentages used should not just be estimates.
They should be derived from historical credit loss experience adjusted for forward-looking infor-
mation.
The expected loss is represented by an allowance for uncollectible receivables, a contra-asset account that
carries a credit balance and reduces the balance in the accounts receivable account. The allowance account
is adjusted to the required balance as of each financial statement date, and the other side of the journal
entry is a gain or a loss on the statement of profit or loss.
Thus, a company calculates what the allowance for uncollectible receivables balance should be at the end
of the period, and the required balancing figure becomes the amount of the credit to the allowance account
and the corresponding debit to a loss account on the statement of profit or loss.
Note: If the required credit balance at the end of a year in the allowance account is less than the credit
balance already in the allowance account at year-end, the company will debit the allowance account for
the amount needed to bring the balance in the allowance account to where it needs to be. As the other
side of the journal entry, the company recognizes a gain on its statement of profit or loss for the period.
Such a situation can arise if the previous estimates of uncollectible receivables were too high and the
company actually collected more of its receivables than anticipated.
Writing Off a Receivable Determined to be Uncollectible

When an account finally goes bad and the company becomes aware of the specific entity that is not going
to pay, that individual receivable is written off the books. The receivable is written off with the following
journal entry:
Dr Allowance for uncollectible receivables (reduces allowance) .... X
Cr Accounts receivable (reduces A/R) ......................................... X
67
IFRS 9, Financial Instruments, Paragraph 5.5.17.
Collecting a Previously Written-off Receivable

Occasionally, a company collects a receivable that it had previously written off. When a previously written-
off receivable is collected, the company makes two journal entries. The first entry is made to reverse the
entry that previously wrote off that receivable, as follows:
Dr Accounts receivable ............................................................ X
Cr Allowance for uncollectible receivables .................................... X
The preceding journal entry above puts the receivable back on the books so that its receipt can be recorded
and also increases the credit balance in the allowance account. The credit balance in the allowance account
must be increased because the receivable that was thought to be one that would not be collected has in
fact been collected. Therefore, it must be a different receivable that will not be collected and so the allow-
ance account should include the amount for the other receivable.
The second journal entry records the collection of the cash. It is:
Dr Cash ................................................................................. X
Cr Accounts receivable .............................................................. X
The T-account for the allowance for uncollectible receivables account follows.
Allowance for Uncollectible Receivables

(1) Beginning balance
(2) Bad debts written off (3) Collection of previously written-off bad debts
(4) Amount charged as bad debt expense for the

period (residual figure)
(5) Ending balance calculated using ending A/R
Example: Anita’s Supply Co. determines its expected credit losses on trade receivables by using an
aging schedule of its accounts receivable and historical loss rates for each aging category, adjusted by
forward-looking information. At December 31, 20X9, Anita’s prepared the following aging schedule in
order to calculate the balance it needed to have in its allowance for uncollectible receivables account:
Outstanding % Estimated
Age of Accounts Balances Uncollectible
Under 60 days 925,000 2%
61-90 days 115,000 5%
91-120 days 56,000 10%
Over 120 days 44,000 30%
As of December 31, 20X9, before recording the year-end adjustment for the allowance account, Anita’s
had a debit balance of 5,000 in its allowance account because more accounts had been written off during
the year than had been expected.
The accounts receivable manager calculated that the balance in the allowance account needed to be a
credit balance of 43,050 by multiplying each aging category’s receivable balance by its expected loss
rate and summing the results, as follows:
(925,000 × 0.02) + (115,000 × 0.05) + (56,000 × 0.10) + (44,000 × 0.30) = 43,050
The balance before adjustment in the allowance account was a debit balance of 5,000. To adjust the
debit balance of 5,000 to a credit balance of 43,050, a credit transaction in the amount of 48,050 (43,050
+ 5,000) was recorded in the allowance account as of December 31, 20X9. The other side of the trans-
action was a debit of 48,050 to a loss account on the statement of profit or loss.
Note: If the balance before adjustment in the allowance account had been a credit balance of 5,000
instead of a debit balance of 5,000, the necessary credit to the allowance account to adjust its balance
to a credit balance of 43,050 would have been 38,050 (43,050 − 5,000), and the debit to the loss
account would have also been 38,050.
Marketable Securities Management

Marketable securities are securities that can be easily converted into cash. They are securities that have
highly liquid secondary markets on which they can be quickly bought and sold at a reasonable price.
Most companies try to avoid holding large cash balances and prefer to borrow to meet any short-term cash
needs. However, while they do not want to hold large amounts of cash, they also do not want to invest all
of their cash in long-term assets. Companies often choose to keep excess cash in the form of marketable
securities. Holding cash usually does not provide any return on the cash that is held, whereas marketable
securities provide some return while maintaining liquidity and the ability to be quickly converted to cash.
Because short-term investments or marketable securities are temporary, they may be purchased so that
the maturity periods of the securities will match a time period of low cash balances or higher than usual
cash needs. These securities may be used to synchronize the cash inflows and the cash outflows of the
business. The purpose of a marketable securities portfolio is to provide a store of liquidity. The return
earned on the portfolio is a secondary objective. Marketable securities should be able to be converted into
cash quickly (usually in less than 24 hours) and the risk of change in value should be very low, meaning
that they can be sold without a large discount.
A firm should choose its investments with a view of the financial (repayment) risk involved with each
security. Repayment risk is the risk that any receipt of money due in the future may not be received for
one reason or another. Investments with a higher risk of default will generally offer a higher rate of return
as compensation for the increased risk the investor accepts. Cash that is needed to pay operating costs
should not be risked in order to earn a higher rate of return. The opportunity for a higher return
should usually be sacrificed in exchange for greater safety (less chance of default).
Interest rate risk is the risk of a change in value of a fixed income security that occurs as a result of a
change in market interest rates. Since short-term securities have a shorter investment horizon, their prices
are less affected by changes in interest rates. Therefore, short-term securities have lower interest rate risk
than long-term securities. In order to minimize interest rate risk, marketable securities should be invest-
ments with short-term maturities.
Liquidity is a function of how quickly an asset can be converted into cash and how safe the investment is
from loss of value. Since marketable securities must be liquid so they can easily and quickly be converted
into cash without a loss in value, only high quality, short-term debt instruments typically qualify as mar-
ketable securities.
Because of the variety of factors that go into the decisions related to marketable securities, a company
should have an investment policy statement. An investment policy statement provides guidance to the
individuals who need to make investment decisions and ensures that the investments made by the company
are in line with its policies.
Cash Management
The two key day-to-day issues in respect to cash management are how to collect the cash as quickly as
possible (cash inflow management) and how to delay the payment of cash as long as possible (cash outflow
management).
The concept of float is very important in cash management. There are two types of float, depending on
whether the company is making payment or receiving payment by check. The company paying has what is
called disbursement float and the company receiving the money has what is called collection float. Obvi-
ously, a company wants to maximize its disbursement float and minimize its collection float.
However, maximizing disbursement float is not as easy as it was just a few years ago. Banks have speeded
up their check collection process to a great extent in recent years, and so the opportunity to take advantage
of the time required to clear a check is virtually gone.
Receipts or Cash Inflow Management

The time between when the payer mails a payment and the receiver of the payment has the funds available
for use is called collection float. Total collection float for the receiving company has three components—
mail float, processing float and clearing float. Any action that reduces float frees funds for the company to
use, thereby increasing its profitability. The amount of funds that have been freed is the firm’s average
daily collections multiplied by the number of days the float is reduced.
A company should always endeavor to receive its cash payments as soon as possible in order to maximize
its cash management position. The following measures can help to expedite cash inflows, thereby minimiz-
ing collection float (the collection of receivables):
• Invoices should be mailed or otherwise submitted as soon as possible under the terms of
the sales agreement, consistent with revenue recognition requirements in IFRS 15, Revenue from
Contracts with Customers, so that they can be paid as soon as they are due.
• The payment terms for credit should be such that they encourage prompt payment. Giving a
discount if the invoice is paid before the due date may achieve this.
• Electronic data interchange (EDI) is the process of using computers from two different compa-
nies to communicate directly for common transactions. This electronic communication usually
takes place between a supplier and purchaser.
• Electronic funds transfer (EFT) is a form of EDI that is very commonly used. EFT involves
payment made by electronic funds transfer from one company’s checking account to another com-
pany’s checking account. Electronic funds transfer is particularly useful when the buyer and seller
are not geographically close to each other and mailed payments would require several days to be
received. By using EFT, the payer can more accurately control the timing of the funds being debited
from its account.
• Credit cards (Visa, MasterCard, or American Express, for example) can be used as an alternative
method of speeding up collection rates. The merchant pays a fee equal to 1%-3% of the credit
card sale. Through the credit card interchange system, the merchant’s credit card processor credits
less than the charged amount to the merchant, and the bank that issued the card used pays a
little more to the credit card processor than the card processor paid to the merchant but still less
than the charged amount. When the buyer pays the full amount of the charge to the bank that
issued the card, the issuing bank receives its fee, which is the difference between the full amount
of the charge and the amount the issuing bank paid to the card processor. The advantage to the
merchant is that the funds are immediately available. The responsibility for collection has been
transferred to the credit card issuing bank in exchange for the fee the issuing bank receives.
• Wire transfers may be used as a means of collection from customers.
• A lockbox system can be utilized. With a lockbox system, a company maintains special post office
boxes, called lockboxes, in different locations around the country. Invoices sent to customers con-
tain the address of the lockbox nearest to each customer as that customer’s remittance address,
so customers send their payments to the closest lockbox. The company then authorizes local banks
to check these post office boxes as often as is reasonable, given the number of receipts expected.
Because the banks are making the collections, the funds that have been received are immediately
deposited into the company’s accounts without first having to be processed by the company’s
accounting system, thereby speeding up cash collection.
o The company receives reports from the bank(s) and copies of the items received so it can
record the receipts in the customers’ accounts.
o For a company to benefit from a lockbox system, the interest earned on the additional funds
that can be invested (because the bank collected it directly and deposited it immediately)—or
the interest cost avoided on borrowings—must be greater than the cost of the bank fees for
providing the lockbox service.
o Having several lockbox locations reduces the time a payment is in the postal system and also
reduces the time from receipt to deposit in the company’s checking account. Lockbox service
is often used along with concentration banking.
• Concentration banking is a system in which a company uses one or more major concentration
banks along with many different regional bank accounts that are near its various collection points.
The money deposited to the regional accounts is transferred regularly from the regional banks to
the concentration bank or banks. Concentration banking may be used either along with lockbox
arrangements or when regional offices process the receipts and deposit them to their local banks.
When used with lockbox arrangements, each local bank that is collecting and depositing receipts
for the company transmits the deposit amount information to a central location throughout the
day. At a specified cut-off time, the deposit information from all of the local banks is transmitted
to the concentration bank. The concentration bank electronically moves the funds from the local
banks into the concentration account. As a result, the company has faster use of its cash for
investments, debt reduction or working capital uses.
Note: Lockboxes and concentration banking are fairly expensive services. They can benefit a
company with widespread operations only if the company’s receipts are great enough to make
the benefit from speeding up collections greater than the cost of the services.
Disbursements or Cash Outflow Management

Disbursement float describes funds the company has spent but that have not yet been deducted from
the company's bank account. Disbursement float occurs when a company writes a check. The check may
be mailed, and when the payee receives it, the payee deposits it in its bank. After the check has been
deposited in the payee’s bank, it usually takes a day before the money is deducted from the payer’s account,
because the check needs to go through the clearing system. So, disbursement float consists of mail float
(time for the check to be delivered through the mail), operational float (time for the payee to record the
payment and deposit it in its own bank) and clearing float (time for the check to clear and be deducted
from the payer’s bank account). Disbursement float may be thought of as the difference between what is
in the company's bank account according to the company’s books and what the bank shows to be in the
account. The difference arises as the result of uncleared checks.
As opposed to cash inflows, a company should slow its cash disbursements in order to increase the amount
of time it has the cash in its account. The effect of this delay is an interest free loan for the time that the
check has been credited to the payee’s bank account but not yet deducted from the payer’s bank account.
Payments should be made as close to deadline requirements as possible, unless taking a cash discount
is beneficial. However, if a company misses the payment date it may incur interest charges or lose the
chance to purchase from that supplier on credit again, so there is very little room for error when paying
just in time. Scheduling the payments to be made just before the deadline by means of electronic funds
transfer enables close control over the payment date, because there is no need to rely on mail service to
deliver the payment in time.
Some banks offer zero-balance checking accounts, although a fee is charged for this service. Zero-
balance accounts would be used by a company that needs to maintain several checking accounts at the
same bank for different purposes, such as a payroll account and a general disbursements account. In a
zero-balance account arrangement, these individual account balances are maintained at zero until checks
are received by the bank for payments from the accounts. The resulting “overdrafts” are automatically
“covered” by the bank by transferring money from a centralized concentration account belonging to the
company that is in the same bank.
Zero-balance accounts do not do anything to slow cash outflows, but they do permit a company
to carry lower cash balances. Thus, more money is available for short-term investment in accounts that
pay a return because excess balances in multiple disbursement accounts are not needed. Any technique
that helps a company to keep its checking account balances as low as possible will help its cash manage-
ment and therefore its net income, as long as the incremental return the company can earn on the funds
invested as a result of the technique is greater than the bank’s fees for the service.
Overdrafts are a method of slowing payments by writing checks for amounts greater than the amount on
deposit in the checking account. If the bank honors the overdraft, the company will have a negative balance
at the bank and as a result will need to pay various penalties and/or high interest on the negative balance.
Because of the penalties and interest as well as the ill will generated with the bank, overdrafts should not
be a common method used by a company to slow its payments. In fact, if a company regularly overdraws
its account, the bank will not honor the checks for which the company has nonsufficient funds and may
even close the account. Damage will also be done to the company’s relationships with its suppliers to whom
it has written the dishonored checks. However, some banks may provide a service that has the effect of
offering “overdraft” privileges under agreed-upon terms at an agreed-upon interest charge.
A controlled disbursement account is a special type of account where the bank provides the company
with information every morning about what checks will be clearing against the company’s account in that
day’s banking business. The service permits accurate forecasting of daily cash needs. The company can
then make full use of any cash that is not needed to cover the day’s disbursements by investing it or using
it to pay down debt or to meet other obligations. Controlled disbursement accounts would be used by
companies that need to make full use of their surplus cash while at the same time funding their disburse-
ments. The fees for controlled disbursement service can be quite high, so the service would be used only
by large companies with a lot of cash to manage because it would not be profitable for others.
Controlled disbursement is another banking service that does not actually slow cash outflows
but instead makes it possible for the company to carry lower cash balances and invest more excess
funds in short-term investments that earn a return.
If the bank calculates compensating balances on an average daily basis rather than requiring a
minimum balance to be carried at all times, the company can manage its cash more effectively, as it does
not always need to keep a minimum balance in the bank as long as the average cash balance is at least
the required amount.
Short-Term Financing
The type of short-term credit a firm will choose depends on a cost-benefit analysis of the different options.
The “costs” of the different sources of financing are the differences in the rates of interest that the company
must pay on each type of financing as well as other costs associated with that particular type of credit (for
example, dealer fees or warehousing fees). The most desirable financing is the option that results in the
lowest cost of borrowing, given the associated risks and benefits of that type of financing.
Trade Credit
Trade credit is a source of credit that arises from the process of purchasing an item on credit, and it is a
major source of financing for many small and medium-sized businesses.
If vendors give a cash discount for paying within a discount period, payments should be made within the
cash discount period, if taking the discount results in a lower cost of funds than not taking the discount.68
The cost of not taking a cash discount offered for early payment is calculated as follows:
360 Discount %
×
Total Period for Payment − Period of 100% − Discount %
Discounted Payment
If the cost of not taking the discount is higher than the cost of short-term borrowing, the company should
take the cash discount and pay within the discount period, even if it needs to borrow from a bank to do so
(as long as the company is creditworthy, that is). The cost of not taking the discount is generally greater
than the company’s cost of short-term borrowing, so making the payments within the cash discount period
is advantageous.
Example: A vendor offers terms of 2/10, net 30. If the company pays within 10 days, it will receive a
2% discount. If payment is not made within 10 days, then the full (undiscounted) amount is due in 30
days.
The calculation of the cost of not taking the discount is calculated as follows:
360 0.02
Cost of Not Taking the Discount = × = 0.3673 or 36.73%
30 − 10 1.00 − 0.02
If the company pays in 30 days and thus does not receive the discount, the annualized cost to the
company of not taking this vendor’s discount, expressed as an annual interest rate, is 36.73%.
Short-Term Commercial Bank Loans

Commercial banks offer many different types of loans to business borrowers and candidates need to be
familiar with the different types and how the interest is calculated under the different arrangements.
Short-term bank loans are perhaps the most common source of short-term financing used by companies,
after trade credit. A short-term loan is a loan that matures in less than one year. A short-term working
capital loan should usually be self-liquidating. A self-liquidating loan is a loan that is repaid from the
liquidation of the inventory and accounts receivable that it has financed. It is used to finance seasonal
68
Taking discounts for paying promptly is an exception to the rule of slowing disbursements for effective cash manage-
ment. Because the cost of not taking a discount is usually quite high, it is generally preferable to pay promptly and take
the discount.
needs for cash to build up inventory ahead of a busy season. When the inventory is sold and the accounts
receivable from its sale have been collected, the cash flow received is used to pay off the short-term loan.
Short-term commercial loans may be secured or unsecured.
• A secured loan is one for which the borrower has pledged an asset as collateral. If the borrower
defaults (does not repay the loan), the lender can take the collateral and sell it and use the pro-
ceeds to repay the loan. Collateral for a loan is considered a secondary repayment source.
Short-term debt is often secured by a blanket lien on the borrower’s accounts receivable and
inventory. A blanket lien is a security interest in property that is constantly changing its structural
makeup, such as accounts receivable and inventory. Accounts receivable are constantly being paid
off and replaced with new ones, and inventory is constantly being sold and replaced with new
inventory. A blanket lien applies to whatever specific accounts receivable or inventory items are
included on any day in the classification “accounts receivable” or “inventory” that is pledged as
collateral for the loan, and those specific items will be different from day to day.
Receivables that are pledged as collateral are pledged to the bank as a guarantee for the repay-
ment of the loan. The bank’s security interest is perfected by means of a filed UCC-1 blanket filing
on all accounts receivable.69 If the borrower defaults, the bank will instruct the borrower’s cus-
tomers to send their payments on their accounts directly to the bank instead of to the borrower.
The bank will apply the payments to the borrower’s loan balance until the principal and all accrued
interest on the loan have been repaid.
The amount a bank will lend against any collateral depends upon its lending policies and the
amount of risk it perceives. If the collateral is receivables and there is little risk that the receivables
will prove to be uncollectible or that the borrower will default, a bank may lend up to 80% of the
receivables taken as collateral. The greater the risk the bank perceives, the less the bank will lend
against the collateral.
• An unsecured loan has no collateral backing it and thus if the borrower defaults, the lender has
no secondary repayment source. Everything else being equal, the interest rate on an unsecured
loan will be higher than the interest rate on a secured debt, to compensate the lender for the
greater risk of loss.
When a company is privately held, a bank will frequently ask for the personal guarantee of the owner or
owners as a secondary repayment source for a loan, with or without other collateral.
Loans with Compensating Balances

If a loan has a compensating balance requirement, the borrower is required to keep some minimum balance
in an account with the bank. The account is usually a non-interest bearing account, although in some cases
the account may pay some interest. The compensating balance gives the bank some assurance that if the
borrower does not fulfill the terms of the loan, some cash will be available to the bank that it can take to
partially offset the amount due on the loan (that is, partially pay down the interest and/or principal). The
amount of the cash required may be a percentage of the amount of the loan or it may be a fixed amount.
In any case, the requirement to keep a minimum amount on deposit with the bank is called a compensat-
ing balance requirement. The amount that is held as a compensating balance reduces the amount of the
loan proceeds that are available for the borrower’s use but not the amount of interest the borrower must
pay, as the interest is calculated on the full amount of the loan. Therefore, the compensating balance
requirement increases the effective rate of interest paid by the borrower.
Sometimes, funds kept as a compensating balance can be withdrawn for short periods of time as long as a
minimum average balance is maintained. When a company is negotiating a compensating balance with a
bank, it is better to negotiate for an average compensating balance because for some periods during
69
See the discussion of the Uniform Commercial Code and UCC-1 financing statements in the Accounts Receivable
Management topic in this volume.
the month the amount in the account may be below the required amount as long as the average for the
month is above the minimum average balance required. An average compensating balance requirement
provides more flexibility for times when cash demands are greatest or expected deposits are not received.
With an absolute compensating balance, the company’s use of the compensating cash for short periods
is not allowed because the minimum balance must be maintained at all times.
The effective annual interest rate on a short-term loan (a loan of one year or less) that requires a
compensating balance equals the annualized net interest cost divided by the effective amount of cash
received (the amount of new funds the company has available as a result of the loan).
The effective annual interest rate is calculated as follows:
Annualized interest‡ paid on full amount borrowed – Annualized interest re-

ceived on cash deposited to meet compensating balance requirement, if any
Amount of the Loan – Additional amount required to be kept on deposit to meet
the compensating balance requirement
‡If the loan term is less than one year, the amount of interest paid on the loan and received on the deposit (if
any) must be annualized in order to calculate an effective annual interest rate. The annualized interest amount
is the amount of interest that would have been owed if the same average loan balance had been outstanding
for one full year. For example, if a loan is for 6 months and the amount of interest paid for 6 months is $3,000,
the annualized amount of interest will be $3,000 × 2, or $6,000.
When the bank requires a compensating balance, it is very possible that the company already has some
cash in the bank and therefore already has some of the compensating balance. In that case, only the
additional amount the borrower needs to add to its account to meet the compensating balance require-
ment is used in the denominator of the calculation to find the effective annual interest rate.
Example #1: Assume a one-year loan of $100,000 at 6% simple interest that requires a $20,000 com-
pensating balance. Annual simple interest is $6,000 and the usable loan balance is $80,000 ($100,000
− $20,000), so the effective annual interest rate is $6,000 ÷ $80,000 = 0.075 or 7.5%.
Example #2: However, if the company already has an average balance of $10,000 on deposit in the
bank, then it would need to add only $10,000 to its existing deposit to meet the $20,000 requirement.
Now, the effective annual interest rate would be calculated as $6,000 ÷ $90,000 = 0.0667 or 6.67%.
Example #3: Now assume that the bank will pay 2% interest per annum on the money deposited in
the bank as a compensating balance and that the company already maintains a $10,000 balance at the
bank. The effective interest expense will be the interest expense reduced by the amount of interest
earned on the additional money that needed to be deposited in order to meet the compensating balance
requirement, which is $10,000. The 2% interest on $10,000 is $200, which reduces the effective interest
expense (the numerator) to $5,800 ($6,000 minus $200). Earning interest on the compensating balance
reduces the effective simple interest rate to 6.44% ($5,800 ÷ $90,000).
Note: On the loan’s maturity date, the full principal balance of the loan must be repaid along with any
accrued and unpaid interest. In the first example above, the $80,000 in usable funds must be repaid
and in addition, the $20,000 that was deposited into the company’s account at the bank as a compen-
sating balance must be withdrawn from the account and repaid, plus the $6,000 simple interest accrued
on the full $100,000 principal must be paid.
Loans with Discounted Interest

When a loan’s interest is discounted, the bank deducts the full amount of the interest that will be due on
the loan or note in advance, and the interest is withheld and not disbursed to the borrower. Having the
interest discounted and withheld results in a higher effective interest rate than simple interest because the
borrower receives less than the face value of the loan but has to repay the full amount of the loan, effectively
paying interest on the entire amount. In effect, discounted interest is similar to a compensating balance in
that it reduces the amount of funds that are received by and available to the borrower, thereby raising the
m
effective annual rate of interest on the loan because the interest is paid on the full amount.
o
However, because the amount actually disbursed by the bank on the loan is lower (since the bank keeps
il.c
the interest), the overall risk to the lender is reduced. Therefore, the lender should offer the funds at a
a
lower stated rate of interest.
gm
The following formula can be used only for loans with terms of exactly one year.
@
01
Effective Rate of Interest on the Principal Amount of the Loan
=
Discounted Interest Principal Amount – Interest “Withheld”
e1
lin
Example: Assume a $100,000 one-year bank loan at 4% discounted interest with principal and interest
on
due in one year. Because the interest of $4,000 is discounted, the $4,000 of interest will not be disbursed
do
to the borrower with the rest of the loan proceeds. Thus, the borrower will pay $4,000 of interest but
will receive only $96,000 in available proceeds. When the loan matures, the borrower will repay
ar
$100,000, which will include the $96,000 principal disbursed plus the $4,000 in interest. Thus, the ef-
fective annual interest rate is 4.17% ($4,000 ÷ $96,000).
on
- le
Loans with a Compensating Balance and Discounted Interest

If a compensating balance is also required on a loan that has discounted interest, then the amount of
n
available funds is further reduced, causing the effective interest rate to be even higher.
me
Example: Assume the same one year, $100,000, 4% discounted loan as in the previous example, but
ar
the bank also requires a 10% compensating balance. The borrower will have the use of only $86,000,
because the $4,000 of discounted interest will be deducted from the loan proceeds and the borrower
lC
will not have the use of the $10,000 of the loan proceeds required for the compensating balance (10%
of $100,000). However, the borrower must pay interest of 4% on the full $100,000. The effective annual
De
rate of interest to be paid on the loan will be 4.65% ($4,000 ÷ $86,000).

Jr
Factoring of Receivables
do
When a company factors its receivables, it is essentially selling its receivables before they are due to be
ar
collected in order to receive the money from the receivable faster. However, when a company factors its
receivables, it does not sell the receivable for the full amount of the receivables. The factor (the party
on
purchasing the receivable) will charge a fee for doing this and will also charge interest for the time period
Le
between when the factor purchases the receivables and when the factor receives the cash from collecting
the receivable.
In a sense, the factoring of receivables is the same as getting a loan and using the receivables as the source
of repayment of the loan.
Factoring receivables is a very common practice in many countries as it enables a company to immediately
receive cash from its receivables and use this money for other purposes. The factor then collects the cash
from the company’s customers as its repayment for the money advanced to the selling company. Thus, a
company that factors its receivables is not assuming a principal liability that it will need to repay, though it
does need to pay interest to the factor for the use of the money.
One of the main issues in factoring that also impacts how much cash is received by the company selling
the receivables, is which party bears the risk of loss if the customer does not pay the receivables when they
are supposed to. This risk of loss will be established in the contract of the factoring of the receivables.
If the risk of loss remains with the company selling the receivables, the factoring is said to be with re-
course and in this case if the customer foes not pay, the company that sold the receivable must pay the
factor. When the receivables are sold with recourse the factor has less risk, and the seller will receive more
money from the sale of the receivables.
If the risk of loss transfers to the purchaser of the receivables, the sale is said to be without recourse. In
this case, the seller will receive less money from the sale of the receivables because the risk of loss is
transferring to the purchaser.
Calculating the Cash Received from Factoring

The factor does not credit the seller for the full face value of the receivables it purchases. The factor deducts
its factoring fees and an estimated interest charge, if applicable, and also holds back a percentage of the
receivables to cover merchandise that may be returned to the seller because receivables for returns will
not be collectible by the factor. The factor’s holdback for returns is considered to represent receivables
“retained” by the seller. At the end of the return privilege period, the factor will pay to the seller any amount
not needed to cover returns.
Although the amount the company receives from factoring its receivables is less than it would have received
if it had held the receivables to maturity and collected them itself from its customers, factoring may offer
a benefit because the factor assumes responsibility for any collections activity necessary to collect the
amounts owed. In addition, if the factoring contract provides that the sale is without recourse, the selling
company transfers to the factor the risk of loss from uncollectible receivables.
Three things can reduce the amount of money that is actually received from the factoring of receivables:
the factor’s fee, the allowance for customer returns, and an interest charge.
Factor’s Fee
The company purchasing the receivables (called the factor) will usually charge an administrative fee for the
service. The fee is usually a set percentage of the amount of the receivables, generally between 1% and
3%. The amount of the factoring fee will be dependent upon the amount of risk the factor determines is
related to the receivables purchased and whether the factoring arrangement is with recourse or without
recourse. The factoring fee will be higher if the amount of risk is higher and lower if the amount of risk is
lower. When the factoring is without recourse, the factor’s fee will be higher because the factor is assuming
the risk of non-collectibility.
Interest Charge
Because the seller is receiving the cash immediately, the factor is in essence providing a loan to the seller
of the receivables. The factor will collect the loan repayment as it collects the receivables. The factor will
charge interest on the amount of the loan provided to the seller of the receivables for the period until the
receivables are collected. Usually the factor calculates an estimated interest charge when it buys the re-
ceivables, based on the weighted-average estimated time to collection. The estimated interest charge is
deducted from the proceeds.
Allowance for Returns

In addition to the factor’s fee and the interest charge, the factor will withhold a percentage of the face
amount of the receivables to cover potential customer returns, sometimes called a reserve or a holdback,
because receivables for returned items will not be paid by the customers who returned the items. At the
end of the return privilege period, the factor will pay to the seller any amount of the holdback not needed
to cover returns.
Face value of the accounts receivable

− Factoring fee (a percentage of the face value of the receivables)
− Factor’s holdback for merchandise returns (a percentage of the face value of the receivables)
= Funds available before estimated interest charge
✻
− Estimated interest charge (funds deposited to seller’s account × annual interest rate ÷ 360
days† × estimated weighted average number of days to maturity of the receivables sold‡)
Proceeds to the seller
✻
This is the annual interest rate the factor is charging the seller and it will be given in the problem. It is usually higher
than the normal interest rate and will be higher the greater the risk associated with the receivables.
† The number of days used for annualizing the interest may be 365 or it may be 360. Most commercial financing uses
360 days.
‡ This is the estimated time period between the sale of the receivables and the weighted-average maturity of the receiv-
ables.
Example: The factor charges a 4% factor’s fee plus 12% interest on all monies that are advanced to
the seller. The factor also holds back 7% for potential sales returns. The receivables are being sold
without recourse. The receivables being sold total $150,000 and the weighted-average estimated col-
lection time is 120 days. The amount of proceeds to the seller is calculated as follows:
Amount of receivables submitted $ 150,000

Less: 7% holdback on gross receivable (10,500)
Less: 4% factor’s fee on gross receivable (6,000)
Funds available before estimated interest charge $ 133,500
Less: 12% interest for 120 days ($133,500 × 0.12 ÷ 360 × 120) (5,340)
Cash available to the seller $128,160
In addition to the $128,160 the seller receives at the time of factoring, any receivables collected in
excess of $139,500 ($150,000 − $10,500) will be paid to the seller because the factor withheld that
$10,500 as a protection against some of the sales being returned and the receivables not being collected
as a result. Furthermore, the seller might receive a refund of some of the interest if the receivables are
collected more quickly than expected or the seller might receive a bill for additional interest if the re-
ceivables are collected more slowly than expected.
If all of the receivables are ultimately collected when expected, the total cost to the seller of factoring
the receivables will be $11,340 ($6,000 factor’s fee + $5,340 interest). The total factoring cost must be
compared to the costs that the selling company would have incurred if it had operated its own collections
department and the cost of other financing options available.
1 E 1. Capital Structure
Long-term financial management concerns the way a firm finances its assets over the long term (meaning
more than one year).
The main issue in long-term financial management is finding the proper balance between the different
sources of finance, which will be different for each company. Some of the factors that go into this decision
are included at the end of the discussion of the different sources of finance.
Every firm has the need to raise capital (funds) in order to finance the necessary purchase of assets (such
as inventories and manufacturing plants) to run its business. While smaller amounts of financing are avail-
able from short-term sources for day-to-day operating needs (such as inventory or short-term working
capital needs), larger amounts of capital are of a more permanent or long-term nature. The permanent,
long-term sources of financing that a company uses are referred to collectively as the company’s capital
structure.
The capital structure of a firm includes its long-term liabilities and equity. Long-term liabilities and equity
indicate how the company obtained the necessary money to buy the assets the company holds.
The sources of permanent and long-term financing may be broken down into external and internal sources.
External Funds
External funds may be raised through the issuance of debt securities, equity securities (common or pre-
ferred stock), long-term bank financing or other types of financing such as leasing. No matter what source
of external finance a company uses (and it is very possible that a large company will use more than one
source), the company will need to pay for the use of the funds raised. The company’s payment may be in
the form of interest (debt or loans) or dividends (common or preferred shares), depending on the source
of the funds.
The money raised from long-term debt includes money as a loan from a financial institution, money raised
from a debt issue is a loan from the bondholders, and the money raised from a stock offering is an invest-
ment from the stockholders.
• Long-term debt. Most companies that borrow long-term will pay the interest as it is due and then
refinance (or “roll over”) the principal to pay off the existing debt when it matures. The refinancing
of a bond issue is accomplished by selling more debt to pay off the maturing issue.
Despite the fact that in reality long-term debt is not permanent (there is a maturity date), rolling
over the debt makes it appear as though the debt is permanent.
Note: For a bank loan, the refinancing is accomplished by obtaining another bank loan.
• Common stock. Common stock represents ownership shares of the company. In order to raise
financing from the issuance of shares, the company must issue the shares. After shares have been
issued the sale of shares from one shareholder to another does not provide any financing to the
company.
On the balance sheet, common stock consists two balance sheet accounts which together equal
the amount of money the company received when it sold the stock initially. The two accounts are:
o Common stock (the par value of the shares), and
o Additional paid-in capital. Additional paid-in capital is the excess of the sales price of the
shares of the stock when originally issued over the par value of the shares.
Dividends are paid from retained earnings. Issuers of common stock may or may not declare and
pay quarterly dividends to the common stockholders. Some companies do not pay dividends on
their common stock at all but instead retain all their earnings in the company. Other companies
pay dividends, and some have a policy of increasing the dividend periodically as long as they have
earnings to support doing so. However, there is no requirement for a company to pay dividends
on its common stock, and if a company’s board of directors does not declare a dividend, the com-
pany does not pay a dividend.
• Preferred stock. Preferred stock reflects the issuance of a security with characteristics that make
it a hybrid of (or cross between) bonds and common stock. Preferred stock is like bonds in that
the dividends are a percentage of the par value of each share, and it is like stock in that the
principal does not have a maturity date and the dividend is not legally required to be paid every
year. A preferred dividend is usually paid if it is at all possible to do so, but nonpayment of it does
not cause a default and bankruptcy as does nonpayment of interest on debt.
Internal Funds
Internal funds are available from profits the company generates but does not distribute to the stockholders.
These retained earnings of the company are available as a source of capital. The advantage of internal
sources of capital is that there is no cash cost (interest or dividends) to the company associated with these
funds.
Determining the Capital Structure

It is up to management to determine the best source of financing for the company. Usually, the optimal
capital structure is reached by using some of each of the different sources of financing. The optimal alloca-
tion of financing among the different types of capital will be determined on the basis of many different
considerations. Among the considerations are the following:
• The future prospects of the company. Will increased levels of sales bring in additional cash in
the future? Will the company have a need to expand, requiring additional cash resources? Projec-
tions of the amount and volatility of future cash flows are very important. If the firm’s cash flows
tend to be highly volatile, the firm is said to have a high degree of business risk, and as a result,
it should be more conservative in its financing sources.
• The state of the equity market. If the equity market is doing poorly, the cash received from the
sale of stock in an initial public offering will be less than it would be in a period of a strong market.
• The composition of the company’s assets. Companies tend to finance current assets with short-
term sources of capital (current liabilities) and permanent assets (primarily fixed assets) with their
capital structure sources. Therefore, if a firm anticipates higher investment in property, plant and
equipment, it will require higher levels of capital from permanent sources.
• The amount of risk the company is willing to accept. Debt sources are inherently riskier to the
firm than equity sources because a default on the debt could put the firm into bankruptcy.
• The reputation of the issuer (the company issuing the securities) and the interest rate it
would need to pay in order to be able to issue debt. The greater the risk the lender or lenders
perceive, the higher will be the rate of interest the company will be forced to pay, causing the debt
to be more expensive.
• The cost of each source of capital. The cost of capital is an important part of the decision
process. The weighted-average and marginal costs of capital will be covered later in this text.
Bonds (Debt Securities)

Bonds are a means of financing in which a company borrows money by selling debt securities (bonds) to
investors. A bond issue represents a loan by the bondholders (investors) to the issuing company. By selling
the bond, the company is making a promise to pay the investors a certain amount of interest every period
until the bond matures. On the maturity date, the company promises to pay the face amount of the bond
to the investors. The interest that will be paid each period, the face (or maturity) value and the maturity
date are all printed on the face of the debt certificate, the financial instrument that evidences the debt.
Bonds are used for long-term financing, and they generally are issued with maturities of ten years or longer.
Investors purchase bonds because the bonds pay a specified amount of interest to the purchaser, and
additionally, the face amount of the bond will be repaid at the bond’s maturity in the future. Because the
interest rate is fixed over the term of the bond, the investor knows what return they will receive from the
bond.
The Bond Instrument

In the U.S., bonds are issued in $1,000 increments. If a company issues $10,000,000 in bonds, that means
the company has issued 10,000 bonds, each with a face (or par) value of $1,000. Investors can purchase
the bonds individually, so investors can purchase bonds in $1,000 (face value) increments. If an investor
wants to purchase $10,000 face value of bonds, for example, the investor would purchase 10 bonds.
Bonds are issued by a company that needs financing, and the net cash received from their sale goes to the
issuing company. The investor who purchases an original issue bond or bonds is making a loan to the
company that issued the bonds.
The Bond Indenture

A bond represents a contract between the issuer (the borrower) and the bondholders (the lenders). The
legal contract is called the indenture and it contains all the terms and conditions of the contract including
the interest rate, the stated value, payment dates, maturity date, and so forth.
Following is an example of basic bond information.
BOND
Par (Face) Value – $1,000 Interest Rate – 8%
Issue Date – January 1, 20X0
Maturity Date – December 31, 20X9
Interest – paid semi-annually, June 30 and December 31
All of the amounts the issuer will pay to the buyers of the bond over the life of the bond can be determined
from the information given on the bond itself. The issuer of the bond will pay two cash flows to the buyers:
the repayment of the face value of the bond at the end of the bond term and regular payments of interest.
Par (Face) Value Payment

On the maturity date of the bond, the issuer will pay the face amount of the bond to the bondholders. Since
bonds are issued in face amounts of $1,000, on December 31, 20X9 (the maturity date), the holders of
each $1,000 par value bond will receive the regular semi-annual $40 interest payment for the period from
July 1 through December 31 of that year and also the $1,000 repayment of the face value of the bond.
Interest Payments
Bonds pay interest at their stated, or nominal, rate, based on their par value. The annual interest rate to
be paid by a bond throughout its term is set when the bond is issued.
In the bond example provided above, the issuer of the bond will pay $40 in interest for each $1,000 in par
value to the holders of the bonds ($1,000 × 0.08 ÷ 2) every June 30 and December 31 for ten years,
beginning June 30, 20X0, and continuing through December 31, 20X9. The cash investors receive over the
life of the bond is the same each period because it is calculated from the information on the bond itself.
The rate of interest to be paid on the bond is sometimes called the coupon rate. That term originated with
bearer bonds that were issued in the past with coupons for each scheduled interest payment. Records of
who owned the bonds were not kept by the issuers of the bonds. In order to receive the interest payment,
the owner of a bond had to send in the coupon to the company or its agent. Bearer bonds are seldom used
any longer, but the term coupon rate has survived as another term for the interest rate on a bond.
The amount of interest to be paid annually by a bond is calculated by multiplying the par (face) value of
the bond by its stated annual rate of interest (or its coupon rate). If the bond pays interest semi-annually,
for example, the amount of each interest payment is the annual interest amount divided by 2, since interest
is paid twice a year.
Additional Characteristics of Bonds

The contract is likely to include additional provisions that relate to the characteristics of the bonds or the
rights of the bondholders or the issuer as well as the basic terms discussed above. These additional provi-
sions may include:
• Restrictive covenants that limit the actions the company may take that could be detrimental to
the bondholders. The covenants may be related to various ratios that must be maintained, mini-
mum working capital amounts or maximum dividend payments that may be made. Covenants are
a means for the bondholders to protect their investment by increasing the likelihood that they will
receive their scheduled interest payments and the repayment of their principal on the maturity
date. Because covenants make the bond issue more attractive to investors, they may enable the
bond issuer to borrow the funds at a slightly lower interest rate. Examples of covenants include
the following:
o The bond issue may include a sinking fund requirement. A sinking fund is a separate fund
into which the company must transfer a certain amount of money each year. The money that
is accumulated in the fund will be used to retire the bonds as they come due.
o If the bond is a mortgage bond (secured by real property), the covenants may include require-
ments such as the issuer of the bond will maintain the property in good operating condition,
will insure the plant and equipment for adequate amounts, and will not dispose of the property
without permission of the bond trustee.70
o A mortgage bond’s covenants may also include a negative pledge clause. A negative pledge
clause is a covenant stating that the issuing corporation will not pledge any of its assets as
security for any other debt if doing so would give the holders of the mortgage bond less secu-
rity. A negative pledge clause in a bond indenture makes the bond a less risky investment
from the investors’ perspective.
• A call provision enables the issuing company to repurchase the bonds (call the bonds) at its
option. A call provision is very beneficial to the issuer (and therefore not beneficial to the investors)
because the issuer can call the bonds (retire them) if the market interest rate falls below the rate
of interest paid on the bonds. In the place of the retired bonds, the issuing company can issue new
bonds at the lower market interest rate. Bonds do not need to contain a call provision, but man-
agement may choose to include one. A call provision is not beneficial to the investors because if
financing is available at a lower rate for the company, it is unlikely that the bondholders will be
able to find other investment opportunities that will pay the same rate as the bonds did.
• Bonds may also be putable. “Putable” is similar to callable, except that the option to retire the
bond belongs to the purchaser of the bond. If certain events occur, or if the issuing company
violates any bond covenants, an investor can require that the issuer repurchase the bonds from
him. The price the issuer must pay to repurchase the bonds will either be specifically established
or can be calculated in accordance with the terms in the indenture.
70
The bond trustee is a financial institution that has trust powers, such as a commercial bank or a trust company. The
bond issuer contracts with the trustee, and the trustee is responsible for enforcing the terms of the bond indenture. The
trustee sees that interest payments are made as scheduled to the bondholders and protects the interests of the bond-
holders if the issuer of the bond defaults.
Bond Quotes
The price of a bond is quoted as its price per $100 of par value. Bonds are priced and quoted in two decimal
places. Thus, if a $1,000 par value bond is quoted at 103.25, it means the bond’s price is $103.25 per $100
of par value, or the price is $1,032.50 for a $1,000 par value bond. If a company issues $15,000,000 of
face value bonds at 103.25, the selling price of the bond issue will be $15,000,000 multiplied by 1.0325,
or $15,487,500. The issuing company will receive that amount for the sale of the bonds less the bond
issuance costs.
Bonds are valued and sold at the present value of all the future cash payments the company is expected
to make, discounted at the market rate of interest for bonds of similar terms and risk. Thus, the price at
which a bond can be issued depends on how its nominal interest rate compares with the market interest
rate for bonds of similar term and risk on the date of the sale. If the bond’s nominal interest rate is higher
than the market rate of interest, the bond will be sold at a premium, that is, at a price higher than its par
value. If the bond’s nominal interest rate is lower than the market rate of interest, the bond will be issued
at a discount, that is, at a price below its par value. The issuance price is adjusted so that investors will
receive the market rate of return on bonds they purchase.
Default Risk of Bonds

The buyer of a bond is a lender to the issuer of the bond, and one of the main risks the buyer takes is the
risk that the issuer will default on the bond obligation. A default means that the issuer will not be able to
pay the interest due periodically on the bond or the principal amount when the bond is due, or both. This
default risk is generally measured by independent analysis performed by financial services companies like
Moody’s and Standard & Poors. Their rating systems rank bonds from highest quality (low default risk) to
lowest quality (high chance of default). The lower the rating, the higher the interest rate the bond will need
to pay to convince investors to purchase it.
Note: Bonds that are rated below investment quality are called junk bonds.
Benefits of Issuing Bonds
• The bond issuer has no loss of control or ownership. The holders of the bonds are not owners of
the company and do not have any voice in the running of the company.
• The total cost of the bonds is limited and known because the interest rate that is used to
calculate the cash paid for interest is constant throughout the life of the bond. Furthermore, the
bondholders will not receive any additional payments above the stated interest, regardless of how
successful the company is (unless the bonds are participating bonds).71
• Interest paid on bonds is tax deductible as a business expense. As a result, the after-tax cost of
interest is lower than the before-tax cost of interest. In contrast, dividends paid to shareholders
are paid after taxes and thus are not deductible for tax purposes.
• If the bonds are callable or can otherwise be retired early, the company has the flexibility to retire
the bonds and eliminate the interest payment if it no longer has a need for the financing or if less
expensive alternative sources of financing become available.
71
Participating bonds can participate in dividends (the distributions of profits) of the company during a period of high
profits.
Limitations of Issuing Bonds
• Debt as a source of capital creates less flexibility for the company than does equity. Interest on
bonds is fixed and required. Even in periods of losses and low cash balances, the interest must be
paid, and the principal must be repaid on the maturity date. If payments are not made on time,
the company breaches its contract with the bondholders and defaults on the bond, which can lead
to bankruptcy and liquidation of the firm. In contrast, dividends on equity capital are not required
to be paid to shareholders and the shareholders’ investment does not need to be repaid to them.
• The issuing company assumes increased risk because of the possibility of default on the debt. In
times of decreased income or poor cash flows, the required interest payments on the bond may
become a burden.
• As the level of debt grows, the interest rate on the next loan or bond and the return required by
not only the debt holders but also the company’s shareholders will increase.
• The maturity of the debt will result in a large future cash payout that will need to be made all at
one time unless the firm is able to refinance the debt with another bond issue.
• The terms of the bond issue may include restrictive terms and covenants that must be adhered to
by the issuer. Failure to fulfill all of the covenants creates a default for the issuer, even if all
required payments have been made. For example, the bond indenture may require the issuer to
maintain a current ratio of no less than 2:1 and a debt to equity ratio of no more than 0.5:1.
Failure to maintain those ratios at any financial statement date is a default that can cause the full
principal and all accrued interest to become due immediately, which would probably force the
company to declare bankruptcy.
Stock (Equity Securities)

Equity represents the claims of the owners of the company on the assets of the company. From an account-
ing standpoint, equity is calculated as
Total assets − Total liabilities = Equity
All of the assets of the company need to be “owed to” someone or “owned by” someone. The liabilities
represent amounts that are owed to other parties and the equity represents the amounts that are owed to
the owners, or owned by the owners. An individual becomes the owner of a company by purchasing the
stock of that company. Each share represents an ownership interest in the company.
Note: Every company has equity, though the form of the equity will be different depending on the
ownership structure of the company. For a corporation, the equity is in the form of the stock that has
been issued and the retained earnings. For a partnership, the equity accounts will be the capital account
of each partner. For a sole proprietor, the equity accounts will represent what is owed to the individual
owner.
Equity securities can be of two general types: common stock and preferred stock. Common stock is used
by all corporations, while only a few companies issue preferred stock.
Common Stock
Shareholders who own common stock are the residual owners of the company. Residual ownership of the
company means that in the event the company is liquidated, the common shareholders will receive money
only after all other creditors (including preferred shareholders, if there are any) have been paid in full.
As a result of their ownership of common stock, shareholders participate in the leadership and management
of the company through their right to vote. The laws of the state where the company is incorporated and
the registration statements of the shares themselves govern the characteristics of the common shares and
shareholder rights. Therefore, it is not possible to list all of the possible characteristics of common shares.
However, most common shareholders have the following rights and expectations:
• The right to vote.
• The right to receive dividends, if common dividends are declared. Note that the common
shareholders do not have an absolute right to receive dividends. There is no requirement that the
company declare and pay dividends.
• The right to buy shares of a new issue IF the shares have preemptive rights. Preemptive
rights allow existing current shareholders to purchase the same percent of a new issuance of shares
that they own of currently outstanding shares. The option to purchase these shares allows a current
shareholder to prevent the dilution of their ownership from the issuance of new shares. However,
this is only the right to purchase the shares. If the shareholder does not have the cash to purchase
the shares, they will not be able to maintain their ownership share, even if they want to.
• The rights to share in the distribution of residual assets if the company is liquidated. Common
shareholders will receive a distribution of whatever assets are left after all creditors have been
paid in full. If the company is liquidated through a bankruptcy, the common shareholders will
usually receive very little, if any, money. However, if the liquidation occurs because the company
was purchased, the common shareholders may make a lot of money on the liquidation.
Because shareholders are not guaranteed an annual return such as interest and they are usually the last
ones to receive any distribution of assets in the event the company is liquidated, ownership of equity
(shares) involves more risk for the shareholders than the owning of bonds confers to bondholders. However,
the owners of shares are in a position to benefit more from the success of the company than a bondholder
would, because there is no limit to the dividends or capital appreciation they may receive.
Benefits of Issuing Common Stock
• Common stock does not have a fixed periodic payment (like bond interest) that must be made to
the holders. Dividends can be paid only when the money to pay them is available and may also be
limited in amount if the company has other needs for the cash.
• Shares do not mature and do not require a future repayment of the principal.
• Common stock provides the firm with greater flexibility in its financial structure because it does not
have an obligation to make interest payments or repay principal. Furthermore, unlike debt financing,
common stock does not have covenants that need to be maintained.
• The issuance of shares brings additional capital into the firm, thereby lowering its debt-to-equity
ratio and the perceived riskiness of its capital structure. This lower debt-to-equity ratio will reduce
the credit risk of the company and may lead to lower interest rates on future debt issues.
Limitations of Issuing Common Stock

• There is a limit to the number of shares a company can issue. The number of authorized shares is
set in the company‘s corporate charter and may not be exceeded without the approval of share-
holders. Each issuance of new shares dilutes the ownership share of existing shareholders and will
also decrease the value of each share. Thus, as more shares are issued, the amount of money raised
per share from each issuance will be smaller.
• The cost of issuing stock may be higher than the cost of issuing debt, largely due to the fact that
fees paid to investment bankers for the issuance of equity securities are usually substantially higher
than the fees paid for the issuance of debt securities. The higher fees are primarily a result of the
cost of selling equities to the public. Most debt securities are privately placed with institutional
investors at a small cost. Equities, however, require substantial selling effort and the cost is there-
fore significant.
• Since common stock is the riskiest security from an investor’s viewpoint, investors expect the high-
est return on their equity investments. Therefore, the issuance of too many shares can move the
average cost of capital above the most optimal level for the firm.
• Unlike interest on bonds, distributions made in the form of dividends are not a tax-deductible busi-
ness expense to the payer. The corporation pays income tax on the income that it distributes as
dividends, and the dividends are at least partially taxable to the recipients (the shareholders) as
income. Therefore, distributed corporate profits are subject to double taxation, meaning they are
taxed twice, once to the firm as taxable income and again to the shareholder as dividend income.
Preferred Stock
Preferred stock shares some characteristics with bonds and some characteristics with common stock. In a
sense, preferred shares sit between bonds and common stock.
Preferred stock is similar to bonds in five main ways:
• Preferred stockholders usually do not vote on issues at the annual meeting.
• Preferred stock usually pays, or earns, a fixed annual payment in the form of a dividend. A
preferred dividend may be stated as, for example, 6% of par value. If the share has a $100 par
value, the preferred dividend is then $6 per share. The company does not need to declare a pre-
ferred dividend each year, but if it does declare a preferred dividend, it would be $6 per share.
• Preferred shareholders receive preference over common shareholders in an asset distribu-

tion in a liquidation (though preferred shareholders have a lower priority than bondholders in
the distribution of assets).
• Preferred stockholders generally receive dividends before common stockholders.
• Often, preferred stocks are issued with bond-like features such as callability, convertibility, hav-
ing a maturity date (if mandatorily redeemable), and so forth.
Preferred stock is similar to common stock in the following three ways:
• Not paying preferred dividends during times of financial distress does not breach a contract
and cannot result in bankruptcy proceedings.
• Preferred dividends are paid after interest and taxes. Therefore, like common dividends, the
dividends paid on preferred stock are not tax-deductible for the firm.
• In the event of asset distribution in a liquidation, preferred shareholders are junior to bond-
holders and other creditors. However, preferred shareholders are senior to common shareholders
in a liquidation and will receive money before common shareholders receive anything.
Benefits of Issuing Preferred Stock

• Since preferred shareholders have no voting rights, the voting control of the company is not di-
luted.
• In most cases, any unusually high profits are maintained for the common shareholders rather than
needing to be distributed as dividends to preferred shareholders.
Limitations of Issuing Preferred Stock
• Preferred dividends are not tax-deductible as interest on debt would be.
Cost of Capital
A firm’s capital is supplied by its creditors (its lenders) and its owners (its shareholders), and consists of its
long-term debt and equity. Long-term debt is usually defined as bonds outstanding, but it can also be long-
term bank debt. Equity includes both preferred stock and common stock. Common stock includes not only
outstanding common stock but also retained earnings, because the company’s retained earnings belong to
its common stockholders. In fact, common equity is all equity minus preferred equity.
Investors providing equity capital (stockholders) expect returns in the form of dividends and/or share price
appreciation while investors providing debt capital (bondholders and other lenders) receive interest as the
return on their investment. To entice investors into providing capital (funding), a firm must be willing to
provide an adequate level of return for the risk that investors perceive in their investment.
A company’s overall cost of capital is the return expected by investors on a portfolio consisting of all the
company’s outstanding long-term debt and its equity securities. The overall cost of a firm’s capital depends
upon the return that is demanded by each of the suppliers of its capital—its creditors and its shareholders.
The instruments used by a company acquiring capital (and an investor providing it) are securities such as
stocks and bonds. Since the security represents the agreement between the two parties, the required
return from the investor’s perspective is equal to the cost of capital from the company’s stand-
point. If this were not the case, then one of the two parties would not have entered into the arrangement.
Therefore, a company’s cost of capital is the average rate of return that investors demand to
invest in the company’s debt and equity.
Note: Because the cost of capital is the rate of return expected by investors, cost of capital is calculated
using the market values of the outstanding debt and equity, not their book values.
Managers need to know the company’s cost of capital, as the cost of capital is an important part of invest-
ment planning. The company should not make any investment that does not provide a return of at least
the company’s cost of capital. If the company’s cost of capital is higher than its return on investment, the
company’s shareholders’ wealth will decrease. For example, it would not be beneficial to borrow money at
a 10% interest rate and invest it in a project with an expected return of only 6%. The company loses value
when it makes an investment in which its cost of capital is greater than its return on the investment.
Therefore, when a company makes a long-term investment, the minimum rate of return it requires on the
project or investment is called the hurdle rate, or its required rate of return. The company’s cost of
capital usually serves as the hurdle rate for a capital budgeting project. However, if management perceives
unusual risk in an investment, it should set the hurdle rate higher than the cost of capital to compensate
for the additional risk it is taking.
Overall Cost of Capital and the Weighted-Average Cost of Capital

A company’s overall cost of capital is a weighted-average of all its outstanding capital, weighted according
to the percentage each component represents in the firm’s capital structure at market values.
If information on the total after-tax cost of financing and the total market value of all of the financing is
available, the weighted-average cost of capital can be calculated as follows:
Total After-Tax Costs of Financing

Weighted-Average Cost of Capital =
Total Market Value of Financing†
†The current market value of the total financing should be used, not the historical cost that is
used for accounting purposes.
However, usually the overall cost of capital is calculated as a weighted average of the individual compo-
nents by summing the products of each component’s cost and the component’s weighting using the market
values of each component of the financing and each component’s after-tax cost. The weighted-average
cost of capital is the most common way of expressing the overall cost of capital for a company. The steps
to follow to calculate the WACC are:
1) Calculate the annual after-tax cost of each individual component (debt, preferred stock, common
equity) of the firm’s capital structure. The cost is an annual rate. Use the market value of each
form of capital in calculating its cost, not their book values.
2) Assess the firm’s capital structure to determine the appropriate weighting (as a percentage of total
capital) to be assigned to each component.
3) Calculate the weighted-average cost of capital (WACC) by summing the products of the weights
and the after-tax costs for each component of capital.
The weighted-average cost of capital is expressed as an annual rate.
The debt used in calculating the weighted-average cost of capital is long-term debt only. Accounts payable,
accrued expenses and other non-debt forms of liabilities are excluded. Short-term seasonal debt is also
excluded. The focus in calculating the overall WACC is on permanent financing. If short-term debt is con-
tinuous, as a revolving line of credit is, that debt can be included at its average balance in the calculation
of the Weighted-Average Cost of Capital because it is essentially long-term. However, bank debt is generally
not listed in CIA exam questions about WACC. Generally, on the CIA exam, “debt” means bonds.
The cost of debt will need to be reduced for the effect of taxes, because interest is a tax-deductible expense.
Because interest is tax deductible, the cost for interest is less than the actual interest expense. The cost of
preferred stock and common equity are not adjusted for taxes, because dividends are not tax-deductible.
Example: A firm finances its business with 60% debt and 40% common equity (no preferred stock). If
the after-tax cost of debt is 6.8% and the cost of common equity is 12.4%, the firm’s WACC is 9.04%,
calculated as follows: (6.8% × 0.6) + (12.4% × 0.4), or 4.08% + 4.96%, which equals 9.04%. The
calculation would most likely be more complex in practice, but this simplified example provides a basis
for understanding the calculation of WACC.
Step 1: Calculating Costs of the Components of Capital Structure

The cost of capital from a specific source such as bondholders is called the component cost of capital.
The various sources of financing include debt, retained earnings, common shares, and preferred shares.
The calculation of these component costs should be done on an after-tax basis for debt and using market
values for debt and equity, not book values.
Note: A basis point is 1/100 of a percentage point. Basis points are often used to describe the move-
ment of an interest rate. For example, if an interest rate is 6.85% today, an increase in that rate to
6.90% is an increase of 5 basis points.
The example below will be referred to throughout the explanation that follows:
Example: TAM Corporation has the following outstanding capital (book values):
Debt 1,000,000
Preferred stock 300,000
Common stock 57,800
Additional paid-in capital-common stock 492,200
Retained earnings 1,200,000
Total capital 3,050,000
The debt consists of 1,000 bonds with a face value of 1,000 each. They mature in 5 years and have a
coupon rate of 4.09%, payable semi-annually. They were sold 5 years ago at par and have a current
market value of 96, which means their market value is 96% of their face value of 1,000,000, or 960,000.
The current annual effective interest rate on the bonds is 5%.
The preferred stock consists of 12,000 shares of preferred stock outstanding, par value 25 each, and a
market value of 25.50 per share. The annual dividend is 4% of the par value.
The common stock consists of 57,800 shares outstanding with a par value of 1 each. The market value
of the common stock is 30 per share. The common stock dividend was 1.25 last year and is expected to
grow consistently by 4% annually.
The firm’s tax rate is 35%.
Cost of Debt
The cost of debt is the interest rate demanded by investors, adjusted for taxes. Adjustment for taxes is
made because interest is a tax-deductible expense. Therefore, the actual cost of the interest to the company
is less than the amount of the interest expense. Because of the tax deductibility of interest and the
lower inherent risk in bonds than in equity sources, bonds are usually the least expensive source
of new financing, as long as the company’s debt level does not increase to the point where its equity and
debt investors perceive too much credit risk and require additional compensation for the risk in the form of
increased return on their investments.
The formula to calculate the after-tax cost of debt is as follows:
Cd = C (1 − t)
Where: Cd = Cost of debt after tax

C = Cost of debt before tax (using the current ef-
fective annual interest rate, not the stated
interest rate) on issuance of new debt
t = Marginal tax rate
Note: A careful look at the formula for the after-tax cost of debt — Cd = C (1 – t) — will confirm that if
the tax rate increases while the effective annual interest rate (C) remains the same, the cost
of debt will decrease. The opposite is also true—a decrease in the tax rate increases the cost of debt.
Example: The effective annual interest rate on TAM Corporation’s bonds is 5%, and TAM’s tax rate is
35%.
● The interest rate of 5% is the market rate of interest for bonds of the same term and similar risk
characteristics, not the bonds’ coupon rate of 4.09%.
● The after-tax cost of TAM’s debt is 0.05 × (1 − 0.35), which is 0.0325 or 3.25%.
Note: The cost of selling a new debt issue (sometimes called flotation costs) is often ignored in calcu-
lating the effective interest rate on the bonds because it is insignificant since most bonds are privately
placed with minimal flotation costs. Most bank debt also requires the borrower to pay minimal loan fees.
Cost of Preferred Stock
Cost of Existing Preferred Stock

Most preferred shares pay a dividend as a percentage of the face (par) value of the shares. For example,
preferred stock with a par value of 50 that pays a 5% annual dividend will pay an annual dividend of 2.50,
or 5% of 50. The dividend as a percentage of par is established when the preferred stock is issued. Although
the dividend needs to be declared by the Board of Directors each time it is due to be paid, dividends on
preferred stocks are paid very reliably.
Because preferred dividends are a distribution of income and not an expense, they are not tax-deductible.
Therefore, the calculation for the cost of preferred shares does not include an adjustment for taxes.
The cost of existing preferred stock is a function of the annual cash flow in the form of dividends and the
market value of the preferred stock. The market value of preferred stock is equal to the present value of
the stream of perpetual, equal cash flows discounted at the investors’ required rate of return. The investors’
required rate of return is the cost of the preferred stock.
The cost of existing preferred stock is the annual cash flow in the form of dividends divided by the current
market value of the preferred stock.
Cost of Existing Annual Cash Flow Per Share in the Form of Dividends
=
Preferred Stock Current Market Price of Preferred Stock
Since the amount of the dividend is set when the preferred stock is issued, the numerator will not change.
However, the cost of the preferred stock will vary from time to time because the denominator will change
with the changing market price of the preferred stock.
Example: The cost of TAM Corporation’s existing preferred stock is the annual dividend divided by the
current market value of the preferred shares.
The annual dividend is 4% of the par value of 25, or 1.00 per share. The market value of the preferred
shares is 25.50 per share. Therefore, the cost of the preferred stock is 1.00 ÷ 25.50, or 0.039, which is
3.9%.
The cost of the preferred stock can also be calculated on the basis of the total outstanding stock. The
annual dividend is 1.00 per share and 12,000 shares are outstanding, so the annual dividend on the
outstanding shares is 12,000. The market value of the preferred shares is 25.50 per share, so the total
market value outstanding is 25.50 × 12,000, or $306,000. Thus, the cost of the preferred stock is 12,000
÷ 306,000 = 0.039, or 3.9%.
Cost of Newly-Issued Preferred Stock

The cost of newly-issued preferred stock is calculated in a manner similar to the cost of existing preferred
stock, with two exceptions.
• The denominator of the formula for calculating the cost of the newly-issued shares is the net
proceeds to be received per share from the new issue of the preferred shares, not the
current market price per share of any other issue of preferred stock outstanding. The net proceeds
equal the amount received from the sale minus the flotation costs.
• When issuing new shares, the firm will incur flotation costs including administrative expenses
associated with registration of the security and investment banking fees paid to brokers who sell
the securities. The flotation costs reduce the proceeds from the sale of the securities. For example,
if the preferred stock sells for 25 per share but the firm incurs flotation costs of 2 per share, the
net proceeds of the issue are 23 per share. If the flotation costs are given in an exam problem as
a percentage of the sale price, calculate the flotation costs. For example, if the newly-issued pre-
ferred stock sells for 25 and the flotation costs are 8%, the net proceeds of the issue will be the
same 23 per share (25 – [0.08 × 25]).
The formula for the cost of new preferred shares is:
D
Cnp =
Pn
Where: Cnp = Cost of new preferred stock
D = Yearly dividend per share

Pn = Net proceeds per share of the issue (selling
price minus issuance costs per share)
Note: Pay attention to the difference between the cost of existing preferred stock and the cost of
newly-issued preferred stock.
• The denominator when calculating the cost of existing preferred stock is the market price of a share
of stock.
• The denominator when calculating the cost of new preferred stock is the net proceeds per share
received from selling the new issue of stock after deducting the issuance costs.
Cost of Common Equity

The cost of common equity is a broad term and a major topic because common equity has two similar, yet
different, components, and also because there are multiple ways to calculate the costs of equity.
A firm can raise common equity capital in two main ways:
• Retained earnings: the company does not distribute all or any of its profits to its shareholders;
instead it retains some or all of them for reinvestment into the business.
• New common equity: new shares of common stock can be issued.
Both retained earnings and new common equity represent equity positions in the company and, therefore,
have fundamentally the same cost because the return required by existing and new shareholders would be
the same. One difference between retained earnings and new common equity is that the firm incurs no
expense when retaining its own earnings but does incur flotation costs when issuing new shares of common
stock.
Cost of Retained Earnings (Existing Common Equity)

The cost of retained earnings to the company is not a cash cost that is paid in the form of dividends or
interest. Retained earnings on the balance sheet increase when all or part of net income is not paid out to
shareholders in dividends. However, increases in retained earnings do not result in an increase in cash the
way issuing new stock does, and retained earnings do not earn any dividends the way outstanding common
stock can.
Instead, the cost of retained earnings is the opportunity cost of the next best investment that was not
made by the firm on behalf of the shareholders. The fact that the cost of retained earnings is an opportunity
cost makes it harder to visualize it as a cost incurred by the company. Look at it as the return that the
shareholders of the company could have earned had they received all the company’s profit in the form of
dividends and had invested that money somewhere else.
By retaining the profits within the company, the firm is investing those profits back into the company on
behalf of the existing shareholders. The shareholders will still demand an adequate return on their rein-
vested earnings. If the shareholders believe the reinvested earnings are not earning an adequate return,
they will sell their shares in order to put their investment funds to better use elsewhere. Shareholders who
continue to hold the stock are presumably satisfied with the return being earned on the retained funds.
Therefore, the cost of retained earnings is based upon the risk of the firm and the investors’
required rate of return. Investors demand a return on their investment in the company whether it is for
capital provided by buying new stock or generated by the company’s having reinvested its profits on their
behalf.
Note: Because of the relationship between existing common equity and retained earnings, when a ques-
tion states that the company would like to use common equity as a source of financing, the company
will first use its retained earnings. If retained earnings are not adequate, the company will then issue
new common shares.
Models for Calculating the Cost of Retained Earnings

When a company reinvests part or all of its profits back into the organization as retained earnings, man-
agement needs to make certain that the shareholders are receiving at least as much return on the
reinvestment of the retained earnings as they would have received if they had been given that money and
invested it in their choice of investments.
In order to assess shareholder return, the company needs to measure the cost of its retained earnings. The
cost of retained earnings can be measured in different ways. The following two methods will be covered in
these study materials:
• Dividend (Gordon) Growth model, used when dividends are paid and are expected to grow each
year in the future (and an adapted form of that model that can be used when dividends paid are
not expected to grow);
• Capital Asset Pricing Model (CAPM), used when no dividends are paid;
1) Dividend (Gordon) Growth Model

The Dividend (Gordon) Growth Model (also called the Dividend Discount Model or Constant Growth Model)
uses the dividends per share, the expected growth rate of the dividends, and the market price of the share
in order to estimate the cost of retained earnings as a percentage of the market value. For the company to
support a decision not to distribute its profits, it must be able to generate a greater return than the amount
of the dividend plus a growth rate in the level of dividends paid.
The Dividend Growth Model is also used to calculate the fair value of a stock with a growing dividend. That
version of the Dividend Growth Model solves for P 0, the fair value of a share of stock. The model can be
restated to solve for the investors’ required rate of return, called Cre, or the cost of retained
earnings.
The Dividend Growth Model incorporates a very important assumption—that the dividend will increase by
the same percentage each year. If the dividend is not expected to grow in the future, the same formula
can be used, but the value for G must be zero.
The formula for calculating the cost of retained earnings using the Dividend Growth Model is:
D1
Cre = + G
P0
Where: Cre = Cost of retained earnings (investors’ required rate

of return), expressed as a percentage
D1 = The next annual dividend to be paid per share
(the previous annual dividend multiplied by [1 +
the expected annual % growth rate in dividends]
if the anticipated dividend is not given)
P0 = Common stock price per share today
G = The annual expected % growth in dividends
Example: TAM Corporation paid dividends on its common stock last year equal to $1.25 per share, and
the dividend is expected to grow by 4% per year. Therefore, the next expected annual dividend on
TAM’s common stock is $1.25 × 1.04, or $1.30. The market price of TAM’s common stock is $30 per
share. The cost of TAM Corporation’s retained earnings and existing common equity is
D1
R or Cre = + G
P0
$1.30
R or Cre = + 0.04 = 0.0833 or 8.33%
$30
Exam Tip: The dividend amount used in the Dividend Growth Model is always a future dividend—the
next expected dividend. Always check whether the dividend amount given in an exam problem is a
past or a future dividend. If the dividend given is a past dividend, it needs to be increased by the annual
growth rate to change it to the expected future dividend. But if the dividend amount is given as an
expected future dividend, it does not need to be increased.
2) Capital Asset Pricing Model (CAPM)

Many companies pay no dividend to their shareholders. When the company pays no dividend, the Dividend
Growth Model cannot be used to calculate the cost of its equity capital. Therefore, the Capital Asset Pricing
Model (CAPM) is frequently used to estimate the cost of equity—either retained earnings or new equity.
Note: In cases of new equity offerings with substantial flotation costs or underpricing (such as in IPOs,
or initial public offerings), use of the CAPM is not recommended.
The CAPM formula is:
R = RF + β(RM − RF)
Where: R = Investors’ required rate of return

(cost of retained earnings)
RF = Risk-free rate of return
β = Beta coefficient
RM = Expected rate of return for the market portfolio
The risk-free rate (RF) is the rate of return an investor could receive on an investment in a riskless asset.
The risk-free rate is approximated by the return on very short-term U.S. Treasury securities.
The expected rate of return for the market portfolio (RM) represents the expected rate of return on
the average stock in the market, approximated by a benchmark index such as the S&P 500.
The market risk premium (RM – RF) measures the excess return over and above the risk-free rate that
investors demand in order to move investments into the stock market. The market rate of return represents
the expected rate of return on the average stock in the market. The market risk premium is included in the
required rate of return for a security or portfolio of securities.
The beta coefficient represents the correlation between the historical returns of a given stock or portfolio
vs. the historical return of the market as a whole or the average stock in the market as represented by
some index of market activity such as the S&P 500.
• Beta > 1.0: The stock or portfolio has historically been more volatile (riskier) than the market as
a whole. Historically, when the returns to the market have risen by 1%, the returns to the stock
or portfolio have increased on average by more than 1%.
• Beta > 0 < 1.0: The stock or portfolio has historically been less volatile (less risky) than the
market as a whole, while moving in the same direction as the market. Historically, when the returns
to the market have risen by 1%, the returns to the stock or portfolio have increased on average
by less than 1%.
• Beta = 0: A risk-free asset has a beta of zero. However, having a beta of zero does not guarantee
that a security or a portfolio is risk-free. A beta of zero may mean only that historically there has
been no correlation between the security’s or portfolio’s return and the return of the market.
• Beta < 0: A negative beta (less than zero) means the stock or portfolio has historically moved
counter to the market. When the returns to the market have increased, the returns to the security
or portfolio have decreased, and vice versa.
• Beta = 1.0: A beta of exactly 1.0 means the returns for the stock or portfolio have historically
moved in exactly the same direction and in exactly the same amount as the market has moved. A
beta of exactly 1.0 is not likely to occur in an individual stock or in a portfolio. However, it is
important to know that the beta of the market as a whole is 1.0.
Example: Assume Company Y’s common stock has a beta of 0.90, investors demand a market rate of
return of approximately 8%, and the risk-free rate is 1%. The required rate of return on Company Y’s
common stock is calculated as follows using the CAPM:
R = 0.01 + [0.90 (0.08 – 0.01)] = 0.073 or 7.3%
Notice that the calculated required rate of return for Company Y’s stock is below the 8% market rate of
return. The required rate of return for Company Y is below the market rate of return because Company
Y’s beta, at 0.90, is less than 1. If Company Y’s beta had been greater than 1, the investors’ required
return for the stock would have been higher than the market rate, because the risk of this stock would
be higher than the risk to the market as a whole and in order to hold the investment, investors would
demand a higher risk premium than the risk premium for the market as a whole.
Even though Company Y’s beta is less than 1, investors will still require a risk premium to hold the stock,
because the stock is still more risky than a risk-free security.
The risk premium for Company Y’s common stock with a beta of 0.90 is calculated as 0.90(0.08 – 0.01),
which equals 0.063 or 6.3%. This 6.3% is the risk premium that investors require in addition to the
risk-free rate of 1% in order to hold Company Y common stock.
Note that when Company Y’s risk premium of 6.3% is added to the risk-free rate of 1%, the result is the
required rate of return on Company Y’s common stock: 7.3%.
Cost of New Common Equity

The Dividend Growth Model (also called the Gordon Growth Model) is used to calculate the cost of retained
earnings (existing common equity) when the company pays a dividend that is expected to grow in the
future. The same formula can be used with only a slight modification to determine the cost of newly issued
common stock when a dividend is paid that is expected to grow.
The cost of new external common equity is higher than the cost of retained earnings because registering
and selling the new stock has costs. The costs are called flotation (issuance) costs and they need to be
factored into the calculation of the cost of new shares. Furthermore, firms find it more expensive to raise
money through the issuance of shares than through the issuance of debt because the shareholders
will require an additional return to compensate them for the additional risk of owning equity instead of debt.
The formula to determine the cost of newly- issued common stock when the dividend is expected to grow
is:
D1
Cns = + G
Pn
Where: Cns = Cost of the new issuance of common stock, ex-

pressed as a percentage
D1 = The next dividend to be paid per share (the previ-
ous annual dividend multiplied by [1 + the annual
expected % growth rate in dividends] if the antic-
ipated dividend is not given)
Pn = Net proceeds of the issue per share (selling price
minus issuance costs)
G = The annual expected % growth rate in dividends
Note: If the dividend is not expected to grow, the same formula may be used with zero for G.
As with preferred stock, the cost of newly-issued common stock is calculated in a similar manner to the
cost of existing common stock, with two exceptions.
• The denominator of the formula for calculating the cost of the newly-issued shares is Pn, the net
proceeds to be received from the new issue of the common shares, not the current common
stock’s market price as in the formula for existing common stock. The net proceeds equal the
amount received from the sale minus the flotation costs. The amount received from the sale
may or may not be the same as the current market price of the firm’s outstanding stock.
• When issuing new shares, the firm will incur flotation costs including administrative expenses as-
sociated with registration of the security and investment banking fees paid to brokers who sell the
securities. The flotation costs reduce the proceeds from the sale of the securities. For example, if
the new common stock sells for 25 per share but the firm incurs flotation costs of 2 per share, the
net proceeds of the issue are 23 per share. Flotation costs may also be given in an exam problem
as a percentage of the sale price. If the newly-issued common stock sells for 25 and the flotation
costs are 8%, the net proceeds of the issue will be the same 23 per share (25 – [0.08 × 25]).
Like the formula used to calculate the cost of retained earnings (existing common equity), the above for-
mula also assumes that the dividend will increase by the same percentage each year.
Exam Tip: If an exam problem does not give the issue price of a new issue of stock but does give the
current market price of the existing stock, assume that the new stock will be issued at the current market
price of the existing stock.
Step 2: Assessing the Firm’s Capital Structure

After the component costs have been calculated, the next step is to assess the firm’s capital structure to
determine the appropriate weighting (as a percentage of total capital) to be assigned to each component.
A firm’s capital structure is the mixture of capital that it uses to finance its assets.
Note: In assessing the capital structure of a firm, always use the market values of the various com-
ponents, not the book values.
The example of TAM Corporation follows, this time with the book values of the various components given
followed by the market values of each component. Each component’s proportion of the market value of the
total capital is calculated.
Example: TAM Corporation has the following outstanding capital (book values):
Debt 1,000,000
Preferred stock 300,000
Common stock 57,800
Additional paid-in capital-common stock 492,200
Retained earnings 1,200,000
Total capital 3,050,000
The debt consists of 1,000 bonds with a face value of 1,000 each. They mature in 5 years and have a
coupon rate of 4.09%, payable semi-annually. They were sold 5 years ago at par and have a current
market value of 96, which means their market value is 96% of their face value of 1,000,000. The market
interest rate for bonds with the same term and similar risk characteristics is 5%.
The preferred stock consists of 12,000 shares of preferred stock outstanding, par value 25 each, and a
market value of 25.50 per share. The annual dividend is 4% of the par value.
The common stock consists of 57,800 shares outstanding with a par value of 1 each. The market value
of the common stock is 30 per share. The common stock dividend was 1.25 last year and is expected to
grow consistently by 4% annually.
The firm’s tax rate is 35%.
Market values of the capital and the proportion of total capital represented by each are as follows:
Debt (96% of 1,000,000) 960,000 32.0%

Preferred stock (25.50 × 12,000) 306,000 10.2%
Common stock (30 × 57,800) 1,734,000 57.8%
Total market value of capital 3,000,000
Step 3: Calculating the Weighted-Average Cost of Capital

The final step in calculating the overall weighted-average cost of capital is to use the proportion each
component of capital represents of the total market value of the capital and the cost of each component to
find the weighted-average rate.
Example: The component costs of TAM Corporation’s capital are as follows:
● The market rate of interest on TAM Corporation’s bonds is 5%, and TAM’s tax rate is 35%. Therefore,
the after-tax cost of TAM’s debt is 0.05 × (1 − 0.35), which is 0.0325 or 3.25%.
● The cost of TAM Corporation’s existing preferred stock is the annual dividend divided by the current
market value of the preferred shares. The annual dividend is 4% of the par value of 25, or 1.00 per
share. The market value of the preferred shares is 25.50 per share. Therefore, the cost of the pre-
ferred stock is 1.00 ÷ 25.50, or 0.039, which is 3.9%.
● TAM Corporation paid dividends on its common stock last year equal to 1.25 per share, and the
dividend is expected to grow by 4% per year. Therefore, the expected annual dividend on TAM’s
common stock next year is 1.25 × 1.04, or 1.30. The market price of TAM’s common stock is 30 per
share. The cost of TAM Corporation’s retained earnings and existing common equity is (1.30 ÷ 30) +
0.04 = 0.0833 or 8.33%.
The weighted-average cost of TAM Corporation’s capital using the individual component costs and
weighting the cost of each component according to its proportion of the total market value of the capital
is as follows:
Proportion
Cost (Weighting) Cost × Weight
Debt 0.0325 0.320 0.0104
Preferred stock 0.0390 0.102 0.0040
Common stock 0.0833 0.578 0.0481
Weighted-Average Cost of Capital (WACC) 0.0625 or 6.25%
1 E 2. Capital Budgeting
Capital—whether debt, equity, or retained earnings—is a limited resource, and a company must carefully
manage its capital, protect it, and make it grow through identifying and taking advantage of investment
opportunities as they arise. However, a company’s management needs a method to decide whether or not
a particular project under consideration will contribute to profits and thus to the value of the firm’s equity
and the wealth of its shareholders. Furthermore, if several projects are under consideration, management
needs to be able to identify which ones are the most profitable. A new plant, a new product line, a new
business under consideration, or other similar long-term investments are projects that might be evaluated
using capital budgeting techniques.
Through capital budgeting, management can evaluate different investment opportunities and identify
those that will contribute the most to profits and thus to the value or wealth of the firm and its owners, the
shareholders. As an important decision-making tool, most of the capital budgeting methods focus on the
expected value of the future net cash flow (as opposed to net income) throughout the entire life of the
project, including all expected cash inflows, expected cash outflows, and expected cash savings (such as
tax savings resulting from the depreciation of the purchased assets). Thus, capital budgeting is a “life-
cycle” or “cradle-to-grave” approach to selecting, implementing, and monitoring the results of long-term
investments.
Capital budgeting uses the incremental approach to determine the expected cash inflows, outflows, and
cost savings of a potential investment. With the incremental approach, the only cash flows relevant to the
analysis are those that would be additional as a result of the activity. On the other hand, if the decision
calls for a choice between two or more alternatives, the differential approach is used, in which the only
cash flows relevant to the analysis are those that would differ between or among the alternatives.
Note: The terms “incremental” and “differential” are sometimes used interchangeably; however, they
do not refer to the same ideas.
Five capital budgeting techniques—four primary methods and one secondary method—are used, offering
different ways to analyze a project.
• The Net Present Value Method and the Internal Rate of Return Method use the time value
of money. The time value of money recognizes the fact that a 1,000,000 net cash inflow received
next year is worth more than a 1,000,000 net cash inflow received five years from now. Therefore,
to make the analysis meaningful, the expected net cash flows for each of the years over the entire
life of the project are discounted to their present values at the beginning of the project’s life using
the firm’s required rate of return.
• In a third method, the Payback Method, the future net expected cash inflows are compared with
the net initial investment (cash outflow) to determine the time required to recoup the net initial
investment, without considering the time value of money.
• A variation of the Payback Method, the Discounted Payback Method, also uses the time value
of money. It uses the present value of the expected cash flows to calculate the payback period
instead of the undiscounted expected cash flows.
• The final method, the Accrual Accounting Rate of Return Method, is the only method that uses
net income rather than net cash flow. It is calculated by dividing an accounting measure of net
income for the project by an accounting measure of investment for the project to calculate an
annual average accounting rate of return on the investment.
The Stages in Capital Budgeting

The process of making capital investment decisions includes six stages:
1) Identification Stage: In this initial phase, management identifies which capital expenditure pro-
jects are necessary to accomplish its objectives such as expanding into a new market or reducing
expenses.
2) Search Stage: The company explores a variety of capital investments that will achieve the or-
ganizational objectives.
3) Information-Acquisition Stage: The company determines the expected costs and benefits, both
quantitative and qualitative, of the different capital investments.
4) Selection Stage: On the basis of financial analysis and nonfinancial considerations, the company
chooses the project or projects to implement.
5) Financing Stage: The company obtains the necessary project funding.
6) Implementation and Control Stage: The project is implemented and monitored over time.
Note: A post-completion audit (or post-audit) of a capital budgeting project compares the
actual benefits and costs of the project with the original estimates. Post-completion audits
should be done for all large projects and for all strategically important projects, regardless of
size. They should also be done for a sample of smaller projects.
A post-audit lets management know how closely the actual results of the project matched the
original estimates. The feedback from a post-audit helps management learn where its forecasts
may have been inaccurate and to understand which important factors may have been omitted
from its capital budgeting analysis. The information gained from a post-audit can help to im-
prove future capital budgeting analyses.
Although each of the six stages is important, the following discussion will focus on the Information-Acqui-
sition Stage and the Selection Stage, examining potential investments from a purely financial viewpoint.
However, in real-world analysis of potential projects, it is important to realize that there may be non-
financial considerations that may prompt a company to select an investment that may not be the most
financially rewarding. For example, the company might invest in a project that has low or negative net cash
flows but which would benefit the local community and raise the company’s philanthropic profile.
Identifying and Calculating the Relevant Cash Flows

To correctly perform the different capital budgeting methods, it is important to be able to recognize the
relevant cash flows in each of the years of a given project because almost all capital budgeting analyses
will be based upon individual cash flow analyses.
“Relevant Cash Flows” Defined

Relevant cash flows are expected future cash flows that differ between alternatives. Relevant cash flows
can be either differential or incremental.
• Differential cash flows are those that differ between two alternatives.
• Incremental cash flows are those that are received or incurred additionally as a result of an
activity.
Cash flows that are the same for all the options under consideration are not relevant because they will be
the same no matter which option is selected.
“Expected Cash Flow” Defined

The annual expected cash flow in a capital budgeting analysis for a given year is the expected value
of the forecasted cash flows for that year, or the weighted average of all of the possible cash flows,
with the probabilities of each cash flow’s occurring serving as the weights. Thus, several possible cash flows
will be projected for each year of a project’s life and probabilities will be determined for each possible cash
flow for each year so that the expected value of the cash flows for each year can be calculated.
Expected Cash Flows at the Beginning of the Project (Year 0)

All expected cash flows at the beginning of a project relate to the net initial investment. In capital budgeting
analysis, the date of the initial investment may be referred to as either “Year 0” or “Time 0.” Cash flows,
both inflows and outflows, that occur at the beginning of a project take place one year before the end of
Year 1.
These Year 0 cash flows consist of three possible components:
1) Initial investment. The initial investment is the cash outflow necessary to get the project op-
erating, such as purchase or construction of assets, transportation costs to have the assets shipped
to the location where they will be used, installation and setup, testing, and other related costs.
Tax Effect: There is no immediate tax effect with respect to the initial investment. However,
beginning with the first full year of operation, tax benefits will arise over the life of the project
as the capital assets are depreciated. The tax benefit received from the depreciation, called the
depreciation tax shield, is covered later as an annual cash inflow over the life of the project.
2) Initial working capital investment. Working capital, also known as net working capital, is total
current assets minus total current liabilities. Working capital is expected to increase at the begin-
ning of a project. An expected increase in working capital means that accounts receivable and
inventory are expected to increase due to the project under consideration. Cash will be required
to purchase the inventory and to support the increase in receivables. The increase in accounts
receivable represents goods supplied or services rendered for which the company has incurred
costs but for which it has not yet received payment.
On the liability side of the balance sheet, accounts payable related to the purchased inventory will
also increase. However, the increase in accounts payable will not be as great as the increase in
accounts receivable and inventory.
Thus, at the beginning of the project, net working capital will increase by the amount of the in-
crease in current assets minus the amount of the increase in current liabilities related to the
project. This increase in working capital is a cash outflow at the beginning of the project and
it will be recouped as a cash inflow at the end of the project.
Tax Effect: There is no tax effect related to working capital. Therefore, the amount that needs
to be included in the capita budgeting analysis is the actual amount of the increase in working
capital that the company expects to occur.
3) Cash received from the disposal of old or outdated assets. In the process of beginning a
project, assets might need to be liquidated. For example, a new project might require the company
to purchase a new machine to replace an older machine. Since the older machine is now obsolete,
the company might wish to maximize a cash return for the older machine (perhaps through a
heavily discounted resale or a tax-deductible, charitable contribution) rather than throw it away.
Cash received from the disposal of old or outdated assets is a cash inflow and therefore reduces
the initial investment for the newer assets.
Tax Effect: When an old asset is sold, there is an income tax effect related to the gain or loss
on the sale. The amount of the gain or loss is the difference between the cash received from
the sale and the tax basis of the asset (that is, its book value for tax purposes).
Any gain on the sale is taxed, and the amount of the tax constitutes a reduction in the net
cash inflow from the sale.
Any loss on the sale constitutes a reduction of net taxable income, which lowers the company’s
total tax burden. The amount of the tax savings that results increases the net cash inflow re-
ceived from the sale of the asset for the purposes of the capital budgeting analysis. Therefore,
a loss on the disposal of the old assets creates an increase to net cash flow in the form of
lower income taxes. If an old asset is donated to a qualified charitable organization, the tax
savings received as a result of the tax deduction for the donation is a cash inflow from the
disposal.
Annual Net Cash Flows

Annual net cash flows after the project begins include net operating cash flows, cash outflows for follow-up
investments, and the depreciation tax shield, a cash inflow.
Operating Cash Flows

After a project begins, the company will have annual net cash flows from operations that will either remain
constant for each year of the project or else fluctuate. The operating cash inflows may result from one or
both of two sources:
1) Increased sales. If all goes well, the investment will lead to an increase in sales and cash flows.
The cash inflow for capital budgeting purposes is the amount of the increased net operating cash
flows (that is, operating cash inflows minus operating cash outflows) that result each year from
the investment.
2) Decreased operating expenses. Improvements in worker and equipment efficiency may reduce
operating expenses. The amount of the decreased operating expenses constitutes a cash inflow
for capital budgeting purposes.
Tax Effect: The company will need to pay income taxes as a result of either increased sales
and profits or decreased operating costs. Therefore, the cash flows related to these items need
to be reduced for the resulting taxes.
Depreciation is not included in operating cash flows because it is not a cash expense. However,
it is used later in calculating the depreciation tax shield.
Cash Outflows for Follow-Up Investments

The company may have cash outflows after the initial investment is made. Two potential sources of cash
outflows in subsequent years are:
1) Another capital investment. A follow-up capital investment may be needed to maintain the
equipment after a certain number of years. This would be treated as a cash outflow for the
amount expected to be paid in the year it is to be paid.
Tax Effect: The tax effect of a subsequent investment is treated in the same manner as the
original investment. Beginning with the year in which the additional investment is made, a
benefit is received in the form of tax savings resulting from the subsequent depreciation of the
additional investment, covered in the topic on the depreciation tax shield.
2) Subsequent working capital investment. The company may need another increase in its work-
ing capital later in the project’s life. This additional increase is treated in the same manner as the
increase in working capital at the beginning of the project (as a cash outflow), except that, of
course, it occurs in a later year.
Tax Effect: As is the case with the original investment in working capital, any increase in
working capital in subsequent periods has not tax effect.
Depreciation Tax Shield – A Cash Inflow

The most difficult recurring cash flow over the life of the asset is the cash flow that arises from the depre-
ciation tax shield. The tax effect of an asset is received as it is depreciated. Depreciation is a tax-deductible
expense, so it increases expenses and decreases net taxable income on the firm’s tax return. The tax
benefit is received in the form of reduced taxes due to the decreased taxable income. This tax reduction is
not an actual cash inflow, but it does reduce the cash outflow for tax payments. Therefore, the amount of
tax savings that occurs as a result of the depreciation expense is treated as a cash inflow for capital budg-
eting purposes. The amount of tax savings that results from the depreciation is called the depreciation
tax shield.
The depreciation tax shield is calculated as follows for each year of an asset’s life:
Depreciation Tax Shield = Full Cost of Asset × Annual Depreciation Rate × Tax Rate
Cash Flows at the Disposal or Completion of the Project

The termination of a project creates a number of potential cash flows:
1) Cash received from the disposal of equipment. Cash received from the sale of related assets
(equipment or the investment project itself) is a cash inflow in the project’s final year.
Tax Effect: If the sale of the assets results in either a gain or a loss, there will be a tax effect.
The gain or loss is calculated by subtracting the tax basis (or book value, if the tax basis is not
given) from the cash received and multiplying the result by the tax rate. Remember that the
basis is the full cost of the asset minus accumulated tax depreciation on the sale date.
If there is a gain, reduce the cash inflow by the taxes paid on the gain. If there is a loss, it will
be tax deductible and will result in tax savings. Add the tax savings to the cash received from
the sale to calculate the cash inflow. This tax treatment is calculated in the same way as the
calculation of the gain or loss on the sale of old assets at the beginning of the project.
2) Recovery of working capital. The initial incremental investment in working capital and any sub-
sequent investments in working capital are usually fully recouped at the end of the project. The
inventory associated with the project will have been used in production and the finished goods will
have been sold. The final accounts receivable will be collected and not replaced with other accounts
receivable for this project. All the related accounts payable will have been paid. It is also possible
for an investment in working capital to be recovered before the end of the project. Whenever
working capital is recovered, it is a cash inflow in the year of recovery.
Tax Effect: There is no tax effect related to working capital because working capital is neither
an income nor an expense. Therefore, the amount that needs to be included in the capital
budgeting analysis is the actual amount of the working capital that is recovered at the end of
the project.
Irrelevant Cash Flows

Some cash flows are not relevant to a capital budgeting analysis and should be disregarded. Irrelevant cash
flows include the following.
Sunk Costs and Allocated Common Costs

Sunk costs such as the amount paid historically or the current book value of existing assets that will
continue to be used are irrelevant because they will not change as a result of any capital budgeting project
decision made.
The allocation of common costs to a particular segment may increase due to a capital budgeting project
if the common costs are allocated based on assets or sales and the basis used increases as a result of the
capital budgeting project. However, the increase in the cost allocation is irrelevant unless the total com-
mon costs for the company as a whole will change as a result of the project. If the total overhead
costs will increase, the only relevant cash flow related to them is the increase in total common costs
that the project generates. If the common costs do not change in total but are allocated differently as a
result of the project and this particular segment receives a greater allocation, then other segments will
receive less. As long as the total common costs incurred do not change as a result of the project, there is
no relevant increase in costs for the company as a whole.
Financing Cash Flows

Financing cash flows associated with the project—principal and interest payments on new debt or divi-
dends on new stock issued—are irrelevant and are not a part of any capital budgeting analysis. The
cost of the financing is captured in the discount rate, or hurdle rate, 72 used to discount the future cash
flows for discounted cash flow methods. To include the cash flows for financing in the analysis would be to
double count them.
If financing can be obtained on a more favorable basis than anticipated, it could add value to the project;
however, the financing cash flows are never included in the capital budgeting analysis that is used to decide
whether or not to accept a proposed capital budgeting project.
Capital Budgeting Methods

The capital budgeting methods that are covered on the CIA exam are:
1) Payback Period or Payback Method
2) Discounted Payback Period
3) Net Present Value
4) Internal Rate of Return
5) Accounting (or Average) Rate of Return
The first four methods are based on the relevant after-tax cash flows. The final method is based on ac-
counting income and assets. Methods 2, 3, and 4 use time value of money concepts.
72
The hurdle rate is the minimum rate of return on a project or investment required by company management or an
investor. The company’s cost of capital is usually the hurdle rate for a capital budgeting project. However, if management
perceives unusual risk in an investment, it should set the hurdle rate higher than the cost of capital to compensate for
the additional risk it is taking.
1) Payback Period or Payback Method

The Payback Method is used to calculate the number of periods that must pass before the net after-tax
cash inflows from an investment will equal, or “pay back,” the initial investment cost. A company using
the payback method will choose its desired payback period. Projects with payback periods of less than the
chosen amount of time are candidates for further consideration, while projects with payback periods in
excess of the chosen amount of time are rejected.
If the expected cash inflows are constant over the life of the project, the payback period can be calcu-
lated as follows:
Initial net investment

Payback Period =
Periodic constant expected cash inflow
If the expected cash inflows are not constant over the life of the project, the payback period is calcu-
lated by determining the cumulative net cash flow (inflows and outflows) at the end of each year of the
project’s life (including Year 0) to find in which period the inflows will equal the outflows.
Example of the Payback Method with Equal Annual Cash Flows

A company is considering the purchase of a new piece of equipment to introduce a new product line. The
equipment will cost 125,000 including setup costs, installation, and testing. The estimated before-tax an-
nual cash flow from operations is 50,000. The company has an effective income tax rate of 30%.
The equipment will have an economic life of five years and will be depreciated for tax purposes using the
straight-line method. The equipment will have no residual, or salvage, value at the end of its five-year life.
No working capital investment will be required. The company’s required rate of return is 10%.
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Initial Investment in Equipment (125,000)
After-Tax Cash Flow from Operations

35,000 35,000 35,000 35,000 35,000
(50,000 × (1 – 0.30)
Depreciation Tax Shield ([125,000 ÷ 5] ×

7,500 7,500 7,500 7,500 7,500
0.30)
Total After Tax Cash Flows (125,000) 42,500 42,500 42,500 42,500 42,500
Initial net investment

Payback Period =
Periodic constant expected cash inflow
125,000
Payback Period = = 2.94 years
42,500
Benefits of the Payback Method of Capital Budgeting
• It is simple and easy to understand.
• It can be useful for preliminary screening when there are many proposals.
• It can be useful when expected cash flows in later years of the project are uncertain. Cash flow
predictions for periods far in the future are less certain than predictions for three to five years
ahead.
• It is helpful for evaluating an investment when the company desires to recoup its initial investment
quickly.
• Since the Payback Method favors projects with short time horizons, it can be used to concentrate
on more liquid projects and thus avoid tying up capital for long periods of time.
• The Payback Method can help a company manage risk when evaluating the feasibility of a project
in an unstable environment, where quick profit-making is preferable.
Limitations of the Payback Method of Capital Budgeting
• It ignores all cash flows beyond the payback period and does not consider total project profitability.
Therefore, a project that has large expected cash flows in the latter years of its life could be rejected
in favor of a less profitable project that has a larger portion of its cash flows in its early years.
• The Payback Method does not incorporate the time value of money. Therefore, interest lost while
the company waits to receive money is not considered.
• It ignores the cost of capital, so the company could accept a project for which it will pay more for
its capital than the project can return.
Introduction to Discounted Cash Flow Methods

Discounted cash flow (DCF) methods measure all of the expected cash inflows and outflows of a project
using time value of money concepts. The premise of time value of money concepts is that money received
today is worth more than money received in any future period. In a discounted cash flow analysis, the
earlier that a project is able to generate cash inflows the better, because cash flows received earlier in a
project’s life are worth more than cash flows received later. The focus of discounted cash flow methods is
on the cash return that can be obtained in the future for a cash outlay now.
In discounted cash flow analysis, unless otherwise directed, always assume that all expected cash flows
occur at the end of the year. In some instances, a problem may say that a particular cash flow occurs
at the beginning of the year. If that happens, treat the cash flow occurring at the beginning of the year as
though it occurs at the end of the previous year.
Though this assumption about cash flows occurring only at the end of a year is not in line with reality, it is
a necessary assumption in order to be able to use discounted cash flow techniques to determine the present
value of the expected cash flows. The inaccuracy introduced by this assumption is not material to the
analysis and would not cause a change in the decision.
The Discounted Payback Method, the Net Present Value Method, and the Internal Rate of Return Method
use discounted cash flows.
Time value of money concepts are covered in this volume and present value and future value factor tables
are included in Appendix A, Time Value of Money Concepts (Present/Future Value).
2) Discounted Payback Period

The Discounted Payback Method (also called Breakeven Time) is based on the same concept as the
Payback Method, but before calculating the payback period, the expected cash flows are discounted to their
present values using an appropriate interest rate, usually the company’s cost of capital. The Discounted
Payback Method addresses the Payback Method’s limitation of not incorporating the time value of money.
Example of the Discounted Payback Method

nual cash flow from operations is 50,000. The company has an effective income tax rate of 30%.
No working capital investment will be required. The company’s required rate of return is 10%.
Although the undiscounted cash flows throughout the life of the project are equal, the discounted cash
flows are not equal because the discounted cash flow for each year is different. Therefore, the payback
period must be calculated differently. It is necessary to calculate the cumulative net cash flow for each year
of the project’s life until the discounted cash flows for the subsequent years are equal to the cash outflow
in Year 0. Then, the discounted payback period is calculated as shown.

35,000 35,000 35,000 35,000 35,000
(50,000 × (1 – 0.30)
Depreciation Tax Shield

7,500 7,500 7,500 7,500 7,500
([125,000 ÷ 5] × 0.30)
PV of 1 Factor for 10% 1.000 0.909 0.826 0.751 0.683 0.621
Discounted Cash Flow (125,000) 38,633 35,105 31,918 29,028 26,393
Cumulative Discounted Cash Flows (125,000) (86,367) (51,262) (19,344) 9,684 36,077
The cumulative cash flow from the project becomes positive sometime during Year 4. Assuming that the
cash flows occur evenly throughout the year, the exact payback period is 3.67 years, calculated as follows:
Number of the project year in the final year when cash flow is negative: 3
Plus: a fraction consisting of:

Numerator = The positive value of the negative cumulative discounted
cash inflow amount from the final negative year 19,344
Denominator = Discounted cash inflow for the following year 29,028
19,344
Discounted Payback Period = 3 + = 3.67 years
29,028
This same method is used for the Payback Period (using undiscounted cash flows) when the total after-tax
cash flow amounts are not the same for the years following Year 0.
3) Net Present Value (NPV) Method

The Net Present Value (NPV) method is based on the present value of the expected monetary gain or loss
from a project. All expected cash inflows and outflows are discounted to the beginning of the project, using
the required rate of return. The NPV of an investment or project is the difference between the present
value of all future expected cash inflows and the present value of all (initial and future) expected
cash outflows, using the required rate of return.
Thus, a project’s NPV is the present value of its future expected cash inflows minus the present value of its
future expected cash outflows. The initial cash outflow occurs at the very beginning of the project, so that
amount is not discounted (or if it is, it is “discounted” by multiplying it by 1.0). Some projects may have
other net cash outflows (negative cash flows) in subsequent years of the project. If so, those future negative
cash flows are also discounted and the discounted cash outflow amounts are also deducted from the present
value of the project’s future expected cash inflows.
The present value of the expected cash flows is calculated using a discount rate that is the company’s
required rate of return (RRR), which is one of two options:
• The return the company can expect to receive in the market for an investment of comparable
risk
• The minimum rate of return that the project must earn to justify investment of the resources
This required rate of return is also called the discount rate, hurdle rate, or opportunity cost of capital.
Generally, the company’s cost of capital is used as the discount rate. However, the required rate of return
used to discount the future expected cash flows and compute the NPV must be appropriate to the pro-
ject’s risk.
Interpretation of an NPV Analysis

An NPV analysis is interpreted as follows:
• When a project has a positive NPV, it will be profitable because it will earn more than it will cost
the company. Shareholder wealth will increase. The project is acceptable.
• When a project has a zero NPV, the present value of its expected future cash inflows is exactly
equal to the present value of the expected cash outflows. Shareholder wealth would neither in-
crease nor decrease. A project with a zero NPV is questionable at best. Technically, the company
would not lose money on it, but a zero NPV does not provide any motivation to embark upon the
project. Furthermore, the project would have no margin of safety. If the expected cash inflows
were not achieved, the project could quickly become unprofitable.
• When a project has a negative NPV, the project would be unprofitable because it would cost the
company more than it could earn. Shareholder wealth would decrease. The project is not accepta-
ble.
Example of the Net Present Value Method

equipment will cost 125,000 including setup costs, installation, and testing. The project will require a work-
ing capital investment of 15,000 at inception, which will be recovered at the end of the five-year period.
The estimated before-tax annual cash flows from operations are:
Year 1 35,000
Year 2 40,000
Year 3 45,000
Year 4 50,000
Year 5 55,000
The company has an effective income tax rate of 30%. The company’s required rate of return is 10%.
Working Capital Investment (15,000) 15,000

24,500 28,000 31,500 35,000 38,500
(Before-tax cash flow × (1 – 0.30)
Depreciation Tax Shield

7,500 7,500 7,500 7,500 7,500
([125,000 ÷ 5] × 0.30)
PV of 1 Factor for 10% 1.000 0.909 0.826 0.751 0.683 0.621
Discounted Cash Flow (140,000) 29,088 29,323 29,289 29,028 37,881
Cumulative Discounted Cash Flows (140,000) (110,912) (81,589) (52,300) (23,272) 14,609
The cumulative discounted expected cash flow at the end of the project, which is its NPV, is 14,609.
The NPV of a project is also the sum of all the discounted cash inflows and outflows from the project over
its life minus the initial investment. In this case, the sum of all the discounted cash inflows from the project
over its life is 154,609, while the net investment is 140,000. Thus, the NPV is 154,294 − 140,000 = 14,609.
Since the NPV is positive, this project is acceptable.
Benefits of the Net Present Value Method of Capital Budgeting
• It provides an estimate of the profitability of a project and the amount of change in shareholder
wealth that should take place if the project is undertaken.
• It takes into consideration the time value of money.
• It can be used to manage risk in a project by adjusting the required rate of return used as the
discount rate to compensate for projects with higher or lower risk than the company’s current
projects.
• NPV enables ranking of potential projects according to their expected returns, which is useful when
a firm has limited funds for capital projects.
• It can incorporate a fluctuating required rate of return during the life of the project.
Limitations of the Net Present Value Method of Capital Budgeting
• NPV incorporates an assumption that all cash inflows from the project will be reinvested at the
required rate of return, which may not be the case and which may lead to an incorrect evaluation
of the project’s true worth.
• Since the NPV is expressed as a monetary amount, it does not provide an expected rate of return
on the investment.
• There is the risk of incorrect assumptions, which can affect the validity of the results.
• The firm’s actual cost of capital may vary significantly from the discount rate used in the NPV
analysis due to market fluctuations, which can cause the actual change in shareholders’ value to
be different from the initial estimates.
• Cash flows beyond the initial expected lifetime of the project are not recognized in an NPV analysis
but can provide additional shareholder value.
4) Internal Rate of Return (IRR)

The Internal Rate of Return (IRR) for a project is the interest rate (that is, the discount rate) at which
the present value of its expected cash inflows equals the present value of its expected cash outflows. In
other words, the IRR is the interest (discount) rate at which the NPV is equal to zero.
Evaluating IRR
If the IRR is higher than the required rate of return management has established for the project (or hurdle
rate), the project is acceptable. If the IRR is lower than the required rate of return, the project is not
acceptable and should not be considered further.
Remember that the IRR is a rate, in contrast to NPV, which is an absolute monetary amount.
Benefits of the Internal Rate of Return Method of Capital Budgeting
• As a discounted cash flow method, the IRR accounts for the time value of money.
• The IRR can be compared with a required rate of return that is based on market return rates for
similar investments or another hurdle rate chosen by management.
• It is easier for managers to understand and interpret than net present value.
Limitations of the Internal Rate of Return Method of Capital Budgeting
• The IRR incorporates an assumption that the cash inflows from the project will be reinvested at the
Internal Rate of Return. If that is not a valid assumption, the calculated IRR will not represent the
project’s true rate of return.
• If a project is nonconventional (has a negative cash flow or flows after Year 0), it will have more
than one IRR, or the IRR may not be able to be calculated.
• When investments are mutually exclusive and are of different sizes or have different cash flow
patterns, the information provided by the IRR may not be useful for decision making.
5) The Accounting (or Average) Rate of Return

The accounting rate of return (ARR) is a ratio of the amount of the expected increase in annual average
accounting income as a result of the project relative to the required investment. It is calculated as:
Accounting Rate Increase in Expected Annual Average After-Tax Accounting Net Income
=
of Return (ARR) Net Initial Investment
Since the ARR method uses accrual accounting income, the numerator includes depreciation.
The accounting rate of return method does not include any consideration of the time value of money, and
therefore it is also called the unadjusted rate of return model.
Note: Sometimes the average investment is used in the denominator rather than the net initial in-
vestment. The average investment is usually calculated as the initial investment divided by 2, because
the investment will have a book value of zero at the end of the project. Dividing the initial investment
balance by 2 produces the same result as calculating the average balance by summing the beginning
and ending balances and dividing the sum by 2.
When management evaluates a project using the ARR method, it first determines a required accounting
rate of return for the project. Management then compares its calculated accounting rate of return for the
project with its required accounting rate of return. Projects with returns that exceed the required rate are
considered acceptable.
Both the ARR and the IRR produce a rate of return. However, ARR bases the calculation of this rate of
return on accrual net income, not cash flow, and does not consider the time value of money. IRR,
on the other hand, bases the calculation on cash flow and the time value of money. For capital budgeting
purposes, IRR provides better information.
Example of the Accounting Rate of Return

nual income from operations (not including depreciation) are:
Year 1 35,000
Year 2 40,000
Year 3 45,000
Year 4 50,000
Year 5 55,000
The company has an effective income tax rate of 30%.
straight-line method.
The annual average expected after-tax accounting income from operations is:
Before-Tax Net Before-Tax Net After-Tax

Income from Income from Income from Opera-
Operations Operations tions (Before-Tax
(Excluding Reduced by Operating Income ×
Depreciation) Depreciation Depreciation (1 − 0.30)
Year 1 35,000 25,000 10,000 7,000
Year 2 40,000 25,000 15,000 10,500
Year 3 45,000 25,000 20,000 14,000
Year 4 50,000 25,000 25,000 17,500
Year 5 55,000 25,000 30,000 21,000
Average 14,000
14,000
Accounting Rate of Return (ARR) = = 0.112 or 11.2%
125,000
The ARR can also be calculated using the average investment amount in the denominator. The average
investment amount over the life of the project is 125,000 ÷ 2 = 62,500.
14,000
Accounting Rate of Return (ARR) = = 0.224 or 22.4%
62,500
Benefits of the Accounting Rate of Return Method of Capital Budgeting
• Since ARR focuses on operating income, the computations are easy to do and understand.
• When the Accounting Rate of Return method is being used to evaluate management, it is con-
venient to also use it to evaluate projects.
Limitations of the Accounting Rate of Return Method of Capital Budgeting
• The results of the ARR are affected by the method of depreciation used.
• The ARR does not use cash flow.
• The ARR does not incorporate the time value of money. Therefore, interest lost while the company
waits to receive money is not considered.
Adjustments to the Hurdle Rate for Risk

The company’s weighted average cost of capital (WACC) is the appropriate hurdle rate in capital budgeting
decisions and NPV calculations as long as the project’s riskiness is the same as the riskiness of the
company’s existing business. If a project has risk characteristics that differ from the risk of the com-
pany’s existing business, the company’s WACC can be adjusted and a risk-adjusted discount rate used
in the capital budgeting analysis to reflect the amount of risk in the project.
Risk-Adjusted Discount Rate = Weighted Average Cost of Capital +/− Risk Adjustment
1) A company should increase the discount rate used in capital budgeting for investments that are
riskier or more uncertain than the company’s present portfolio of investments. A higher discount
rate requires higher expected future cash flows for the investment to be acceptable, which makes
fewer investments acceptable.
2) A company should lower the discount rate used for investments it judges to be less risky than
the company’s present portfolio of investments, which increases the probability that a given in-
vestment will be acceptable.
When the risk adjustment is an increase to the firm’s WACC, the risk adjustment is called a risk premium.
For the WACC to be used as a hurdle rate without any risk adjustment, the following two conditions must
be met:
1) The new project must not substantially change the firm’s operating environment. If a new project
introduces significant change, risks (as discussed above) must be accounted for.
2) The new capital must be raised in the same proportions as the existing capital, so that the com-
pany’s financial risk remains the same.
If either of these two assumptions does not hold true, the discount rate used as the required rate of return
must be adjusted to reflect the change in the firm’s risk profile that will result from the project.
Thus, a higher risk-adjusted discount rate reflects higher risk, since with a higher discount rate, the
expected cash flows from the investment will need to be higher to create a positive NPV. If the expected
cash flows are not higher, increasing the discount rate could change a positive NPV to a negative NPV, and
the project would be more likely to be rejected. Conversely, if the project is safer than the existing business
of the firm, a discount rate that is lower than the present Weighted Average Cost of Capital should be used
as the required rate of return, increasing the chances of the project’s being accepted.
However, discount rates should not be adjusted for nonmarket risks that are unique or diversifiable, such
as the possibility that a new drug may not be approved or that a drilling project will be unsuccessful.
Instead, the expected cash flows should be adjusted to reflect those risks. If expected project cash
flows give weight to all possible outcomes, both favorable and unfavorable, they will be correct on average.
In other words, the expected cash flows for some projects will be too high and for other projects they will
be too low, but over a long period of time and several projects, the total actual cash flows should be close
to the total expected cash flows.
After adjusting cash flow forecasts for the nonmarket, or diversifiable, risks, management should then
consider whether or not systematic, or market, risks require adjustment of the discount rate.
Note: The preceding guidelines for risk-adjusting the discount rate apply only to projects with positive
net cash flows, in other words projects with cash inflows that exceed their cash outflows. If all of the
cash flows for a project are negative, for example because the project has only costs and no related
revenues or has revenues that are lower than its costs, the guidelines for risk-adjusting the discount
rate are reversed. The discount rate for a project with greater risk should be decreased, whereas the
discount rate for a project with lesser risk should be increased.
1 E 3. Basic Taxation
Taxes are calculated using two measures: a base and a rate structure.
1) The tax base is the value on which the tax is levied. Taxes are levied on items such as personal
income, sales value, property value, or corporate net income. A tax base can be either a stock
measure or a flow measure. A stock measure is a current value, such as the market value of a
home or, for a business, its land and building and the value of its equipment and inventory on
hand. Income and sales tax bases are flow measures.
2) The tax rate structure determines the proportion of the tax base that is due in taxes. For
example, in the U.S., property taxes are levied as a certain dollar amount per $100 of property
value. That dollar amount per $100 of property value is the proportion of the tax base (the tax
base is the property’s value), or the tax rate.
Example: The property tax on property valued at $100,000 is $2.75 per $100 of assessed value. The
property tax due each year is ($100,000 ÷ $100) × $2.75 = $2,750.
Direct vs. Indirect Taxes

Direct taxes are paid directly to the governmental taxing authority by the taxpayer. Examples are personal
income taxes or personal property taxes. Direct taxes cannot be shifted to others.
Indirect taxes are taxes that are collected by one entity in the supply chain and paid to the government,
but they are passed on to the consumer as part of the purchase price of the good or service. Ultimately,
the consumer pays the tax by paying more for the product.
Import tariffs are the classic example of indirect taxes. They are paid by the importer, and when the im-
porter resells the imported goods, the importer charges a price that covers the cost of the goods, profit,
and also the tariff. Value-added tax is another example of an indirect tax. Value-added taxes are imposed
on each member of a supply chain as a product moves along the chain to the final consumer. Each member
of the supply chain pays the tax on its purchases and marks up the price to the next member. The final
price to the ultimate consumer includes all of the taxes imposed all the way along the supply chain, but the
tax is not delineated in the invoice.
A business can recover the cost of the indirect taxes it pays if it can charge higher prices to its customers;
however, the amount that can be passed on depends on the price elasticity of demand and supply for the
product.
A sales tax can be either a direct tax or an indirect tax. If the sales tax is collected only on the final sale
amount when the item is sold to the ultimate consumer, it is a direct tax, even though it is collected by the
seller and remitted by the seller to the government, because it is specifically delineated on the invoice the
consumer pays or the receipt the consumer receives. However, if a sales tax is imposed the same way
value-added taxes are, at each point in the production process on each member of the supply chain and
each member then marks up the price to the next member of the supply chain, then it is an indirect tax.73
Progressive, Proportional, and Regressive Taxes

All taxes are paid out of income and can be classified in three ways:
Progressive taxes increase the percentage of tax as an individual’s income increases.
Proportional taxes remain a constant percentage of income at all levels of income. An example of a
proportional income tax is a flat tax of 15% on every type of income, with no deductions or exclusions, and
no variation in rate between a person earning 5,000 and a person earning 5,000,000.
73
“Indirect Tax”, Investopedia.com, <https://www.investopedia.com/terms/i/indirecttax.asp> (accessed Oct. 8, 2018).
Regressive taxes decrease as a percentage of income as income increases. With a regressive tax, lower-
income taxpayers pay a higher percentage of their income in taxes than do higher-income taxpayers. As a
taxpayer’s income increases, a regressive tax becomes a lower percentage of the taxpayer’s income. Ex-
amples of regressive taxes include property taxes, cigarette taxes, or any tax that is a fixed amount or
based on anything other than income.
Sales taxes are regressive taxes because, although higher-income individuals may pay a larger absolute
amount of sales taxes because they buy more, they actually pay a smaller proportion of their incomes in
sales taxes than do lower-income individuals.
Income Taxes
Income taxes in the U.S. are collected from individuals, corporations, and other taxable entities by the
federal government, many individual states, the District of Columbia (Washington, D.C.), and cities. Per-
sonal income taxes are paid on all types of income, such as employee wages and salaries, dividends,
interest, rental income, and capital gains, although most income is in the form of employee wages and
salaries.
The federal income tax and some state income taxes are progressive. Various deductions reduce the
amount of the income subject to personal income tax. For corporations, taxable income is net income after
deductible expenses are deducted, although some expenses that appear on the corporation’s statement of
profit or loss may not be deductible for tax purposes, and some items that are deductible for tax purposes
do not appear on the corporation’s statement of profit or loss in the same year as they are deducted on the
tax return.
Income Tax Rates

In a progressive income tax structure, the marginal tax rate is the tax rate that is charged on the next
X amount of income. The marginal tax rate increases as taxable income increases.
Example: In a country with a progressive income tax, the first 5,000 in taxable income earned by a
taxpayer is not taxed, because all taxpayers have an automatic deduction of 5,000 per year. The next
5,000 in taxable income is taxed at the rate of 10%. The next 15,000 in taxable income is taxed at 15%.
The next 10,000 in taxable income is taxed at 20%, and income greater than $35,000 is taxed at 25%.
A taxpayer with 30,000 in taxable income in a year’s time would owe income tax of 3,750: (5,000 ×
0%) + (5,000 × 10%) + (15,000 × 15%) + (5,000 × 20%).
The taxpayer’s marginal tax rate is 20%, because taxable income above 30,000 up to 35,000 would
be taxed at 20%.
The average tax rate is calculated as the taxpayer’s total tax liability divided by the total taxable income
(for example, earned interest on tax-exempt municipal bonds would not be included in federal taxable
income).
Example: The taxpayer in the previous example who earned taxable income of 30,000 and paid 3,750
in income tax would have an average tax rate of 3,750 divided by 30,000, or 12.5%.
The effective tax rate is total tax liability divided by total income. Total income includes all income, even
income that is not taxable (for example, earned interest on federally tax-exempt municipal bonds).
Example: If municipal bonds are tax-exempt and the taxpayer in the example had tax-exempt municipal
bonds that earned 1,250 in interest during the year, the taxpayer’s total income for the year would be
31,250, although taxable income would be only 30,000. The taxpayer’s effective tax rate would be
3,750 divided by 31,250, or 12%.
Income Taxes Indexed for Inflation

Because the marginal tax rate increases as income increases, a high earner pays a higher average percent-
age of gross income in income taxes than a low earner.
What happens when employers raise employees’ salaries to keep up with inflation? If increases in income
move people into a higher tax bracket, they could have to pay a higher percentage of their income in taxes.
They could actually end up financially worse off than before the increase because they cannot buy as many
goods and services. However, if the income tax rates are indexed for inflation, then the tax brackets
increase each year so that people do not move into a higher tax bracket as a result of a salary increase
that just keeps up with inflation. Thus, as inflation increases, the amount of income tax paid by taxpayers
will remain approximately the same as a percentage of their total income.
In the U.S., tax brackets are indexed for inflation, so each year the brackets change. For example, in 20X7
a taxpayer may have paid 10% income tax on the first $7,825 earned. Amounts above $7,825 earned in a
year’s time are taxed at a higher rate. In 20X8, an inflation index is applied and for 20X8, the taxpayer will
pay 10% income tax on the first $8,000 earned before paying higher rates on higher amounts. When tax
rates are indexed, deductions also need to be increased each year in connection with an inflation indicator.
Sales and Excise Taxes

A sales tax is levied on most sales of goods and services by local taxing authorities. Almost all state and
local governments use general sales taxes to generate revenue. Sales tax rates vary by state and by loca-
tion within each state. Sellers of goods and services add the sales tax to their prices, collect it from their
customers, and remit it to their local taxing authorities on a regular basis.
Excise taxes are levied only on specific items, such as gasoline or automobile tires. The tax is added to the
sales price of the item and is remitted to the federal government. In addition to generating revenue, some
excise taxes are designed to induce people to behave in certain ways. For example, an excise tax on ciga-
rettes is designed to reduce smoking.
Property Taxes
Although local governments receive revenue from sales taxes and in some cases local income taxes, prop-
erty taxes are their most important source of revenue, particularly for the benefit of school districts.
Property taxes are based on the value of taxable property, which includes residential property and business
property (fixed assets and inventory). The local government maintains tax records on each piece of property
that contain its assessed value, or the tax base used to calculate the tax due. These assessed values
generally change from year to year. The tax rate is often called a millage and it is usually quoted in the
U.S. as an amount due per $100 of property value.
The property tax is the only important U.S. tax that is not based on income or on buying or selling. It is
based on wealth or, more specifically, the value of property that is owned.
Payroll Taxes
Federal payroll taxes are levied on wages and salaries paid to employees. The primary payroll taxes in the
U.S. are Social Security and Medicare, which are paid half by the employee through payroll deductions and
half by employers, who pay a matching amount as a business expense. Payroll taxes are the second most
important source of federal revenue after income taxes. Employers are responsible for filing payroll tax
returns and remitting both their share and their employees’ shares to the federal government.
Social Security taxes are proportional (a flat percentage rate) up to a ceiling that is usually increased
annually to keep up with inflation, and after that point the marginal tax rate is zero. Therefore, high-income
employees pay a smaller percentage of their total income in payroll taxes than do lower-income employees,
so payroll taxes are considered to be somewhat regressive.
Medicare taxes are also proportional. However, there is no ceiling on income subject to Medicare taxes. In
fact, an Additional Medicare Tax applies to an individual's Medicare wages that exceed a certain threshold
amount in a year’s time. Employers are responsible for beginning to withhold the Additional Medicare Tax
on an individual's wages when they exceed the threshold in a calendar year. There is no employer match
for the Additional Medicare Tax.
Value Added Tax (VAT)

Many industrial nations have adopted a value added tax (VAT), which is a tax on consumption. VAT is
essentially a national sales tax. Since consumers ultimately pay the VAT, people in lower-income groups
will spend a greater proportion of their income on the tax. Thus, VAT is a regressive tax.
Each company involved in the production of a good must submit a tax based on the value the company has
added to the product. This value is the difference between what the firm paid to acquire the inputs and
what it sold the outputs for. The amount of the VAT invoiced is based on the total amount invoiced, not
only the value-added amount by that seller. Generally, since each company is both paying and collecting
VAT, each company needs only to submit to the government the difference between their VAT paid and
their VAT received. Thus, value added tax is levied on the difference between a firm’s sales and its purchases
made from other firms of inputs to the production process.
When the seller files a VAT return, the seller reports the gross amount of all the VAT included on all of the
sales invoices it has issued to its customers. But it does not need to remit that amount. On its VAT return,
the seller takes a credit against the VAT that it owes to the government (the gross VAT on all of its invoices)
for any VAT that it paid for materials and services that it bought to make further supplies or services to be
sold to end users.
All of the VAT ends up being passed up the line to the end consumer or business user, because the total
amount of the VAT, based on the total of the consumer's invoice, is paid by the consumer. All of the
producers along the way who have added interim amounts of value to the product on which they have paid
tax have gotten the tax they paid back. Therefore, the end consumer pays all of the VAT.
1 E 4. Transfer Pricing
A transfer price is the price charged by one sub-unit of a company to another sub-unit of the same company
for the services or goods produced by the first sub-unit and “sold” to the second sub-unit. It can also be
the price for “sales” transactions between the parent and a sub-unit. The product or service that is sold and
purchased internally is called an intermediate product. It may be used as a component of a product that
is sold to the final customer by the center that purchased it internally, or the center that purchased it may
sell it outright to the final customer.
Transfer pricing is most common in firms that are vertically integrated; that is, they are engaged in several
different value-creating operations for a single product. For example, Division A produces components for
a product manufactured by Division B. Division A and Division B are both profit or investment centers and
both are divisions of Company C.
When transfers of goods or services are made from one profit center to another profit center within the
same company, the revenue received for the transfer by the selling division is a cost to the buying division.
The internal transaction is eliminated when the financial statements are consolidated. The net income for
the consolidated firm includes only the revenue received from the sale to the final customer and the cost
to manufacture the item that was incurred by all the divisions that participated in its manufacture. The
difference between the external revenue and the internal expense is the company’s consolidated gross
margin. Therefore, the transfer price used has no effect on the net income of the consolidated firm.
However, the price at which the transfer takes place does affect the earnings reported by the participating
divisions. If the transfer price used is not the market price, the discrepancy can distort reported divisional
profits and cause them to be a poor guide for cost center performance evaluation.
As long as the selling division has the necessary unused capacity, the company as a whole usually benefits
when one division of the company supplies a good or a service to another division of the same company,
because the cost to the selling division to produce or provide the item will usually be lower than the company
would need to pay to purchase the same item externally. For performance evaluation purposes, the benefit
the consolidated company gains from having one sub-unit provide an item to another sub-unit should really
be divided between the selling division and the purchasing division, and that can be done by means of the
transfer price used. Both divisions should benefit from the company’s supplying its needed goods and ser-
vices internally. As a result, the selling division’s markup may be slightly less than it would be if it were to
sell the same thing to an external customer. As long as the units the selling division sells internally are
units it would not have sold otherwise, its profit is improved. In addition, if the transfer price is set correctly,
the cost to the purchasing division will be lower than it would have been if it had bought the item externally,
so the purchasing division’s profit is also improved.
The transfer price used should motivate division managers to make decisions that will provide the greatest
benefit to the company while at the same time fairly rewarding the managers. Goal congruence is needed
among the various divisions and between the divisions and senior management, and management of the
company needs to be committed to achieving company goals. The transfer price used can help to achieve
goal congruence.
Thus, a proper transfer price can motivate both the selling and the purchasing division managers to make
decisions that provide the greatest benefit to the company, since the decisions that provide the greatest
benefit to the company will also provide the greatest benefit to the managers. Thus, a properly-established
transfer price promotes goal congruence.
Multinational Transfer Pricing and Taxes

For a multinational company with subsidiaries in different countries, the transfer price charged by a sub-
sidiary in one country to a subsidiary in a different country causes tax consequences that affect the whole
company. Different countries have different income tax rates.
At one time not too long ago, multinational corporations were able to manipulate transfer prices to decrease
their overall income tax burden by moving profits to the divisions in the countries with the lowest income
tax rates. However, today most countries’ taxing authorities have strict regulations that prohibit adjusting
transfer prices simply to move taxable income from one country to another to decrease income taxes,
because of course it decreases their countries’ tax revenues. In the U.S., Section 482 of the Internal Rev-
enue Code requires that transfer prices between a U.S. company and a segment of the same company in a
foreign country be equal to the price that would be charged by an unrelated third party in a similar trans-
action (in other words, an arm’s-length transaction). Other countries have similar tax regulations.
Therefore, transactions between subsidiaries of multinational corporations are supposed to be priced as

“arm’s-length” transactions. In other words, the prices should be the same as they would be if the
two parties were not related and should not be adjusted simply to shift income between coun-
tries to reduce the overall tax payment.
Note: Transfer pricing policies can create tax risks for multinational companies. Multinational companies
risk getting into trouble with the taxing authorities if they play around too much with their transfer
prices.
Multinational Transfer Pricing and Tariffs and Customs

Tariffs and customs duties charged on import of products into a country also create compliance risk for a
multinational company. The issues are similar to income tax considerations. Companies that are shipping
products from a unit in one country to another unit in a different country may be tempted to lower the
transfer price on products imported into a country in order to lower the tariffs and customs duties charged
on those products. The customs authorities are well aware of this tactic, and customs auditors look for
prices that are lower than a market price would be in an arms-length transaction.
Note: Exchange rates between currencies, differing currency laws or tariff laws from one country to
another, or the differing availability of materials or labor from country to country can all cause distortions
in actual performance of individual subsidiaries. When assessing the performance of each of its subsidi-
aries impacted by these factors, the multinational corporation needs to take these distortions into
consideration.
Transfer Pricing Objectives

Since multiple management objectives are involved in setting transfer prices, it can be extremely difficult
to establish well-balanced intra-company transfer prices. Any transfer pricing system needs to accomplish
the following:
• It should promote goal congruence.
• It should motivate the profit center managers to pursue their own profit goals while also working
toward the success of the entire company. The selling division should be motivated to hold its costs
down, and the buying division should be motivated to acquire and use the inputs efficiently.
• It should help senior managers evaluate the performance of individual sub-units.
• It should preserve autonomy74 in decision making among managers of divisions, if senior manage-
ment wants a decentralized organization.
• It should be equitable, permitting each unit of a company to earn a fair profit for the functions it
performs.
• It should meet legal and external reporting requirements.
• It should be easy to apply.
74
“Autonomy” refers to a manager’s freedom to make decisions. The greater the manager’s freedom is to make deci-
sions, the greater is the manager’s autonomy.
Methods of Setting the Transfer Price

Companies have several choices of methods for calculating the transfer price of a product or service. Gen-
erally, top management chooses the method of setting transfer prices and the decision should take into
account the goals of the entire company, maintain motivation of the affected divisions and division manag-
ers, and remain within legal and regulatory guidelines. The more common methods are:
• Market price
• Cost of production plus opportunity cost
• Variable cost
• Full cost
• Cost plus
• Negotiated price
• Arbitrary pricing
• Dual-rate pricing
1) Market Price
Market price is a transfer price equal to the current or market price of the selling division’s product in an
“arm’s-length” transaction. In other words, the transfer price is set as if the selling division were selling to
an outside customer, even though the selling division is really selling to another division of the same com-
pany.
Benefits of Using the Market Price as the Transfer Price
• When the selling division has an external market for the product, market price is almost always the
best transfer price to use for profitability and performance measurement because it is objective.
• A market price satisfies the “arm’s length” requirement by taxing authorities.
• It assures the management of the buying division that it is paying a fair price for the goods while
assuring the management of the selling division that it is receiving a fair price for the goods.
Limitations of Using the Market Price as the Transfer Price
• Sometimes no external market exists for a given product or component being transferred from one
segment to another, and thus a market price is not available.
• Each transfer of product entails profit and loss. Determining the actual cost of the final product may
be difficult because the final prices paid for the items transferred are different from the costs of
production.
• Intra-company profit must be eliminated from the unsold units still in inventories when consolidated
financial statements are prepared.
Note: Transfer price methods numbered 2 through 5 that follow are based on the production cost to the
selling division. All cost-based methods have a significant weakness in that the producing division is not
motivated to reduce the cost of production because management knows that the purchasing division will
have to pay for the costs incurred in production, whatever they may be. These cost-based methods
create great risk for the company because costs for the company as a whole can get out of control.
2) Cost of Production Plus Opportunity Cost

The cost of production plus opportunity cost includes the cost of production (outlay cost) and the profit
margin that the selling division is giving up by selling the product internally rather than externally. Though
the cost of production plus opportunity cost may be very close to the market price, it is not exactly a market
price because a true market price may only be set in an “arm’s length” transaction, which the cost of
production plus opportunity cost clearly is not.
3) Variable Cost
The variable cost method of setting a transfer price uses only the selling division’s variable costs as the
transfer price.
Benefits of Using Variable Cost as the Transfer Price
• Variable cost works well if the selling division has excess (unused) capacity and if the main objective
of the transfer price is to satisfy the internal demand for goods.
• A transfer price equal to variable cost encourages the buying division to purchase the item internally.
Limitations of Using Variable Cost as the Transfer Price
• The variable cost method is not appropriate if the seller is a profit or investment center and does
not have excess capacity, because selling at its variable cost will decrease the seller’s profitability
because the selling division could have earned greater profits had it sold the units externally. There-
fore, when the selling division does not have excess capacity, the selling division will prefer to sell
to an outside customer if the variable cost method is used to set the transfer price.
• It does not satisfy the “arms-length” requirement by taxing authorities.
• The producing division is not motivated to reduce the cost of production because management
knows that the purchasing division will have to pay for the costs incurred in production.
4) Full Cost
The full cost method includes all materials, labor, and a full allocation of overhead in determining a transfer
price. In other words, the transfer price is the inventory cost of the item, calculated using absorption cost-
ing. Nothing is added for a markup.
Benefits of Using Full Cost as the Transfer Price
• The use of full cost as the transfer price is well understood by the managers of both the buying
and the selling divisions and the cost information is easily available in the accounting records.
• Because the product is transferred at cost, intra-company profits do not need to be eliminated from
profit or loss statements and inventories in consolidated financial statements.
• The transferred cost can be easily used to compare actual and budgeted costs.
Limitations of Using Full Cost as the Transfer Price
• Because a full cost transfer price includes fixed costs, full cost can be misleading and can cause
poor decision-making.
• Full cost may not be appropriate in all cases for decentralized companies that need to measure the
profitability and performance of different profit centers.
• If full cost is used, the transfer price may actually be higher than the buying division would need to
pay if it were to purchase the item externally. However, the external price may be greater than the
selling division’s variable cost for the item. Since the company’s fixed production costs will be the
same whether the part is manufactured internally or purchased outside, the consolidated profit of
the firm will be lower if the purchasing division is incented to buy the item outside because pf the
higher transfer price.
• It may not satisfy the “arms-length” requirement by taxing authorities.
• The producing division is not motivated to reduce the cost of production because management
knows that the purchasing division will have to pay for the costs incurred in production.
5) Cost Plus
Under the cost plus method of setting transfer prices, the selling division adds either a fixed monetary
amount or a percentage of costs to the cost of production to approximate a normal profit markup. The
amount used as the “cost” includes variable costs and fixed costs for production and also for selling and
administrative expenses. Average variable cost (including variable selling and administrative costs) plus an
allocation of all fixed costs is used as the “cost,” and a percentage of that amount is added as a markup.
Either standard (or budgeted) costs or actual costs may be used in calculating the “cost.”
Note: Cost plus is what is generally used to price government contracts in the U.S. The U.S. government
created a commission to determine what the cost of production is for government contracts and what
can be included as a cost in calculating a cost-plus price.
Benefits of Using Cost-Plus as the Transfer Price
• The cost-plus method can be used when a market price is not available.
• If standard costs are used, then there will be an opportunity to separate out variances between
actual costs incurred and standard or budgeted costs.
Limitations of Using Cost-Plus as the Transfer Price
• If actual costs are used, then the manager of the producing and selling division will not be moti-
vated to control the division’s costs, since whatever costs are incurred will be passed on to the
purchasing division.
• If the profit markup is a percentage of cost, it actually gives the selling division an incentive to
inflate the cost through production inefficiencies and excessive allocation of common costs.
6) Negotiated Price
The affected division managers and senior management negotiate a transfer price that is acceptable to all
parties.
Benefits of Using a Negotiated Price as the Transfer Price
• Negotiation is most useful when the products in a market are rapidly changing and the companies
need to be able to react quickly to changes in the marketplace.
• Negotiation can also be helpful if the sub-units are having a conflict and negotiation can bring about
a resolution.
Limitations of Using a Negotiated Price as the Transfer Price

• In order for negotiation to work in setting transfer prices, each division or unit must have the ability
to determine the amount of its materials that it buys or the amount of its output that it sells.
• In order for negotiation to be effective, neither negotiating party should have an unfair bargaining
position over the other.
• Negotiation can be time-consuming and require frequent revision of transfer prices due to changing
costs and market conditions.
• A negotiated price may or may not satisfy the “arms-length” requirement by taxing authorities.
• The resulting division profits may be more a measurement of the manager’s negotiating ability than
the division’s productive efficiency.
7) Arbitrary Pricing
Transfer prices may simply be set by central management to achieve some overall objective.
Benefits of Arbitrary Pricing as a Transfer Price
• The price achieves the objectives that central management considers most important.
Limitations of Arbitrary Pricing as a Transfer Price
• Arbitrary pricing defeats the goal of making divisional managers profit-conscious.

• It hampers the autonomy of the division managers as well as their profit incentive.
• It may or may not satisfy the “arms-length” requirement by taxing authorities.
8) Dual-Rate Pricing
Dual-rate pricing is a method in which the selling division and the purchasing division each record the
transaction at different prices. For example, the seller records the transfer price at market value, but the
purchasing division records it at the variable cost of production. As a result, each division’s financial results
appear more positive, at least on paper. With dual-rate pricing, the sum of the divisional profit amounts
will be greater than the profit for the company as a whole.
Benefits of Using Dual-Rate Pricing as a Transfer Price
• The selling division has an incentive to expand sales and production.

• The buying division gets to book the product’s purchase at its actual cost to the firm, so the buying
division’s costs do not include an artificial profit for the selling division.
• Variable cost is used for decision-making but market price is used for evaluation.
Limitations of Using Dual-Rate Pricing as a Transfer Price
• Dual-rate pricing is complex.

• Evaluating the relative performance of the selling and the buying divisions is inherently difficult
because their profits have been determined on different bases.
Deciding Which Method to Use
Note: Theoretically as well as legally, a market price is the best method for determining a transfer price,
as use of a market transfer price essentially treats all internal divisions as though they were separate
companies.
When deciding which method to use, management will generally consider a number of factors. The most
common factors are the following:
• The goals of the company and what method will best enable those goals to be met (goal con-
gruence), and
• Factors relating to the capacity of the producing division, its ability to sell the product on the
open market, and the ability of the purchasing division to buy the product on an open market.
• Legal and regulatory requirements and limitations.
Ultimately, the selling division should be able to recover its costs plus an opportunity cost, if applicable,
and the purchasing division should not be required to pay more than the market price. An opportunity cost
would be applicable if the selling division were operating at capacity and thus would be forced to decline
orders from outside customers to fulfill the needs of the internal purchasing division. The opportunity cost
is the contribution margin the selling division could have earned on the external sales lost as a result of
fulfilling the internal division’s requirements instead of selling to the outside customer.
Usually, the transfer should be done at the market price, as only the market price will satisfy all the objec-
tives above. However, in some situations a below-market price would still be beneficial to both divisions as
well as to the firm as a whole while satisfying legal requirements. Such a situation will occur if the selling
division has excess capacity, because whatever contribution margin it earns from the internal sale will
improve its profit.
If the selling division has excess capacity, transferring the goods at any price that is greater than its variable
cost of production makes sense. By doing so, the selling division will have a greater contribution and thus
a greater profit than it would have had otherwise, and the purchasing division will have a lower cost of
production because the internal transfer price is lower than the market price.
However, if the selling division does not have excess capacity, then for it to be willing to sell internally, the
transfer price must be high enough to cover the selling division’s variable costs of production plus the
contribution that it will lose by having to cancel an existing order. The Blitz Corporation example that follows
illustrates a situation where the selling division is operating at 100% capacity and so does not have any
excess capacity.
Note: The purchasing division management will prefer to buy from the source that has the lowest price,
whether that source is internal or external. However, senior management of the company will look at
the question based upon the variable costs of production for the internal supplier. The fixed costs of the
internal supplier are a sunk cost and will not change no matter where the purchasing division buys the
units. Therefore, even if the transfer price is higher than an outside supplier’s price, the profit of the
company as whole will be higher if the purchasing division buys internally, as long as the variable costs
of the internal supplier are lower than the price charged by the external supplier.
Even though the purchasing division will be worse off for having bought internally, the company as a
whole will be better off than it would have been if the purchasing division had bought externally.
Example: Blitz Corporation has two divisions, A and B. Division B currently operates at 100% of its
capacity and produces two products: widgets and gadgets. Division B sells both products to outside
customers for 15.00 and 30.00 per unit, respectively. The variable costs for widgets are 10.00 per unit
and fixed costs are 3.00 per unit at the current production and sales level. For gadgets, the variable
costs are 16.00 per unit and fixed costs are 8.00 at the current production and sales level.
Division A, which currently purchases widgets from an outside supplier for 16.00 per unit, would like to
purchase 150 widgets from Division B annually. However, if Division B increases its production of widgets
to meet the demand of Division A, it must stop producing gadgets entirely. Also, to meet stricter quality
requirements of Division A, Division B must increase materials cost by 0.80 per widget, but the marketing
and transportation cost per widget will be reduced by 0.50 per unit. The total number of units of gadgets
produced and sold by Division B is 50 units per year.
What is the price range within which the transfer price for widgets would satisfy both divisions?
Solution:
The transfer price acceptable for the seller, the buyer, and the whole company should be:
1) higher than the variable costs (VC) plus the opportunity cost (OC) of forgone production
and sales for the seller (lost contribution margin) per unit. Therefore, the variable cost plus any
opportunity cost of forgone production and sales is the minimum price that the selling department
needs to receive, and
2) lower than the market price of the product per unit. The market price is the maximum amount
that the buying department would be willing to pay.
Expressed as a formula:
VC + OC ≤ Transfer Price ≤ Market Price
To calculate the optimal transfer price, the variable cost (VC) per unit, opportunity cost (OC) per unit,
and the market price per unit are needed.
Variable cost for widgets produced by Division B for Division A is 10.30 per unit (10.00 + 0.80 – 0.50).
The opportunity cost, or the contribution margin lost on each gadget that Division B could not produce
is 30.00 – 16.00 = 14.00. Therefore, the total contribution margin lost by Division B for the 50 gadgets
that would not be produced if it sells widgets to Division A is 700.00 (50 units × 14.00 per unit). The
opportunity cost given up for the production of each widget for Division A is 4.67 (700.00 ÷ 150 units).
The sum of the variable cost per unit and the opportunity cost per unit equal the minimum transfer
price for a widget of 14.97 (10.30 variable costs + 4.67 opportunity cost).
The market price is the maximum transfer price. The maximum transfer price for a widget is 16.00.
The optimal transfer price for all parties must be between 14.97 and 16.00. Any price lower than 14.97
will not be acceptable to Division B because its variable cost and opportunity cost would not be covered.
Any price higher than 16.00 will not be acceptable for Division A because Division A could buy widgets
at a lower price on the open market.
Managerial Accounting CIA Part 3
2. Managerial Accounting
2 A 1. Budgeting Concepts
The budgeting process is inseparably linked to the strategic planning process in an organization. Major
planning decisions by management are required before the budget can be developed for the coming period.
Furthermore, the development of the budget may cause previously developed short-term plans by man-
agement to require adjustment. As the projected quantitative results of the plans become clear in the
developing budget, management may need to revise its plans. After the plans and the budget have been
adopted, as the period unfolds the budget provides control and feedback.
Budgeting Concepts covers the different types of planning and budgets and how the planning and budgeting
process within a company works. The reports that come about as a result of the budget and the different
types of budgets that may be prepared will also be discussed.
The Budgeting Cycle

The budgeting cycle is a process that goes on throughout the year, even though the budget is probably
completed before the year begins. The budgeting cycle consists of more than just the development of the
annual profit plan, although that is a big part of the cycle. Throughout the budget year, actual results need
to be compared with planned results and variances investigated. Without this comparison and investigation,
the budgeting cycle loses much of its usefulness to the company. The process includes:
• Using data from past performance as well as future expectations, managers at all levels in the
organization work together to plan the performance of the company as a whole for the next budget
period. The result is the annual master budget or profit plan for the coming period.
• Throughout the period, actual results are reported on and compared with budgeted results on a
monthly or quarterly basis.
• Managers investigate the causes of the variances from the plan. If necessary, operational changes
are made. If the budget cannot be achieved because of some external situation that has developed,
the budget itself may need to be revised.
• Throughout the period, managers monitor market feedback, external conditions, and actual results
as they plan for the next budget period. For example, if a sales decline occurs, managers may plan
changes to the product line for the next period.
Advantages of Budgets
When properly developed and administered, budgets:
1) Promote coordination and communication among organization units and activities.
2) Provide a framework for measuring performance.
3) Provide motivation for managers and employees to achieve the company’s plans.
4) Promote the efficient allocation of organizational resources.
5) Provide a means for controlling operations.
6) Provide a means to check on progress toward the organization’s goals.
The Annual/Master Budget or Profit Plan

The development of an annual profit plan for a large corporation may take many months to complete
because the annual profit plan is made up of several different budgets, and some budgets cannot be de-
veloped until other budgets have already been completed. For example, the sales budget will be the driving
Section IV Managerial Accounting
factor in determining how many units must be produced, and therefore the sales budget must be completed
before the production budget can be completed.
One of the most important things to do in the process of developing the profit plan is to involve all of the
correct people. Profit planning is not a process to be undertaken exclusively by upper management or
during board meetings. Lower-level managers need to be involved because they know what is possible,
what is not possible, and what resources are required to meet a specific level of activity. Including lower-
level managers in the budgeting process is called participative budgeting.
Participative budgeting has a number of benefits for the organization. When the people responsible for
fulfilling the budget are involved in the process of developing it, they will be more likely to support and
accept the budget and be more motivated to meet it. In addition, the accuracy of the budget will be in-
creased because of the input from the people who are actually involved in the process being planned.
Bottom-up budgeting is similar in concept to participative budgeting. In bottom-up budgeting, the budget
is developed by starting at the lowest levels in the operations systems and building revenues and costs
from there.
Even when participative or bottom-up budgeting are being used, upper management still needs to be in-
volved in the planning and budgeting process. Management needs to set the goals, establish the
priorities, and provide the necessary support to make sure the process is completed correctly.
Benefits of Participative Budget Development

• A participative budget is a good communication device. The process of preparing the budget par-
ticipatively gives senior managers a better grasp of the problems their employees face. The
employees’ knowledge is more specialized and they have the hands-on experience of running the
business on a day-to-day basis. At the same time, employees gain a better understanding of the
problems experienced by top management.
• A participative budget is more likely to gain employee commitment to fulfill budgetary goals. People
are more willing to devote extra effort to attain goals they perceive as their own.
• A participative budget is more likely to be achievable because it was developed with input from the
people responsible for achieving it.
Limitations of Participative Budget Development

• Unless senior management controls the budget process properly, a participative budget can lead
to budget targets that are too easy to achieve, or budgetary slack. Budgetary slack is the practice
of underestimating planned revenues and overestimating planned costs to make the overall budg-
eted profit more achievable. It is the difference between the amount budgeted and the amount the
manager actually expects.
• Integrating corporate strategic plans into the budget can be more difficult when it has a bottom-up
process.
• Participative budgeting is more time-consuming because lower-level managers and employees need
to meet and negotiate their budgets.
The Master Budget

The master budget is the culmination and the goal of the budgeting process. The master budget is also
called the comprehensive budget. The master budget is a full set of budgeted financial statements,
including monthly or at least quarterly interim budgeted financial statements. The budgeted financial state-
ments include the budgeted statement of financial position (balance sheet), budgeted statement
of profit or loss, and budgeted statement of cash flows. The budgeted financial statements are pre-
pared by responsibility center and the individual responsibility center budgeted statements are consolidated
into the company-wide budgeted financial statements. The individual responsibility center budgets and the
consolidated budget together make up the master budget.
Note: A projected financial statement can be called a pro forma financial statement; however, the
master budget is not a pro forma financial statement. The term pro forma is used to refer to a forecasted
financial statement prepared for a specific purpose (for example, to do “what if” analysis in the process
of planning). A company might prepare many different sets of pro forma financial statements for the
same period in its planning process. A pro forma financial statement is not used for formal variance
reporting. However, if an action that was forecasted is implemented, the company will probably want to
compare the actual results with the forecasted, pro forma results. But pro forma financial statements
are not a part of the formal budgeting process. They are used for planning and decision-making pur-
poses, and the amounts in them may be quite different from the amounts in the master budget.
The master budget is a static budget. A static budget is one that is prepared for just one planned activity
level, and the activity level is whatever is projected before the period begins.
Many organizations also use flexible budgets along with the master budget. A flexible budget is a budget
that is prepared using the budgeted per unit costs and the actual level of activity; it is essentially what the
budget would have been if the company had known what the actual level of activity would be in advance
and had used that information when it developed the budget instead of the planned activity. Thus, when
flexible budgeting is used along with the master budget, the flexible budget is also prepared for just one
activity level, but that activity level is the actual activity level achieved during the period. Therefore, the
flexible budget amounts cannot be finalized for a reporting period (usually a month at a time) until the
period is past and the actual achieved activity level for that period is known.
Note: The term activity level or level of activity is used in planning and budgeting to refer to various
activities and volumes. It is often used to mean the planned number of units the company expects to
produce or the planned number of direct labor or machine hours the company expects to use. It can also
refer to a planned sales volume or any other planned volume.
The master budget is created using both non-financial and financial assumptions, which come about as a
result of the planning process. For instance, companies develop budgets for the number of units of each
product that they expect to manufacture and sell, the number of employees they will need, and so forth.
The master budget is a result of both operating decisions and financing decisions. Operating decisions
are concerned with the best use of the company’s limited resources. Financing decisions are concerned with
obtaining the funds to acquire the resources the company needs.
A profit plan that is broken down according to responsibility center lines will provide more feedback and will
function as more of a control tool than one that is not prepared by responsibility center, because each
responsibility center manager will be responsible for meeting his or her department’s profit plan. Ideally,
each manager will also be responsible for developing his or her responsibility center’s profit plan. These
underlying budgets are used in developing the master budget.
Development of the Master Budget

The master budget is the consolidation of all the responsibility center budgets. It comprises operating
budgets and financial budgets.
• Operating budgets are used to identify the resources that will be needed to carry out the planned
activities during the budget period, such as sales, services, production, purchasing, marketing,
and research and development. The operating budgets for individual units are compiled into the
budgeted statement of profit or loss.
• Financial budgets identify the sources and uses of funds for the budgeted operations. Financial
budgets include the cash budget, budgeted statement of cash flows, budgeted statement of finan-
cial position (balance sheet), and the capital expenditures budget.
The Operating Budget

The operating budget includes the budgeted statement of profit or loss and all the budgets that
support it, including:
• Sales budget
• Production budget
• Direct materials usage budget
• Direct materials purchases budget
• Direct labor budget
• Manufacturing overhead costs budget
• Ending inventories budget (finished goods and direct materials)
• Cost of goods sold budget
• Nonmanufacturing budget
The Financial Budget

The financial budget includes:
• Capital expenditures budget
• Cash budget
• Budgeted statement of financial position
• Budgeted statement of cash flows
The Capital Expenditures Budget

The capital expenditures budget is not a part of the annual budget development process, but it is
very important to the development of the annual budget.
The capital expenditures budget is the budget for long-term capital expenditures such as property,
plant, and equipment. Unlike the other budgets, the capital budget usually covers a period of several years
and thus is often prepared years in advance of the budget year it affects and reviewed annually. It is
mentioned first because the capital expenditures budget must be in place for the period covering the budget
year before the budgeting process can begin, since the capital expenditures budget contains items that will
need to be included in the budgeted financial statements for the year.
Capital expenditures budgeted for the coming year will affect the budgeted statement of financial position
as increases in fixed assets and in accounts receivable, inventory, and accounts payable. They will affect
the budgeted statement of profit or loss as income expected from the new projects along with related
expenses, including depreciation on the new equipment. Those effects on the budgeted statement of profit
or loss and the budgeted statement of financial position will affect cash as well, so they will flow to the cash
budget and the budgeted statement of cash flows.
The capital expenditures budget is prepared for several years at a time so that the company will be able to
obtain the necessary financing or accumulate the necessary cash to carry out its capital expansion plans.
Thus, the capital budget covers multiple planning periods.
The Operating Budget

The operating budget consists of the budgeted statement of profit or loss and all the individual budgets
that feed into it. The individual budgets and the purpose of each will be discussed, as well as the order in
which they are prepared.
Note: It is critical to produce the sales budget first so that the company knows how many units will
need to be produced or purchased.
Each of the budgets is developed using monthly figures or at least quarterly figures, so that actual results
for the year-to-date can be compared with planned results for the year-to-date as the coming year pro-
gresses. The monthly or quarterly amounts are needed in order to develop the cash budget, as well. These
monthly or quarterly figures should not be the same for every month or quarter; that is, they should not
be annual amounts simply divided by twelve or by four. Seasonal changes and other expected variations in
activity should be taken into consideration.
1. Sales Budget
The sales budget shows the expected sales in units of each product and each product’s expected selling
price. The sales budget is based on the firm’s forecasted sales level, its short- and long-term objectives,
and its production capacity.
The first operating budget to be prepared is always the sales budget, because the production budget
and all the other budgets for the company are derived from the sales budget. If sales are expected to be
low, the company does not need as much inventory or as many sales people, and so on. On the other hand,
if sales are expected to be high, more of each of these resources will be required.
The sales budgets should be developed for each responsibility center individually or possibly for each sales
person, depending on the nature of the business. The sales budget needs to be based on realistic estimates
of sales, since the sales budget will be the driver behind all of the remaining budgets.
• If the sales budget is too optimistic, production will be too high, inventory will be too high, and
problems such as cash shortfall will result.
• If the sales budget is too low, production and inventory will be too low, and sales will be lost
because of a lack of product to sell.
The sales budget is probably the most difficult to produce because it relies entirely on information and
estimations that are outside of the direct control of the company. The company has no direct control over
the economy as a whole or over competitors and technological advances that affect the company’s sales.
If demand is greater than the company’s production capacity, however, the sales budget should not reflect
the amount the company could sell if it were able to increase production. Unless the company has specific
plans in its capital expenditures budget to increase its production facilities due to the expected increased
demand, the sales budget will need to be adjusted to the quantity that will be available to be sold.
Thus, it follows that the sales budget will need to incorporate information about sales revenues expected
from any capital projects that are expected to begin generating sales during the coming year.
Note: One more item that needs to be considered in the sales budget is the level of credit sales and
when the cash for those credit sales will be collected. Though the timing of collections is not critical for
the sales budget itself, the amount of collections is critical for the development of the cash budget.
2. Production Budget
After determining the sales budget, the production budget is developed so that it incorporates the com-
pany’s sales budget along with its capacity and inventory objectives. The production budget incorporates
the final determination of how many units to produce during the period.
If the company would like to increase its inventory level by year-end, it will need to include the expected
inventory increase in its production plans. Similarly, if the company wants to decrease year-end inventory,
it will need to produce fewer units than it plans to sell in order to sell down the units in inventory. In
addition, the production budget will need to include production from any new capital projects planned to
begin production during the year.
The final determination of how many units to produce during the period is done in the production budget.
The production budget also includes when the units will be produced. The units must be produced prior to
the time when they will be needed for sale but not too far in advance. If increased sales are expected in
the early part of the year, production should be planned to be higher early in the year. If higher sales are
expected later in the year, increased production needs to take place later in the year or the company will
need to pay significant storage costs.
Note: If the prices of the inputs to the product (primarily direct materials) are expected to change
significantly in the future, the expected changes must also be taken into account in determining when
and how many units to produce. As much as possible, the company will want to purchase inputs to
produce its products when the prices of the inputs are lower rather than higher.
The production budget in number of units to be produced provides the foundation for the development of
the following four budgets:
1) Direct materials usage budget.
2) Direct materials purchases budget, which is created in much the same way as the production
budget, taking into account the desired change in inventory of raw materials.
3) Direct labor costs budget.
4) Factory overhead budget, including both variable costs (such as utilities) and fixed costs (such
as supervisory salaries). Fixed factory overhead costs do not change as production levels change
as long as the change in activity remains within the relevant range, but if the budgeted production
is outside the relevant range, appropriate adjustments need to be made to fixed manufacturing
costs.
The direct materials usage and purchases budgets, direct labor budget, and factory overhead budget feed
into the ending inventories budget, and all of these individual budgets feed into the cost of goods sold
budget.
Because all of these budgets are interrelated, a change in one budget will require a change in another
budget or budgets. As the level of production changes, the amount of labor and material required will
change. As the amount of labor changes, there may need to be a change as well in indirect materials and
indirect labor, both of which are overhead costs.
• Indirect materials are materials used in the manufacturing process, but their costs are not directly
traceable to any particular product. Examples are screws, glue, cleaning chemicals, and disposable
tools.
• Indirect labor is likewise not directly traceable to any particular product. The wages of a janitor
who cleans up the plant are indirect labor costs, since the janitor’s wages cannot be traced to any
one product.
As these items change, changes will be required in the overhead budget.
Note: Because of the way the individual budgets are connected to each other, a change in one budget
will almost always affect at least one other budget.
2A. Direct Materials Usage Budget

The number of units to be produced (from the production budget) is used to calculate the amount of direct
materials required and their costs. The quantities of direct materials to be used depend on how efficient
the production employees are in assembling them into finished products as well as the quality of the direct
materials purchased.
For each product, the company has a bill of materials that specifies which materials and how much of
each are to be used in manufacturing the product, the sequence in which the materials are to be used, and
in what department each process is to be completed. Those bills of materials are used to develop the direct
materials usage budget.
The direct materials usage budget will be affected by production needs created by any new capital projects
planned to begin production during the year.
2B. Direct Material Purchases Budget

After the direct material usage budget is complete, the purchasing department can prepare the direct ma-
terial purchases budget because the direct material purchases budget is derived from the direct material
usage budget. Like the overall production budget, the amount of direct materials to be used in production
is adjusted by the amount of change from beginning to ending materials inventory to determine the quantity
of each material to be purchased, and then the costs for those quantities are determined using the standard
costs developed.
The direct materials purchases budget will also be affected by production needs created by any new capital
projects planned to begin production during the year.
2C. Direct Labor Budget

The direct labor budget is developed using direct labor standards – the time allowed per unit of output and
the cost per hour of direct labor time – to calculate the budgeted cost for direct labor. The company usually
prepares a separate direct labor budget for each type of labor used in production at its standard cost.
The standard cost per hour of direct labor time will generally include wages and all other employee costs
such as payroll taxes paid, workers’ compensation insurance for workers who are hurt on the job, federal
and state unemployment taxes paid by the employer, health and life insurance premiums, pension plan
contributions paid by the company, and any other employee benefits that may be provided.
2D. Manufacturing Overhead Costs Budget

Under the traditional method of applying overhead costs to units produced, usually either machine hours
or direct labor hours allowed per unit of output are used as the basis of the allocation. The budgeted total
fixed overhead costs and the budgeted total variable overhead costs are determined. Those totals are each
divided by the standard number of hours of the allocation base (machine hours or direct labor hours)
allowed for the budgeted production to calculate the standard fixed and variable overhead application rates
per hour allowed for the budgeted output.
3. Ending Inventories (FG and DM) Budget

The next budget to be prepared is the budget for ending inventories, both finished goods inventory and
direct materials inventory. The overhead costs are treated as inventoriable product costs, so total overhead
costs will be allocated to production at the cost per machine hour or direct labor hour allowed for each unit
planned (which was calculated in the manufacturing overhead costs budget).
4. Cost of Goods Sold Budget

After all of the production related budgets are completed, the company can produce the cost of goods
sold budget, which is based on the calculation of cost of goods sold, as follows:
Budgeted Beginning Inventory

+ Budgeted Purchases or Production
m
= Budgeted Goods Available for Sale
o
− Budgeted Ending Inventory
il.c
= Budgeted Cost of Goods Sold
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5. Nonmanufacturing Budgets
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Amounts for nonmanufacturing costs come from the various areas of the company that are not involved in
01
production. Those budgets include:
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• Research and development (R&D) budget.
• Selling, marketing and distribution budget, including sales supervisory salaries, sales commissions,
lin
selling expenses (such as travel and entertainment), advertising and promotion expenses, ship-
on
ping-out expenses, telephone and wireless, office supplies, depreciation on office furniture and
equipment used by sales and marketing personnel, and so forth.
do
• Administrative and general expense budget, including salaries and wages for management and
ar
support staff in administrative and staff departments (for example, accounting, legal, IT, and hu-
man resources), travel and entertainment, insurance, audit fees, telephone and wireless, office
on
supplies, depreciation on office furniture and equipment used by administrative personnel, and so
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forth.
• Budgets for other expenses or sources of revenue such as interest income and interest expense.
n
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Note: Each of the individual budgets prepared for expenses should be broken down into variable and
fixed costs. This breakdown is significant because at least in the short-term, fixed costs cannot be
changed. The breakdown is necessary in order to develop a flexible budget as well, since in a flexible
ar
budget, variable items are adjusted to their equivalent values using actual activity while fixed items are
lC
unchanged. Also, the budgeted variable costs are needed to determine the budgeted contribution margin
from each business unit. The contribution margin is total revenue minus all variable expenses.
De
The nonmanufacturing budgets need to be developed in enough detail to be useful. The assumptions un-
Jr
derlying the amounts in them should be documented for reference. When the first drafts of the budgets are
revised, those documented assumptions will be needed in order to determine where changes can be made.
do
For example, the budgeted employees and their salaries underlying the budgeted salaries and wages
amount should be documented. If it is necessary to revise budgeted salaries and wages, it will be much
ar
easier to make that revision if detail is available about the salaries and wages used to develop the first draft
on
of the budget.
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After the operating budget is completed, the company can evaluate the expected profit for the upcoming
period. This evaluation may be done using earnings per share, an industry average, or a price-earnings
ratio.
In addition, the budgeted net income becomes a part of the budgeted statement of financial position
through its effect on retained earnings in the equity section.
The Financial Budget

The financial budget is the other major classification within the master budget. It includes the
• capital expenditures budget,
• cash budget,
• budgeted statement of financial position, and
• budgeted statement of cash flows.
The capital expenditures budget has already been covered, since it must be in place for the budget year
before any other budgets can be developed.
The Cash Budget

The cash budget (also called the cash management, cash flow or working capital budget) draws upon
information from all other budgets. Because it uses information from the other budgets, it is the last
budget prepared before the budgeted financial statements are prepared. It is also one of the most im-
portant budgets developed. The cash budget tracks the inflows and outflows of cash on a month-by-month
(possibly even week-by-week or day-by-day) basis.
The cash budget is similar to but not exactly the same as a budgeted statement of cash flows. The cash
budget must be prepared before the budgeted statement of financial position can be prepared. On the
other hand, the budgeted statement of cash flows is prepared after the budgeted statement of financial
position and statement of profit or loss are prepared. The cash flows in the budgeted statement of cash
flows are segregated according to operating, investing, and financing cash flows. In contrast, the cash flows
in the cash budget are segregated according to receipts and disbursements.
The cash budget shows the planned sources and uses of cash for the budget period. The various budgets
prepared up to this point provide the information for the cash budget. For example, the capital expenditures
budget provides information on planned equipment purchases. The sales budget provides the information
needed to determine budgeted collection of accounts receivable. The direct material purchases, direct labor,
and the nonmanufacturing costs budgets provide the information needed for budgeted cash disbursements.
The ending cash balance appears on the budgeted balance sheet for the period end.
If the cash budget is accurate, it will enable the company to plan for any cash shortfalls that may occur or
any excess cash that may accumulate during the year. Any excess cash should be invested for the time
period that it will not be needed.
One advantage of predicting cash shortfalls is that it will be easier (and less expensive) for the company to
obtain a short-term loan if management is aware of its need before the shortfall arrives and if it is able to
present cash inflow and outflow projections to the bank to support its loan request and show the source of
the repayment of the loan. The company also would have more time to obtain permanent capital from
equity sources by selling shares if that is the best alternative.
Note: Although all companies should prepare a cash budget, it is particularly important for those that
operate as seasonal businesses to do so, preferably on a monthly basis. For a seasonal business,
production, sales, and ending inventory by month are also critical budgets.
The following is the format of a cash budget. This format assumes the budgeting is done by quarter, but a
monthly budget would be even better, with columns for each month.
Cash Budget for the Year Ending December 31, 20X5

Quarters Year as
Q1 Q2 Q3 Q4 a Whole
Cash balance, beginning
Plus receipts:
Collections from customers
Sale of capital equipment _________ _________ _________ _________ _________
Total cash available
Minus disbursements:
Direct materials
Payroll
Manufacturing overhead costs
Nonmanufacturing costs
Capital equipment purchases
Income taxes _________ _________ _________ _________ _________
Total disbursements
Minimum cash balance desired _________ _________ _________ _________ _________
Total cash needed _________ _________ _________ _________ _________
Cash excess (deficit)
Financing:
Beginning borrowings
Repayment(s) during period
Interest expense _________ _________ _________ _________ _________
Total effects of financing
Cash balance, ending
The Master Budget Financial Statements

Once the operating budgets and the cash budget have been prepared, the company can prepare its master
budget financial statements. The individual budgets that make up the operating and financial budgets are
compiled into a budgeted statement of profit or loss, statement of financial position, and statement of cash
flows. All of the budgeted financial statements are interconnected in the same manner as are the actual
The master budget is the document the company relies on as its operating plan as it carries out manage-
ment’s plans in order to achieve its goals and objectives. It is a summary of management’s operating and
financial plans for the period, expressed as a set of budgeted financial statements for the period that reflects
the impact of the operating decisions and financing decisions to be made during the coming period.
Master budget financial statements will probably be prepared for each month of the budget period, or at
least for each quarter. The monthly budgeted financial statements can be developed and presented in a
spreadsheet format with the months as the column headings. Monthly budgeted financial statements are
very important because looking at the budgeted financial statements, particularly the cash flows for each
month during the period, will enable the company to identify any potential problems before they develop.
Furthermore, variance reports comparing actual year-to-date amounts to year-to-date budgeted amounts
can be prepared regularly throughout the year if monthly budget amounts are available.
Potential problems identified may relate to the company’s existing loan agreements or restrictive covenants.
For example, if the organization can determine, based on preliminary planned financial statements, that it
will probably be in violation of a loan covenant during the second quarter of the year, it will have time to
take corrective actions to prevent the violation and to adjust the budget accordingly.
Also, if management sees that it will not meet the expected (or desired) profits or other financial measures
after the preparation of the master budget financial statements, it needs to go back and look at the plans
for the year. This process of revision will probably take place several times until the resulting budgeted
financial statements are the way senior management wants them to look. However, as this reconsideration
takes place the company needs to be very careful to not perform unrealistic budgeting by making unattain-
able changes to the budgeted amounts.
Ongoing Budget Reports

After the budgets are determined and approved, they will be used throughout the year to measure how the
actual period-specific and year-to-date results compare to the budgeted results. Variance reporting is a
very important part of budgeting.
A budget variance report compares the actual items (revenues, expenses, or units) with the budgeted
amounts for the same time period. If the company is doing better than the budget (meaning that actual
revenues are higher than budgeted or actual expenses are lower than budgeted), the company has a fa-
vorable variance. If the opposite is true, the company has an unfavorable variance.
If the variances are significant or unexpected, management must investigate and determine the cause or
causes of each variance. Some variances are expected. For instance, if sales are higher than budgeted,
then it is only logical that there will appear to be an unfavorable variance in direct materials and direct
labor if the company uses a fixed (or static) budget for the variance reporting. However, an unfavorable
variance in manufacturing inputs is a matter for concern only if the flexible budget variances for direct
materials and direct labor are also unfavorable. If the variances are caused only by the higher than expected
sales having resulted in increased cost of sales, the variances are not a cause for concern as long as the
costs are in line with the expected costs for the actual level of output and sales.
Investigating the causes of unexpected variances is one of the most important steps in the budgeting
process. Investigation of variances is part of the control loop, which is the process by which the activities
of the company are controlled.
The major steps in the control loop are:
1) Establish the budget or standards of performance.
2) Measure the actual performance.
3) Analyze and compare actual results with the budgeted results (variance reporting).
4) Investigate unexpected variances.
5) Devise and implement any necessary corrective actions.
6) Review and revise the budget or standards if necessary.
An example of a variance report is on the following page.
Example: Below is an example of a statement of profit or loss variance report showing the static budget
variances, the flexible budget variances, and the sales volume variances for each line item and for oper-
ating income. The sales volume variance is the amount of the static budget variance attributable to sales
volume either higher or lower than expected.
For each line, the flexible budget variance plus the sales volume variance equals the total static budget
variance. The formulas for the variances are given at the top of each variance column, plus the calculation
of the operating income variances is shown in the diagram at the bottom.
Statement of Profit or Loss Variance Report

Including Flexible Budget Variances
Col. 1 Col. 2 Col. 3 Col. 4 Col. 5 Col. 6
(2)=(1)–(3) (4)=(3)–(5) (6)=(1)–(5)

also
(6)=(2)+(4)
Flexible Static
Actual Budget Flexible Sales Volume Static Budget
Results Variances Budget Variances Budget Variances
Units sold 20,000 0 20,000 4,000− U 24,000 4,000− U
Revenues 2,500,000 100,000+ F 2,400,000 480,000− U 2,880,000 380,000− U
Variable costs:
Variable manu-
facturing cost
of sales 1,639,200 119,200+ U 1,520,000 304,000− F 1,824,000 184,800− F
Variable selling
& admin. ex-
penses 261,000 21,000+ U 240,000 48,000− F 288,000 27,000− F
Total variable
costs 1,900,200 140,200+ U 1,760,000 352,000− F 2,112,000 211,800− F
Contribution
margin 599,800 40,200− U 640,000 128,000− U 768,000 168,200− U
Fixed costs:
Fixed manufac-
turing costs
incurred 450,000 2,000− F 452,000 0 452,000 2,000− F
Fixed selling &
admin. expenses
incurred 120,000 20,000+ U 100,000 0 100,000 20,000+ U
Operating income 29,800 58,200− U 88,000 128,000− U 216,000 186,200− U
58,200− U
128,000− U
Total flexible Total sales
budget variance volume variance
186,200− U
Total static budget variance
2 A 2. Cost-Volume-Profit Analysis
Cost-volume-profit analysis (CVP), also known as breakeven analysis, is used primarily for short-run
decision-making. In the short run, the market usually determines the prices and costs of a company’s
products. Generally speaking, the market governs prices, chiefly through the prices consumers are willing
to pay and through actions of competitors. Furthermore, costs can be reduced to a certain degree by
seeking cost concessions from suppliers and by value engineering.75 Otherwise, the only things the com-
pany can control are the products it makes and the quantities it produces and sells—in other words, the
supply of the product.
Companies use CVP analysis to determine which products they will supply and the amount they will supply
at a given price and cost. Since prices and costs are reasonably fixed in the short run, the profitability of a
product depends most upon the quantity sold. Therefore, CVP analysis is used to calculate the effect on
profitability caused by changes in product mix and in quantities sold.
CVP analysis enables a company to find the level of production and sales, both in units and in revenue,
required for the company to break even. It may also be used to determine the level of production and sales
necessary to achieve a specific profit level. In short, CVP analysis examines the relationship among
revenue, costs, and profits.
In order to use CVP analysis, a number of assumptions need to be made. These assumptions simplify the
many variables in the real world:
• All costs are either variable or fixed costs. The presumption is that there are no mixed (that
is, semi-variable or semi-fixed) costs.
• Total costs and total revenues are predictable and linear (they graph as straight lines) in
relation to output units within the relevant range and time period.
• Changes in the level of revenues and total costs arise only because of changes in the number
of units produced and sold.
• Fixed costs remain constant over the relevant range. Fixed costs include both direct fixed costs
and indirect (allocated) fixed costs.
• Unit variable costs remain constant over the relevant range. Total variable costs change in
proportion to activity level because the cost per unit remains constant. Variable costs include both
direct variable costs and indirect (allocated) variable costs.
• The unit selling price remains constant over the relevant range, and the sales mix remains
constant as the level of total units sold changes.
• The time value of money is ignored.
In the real world, the preceding assumptions may not hold. For example, as the quantity of direct materials
purchased increases, the supplier may offer a lower price per unit, or in order to make more sales the
company may need to reduce its selling price per unit. Variations such as these would complicate the
analysis, so they are excluded.
Note: There are several kinds of costing, including job-order costing, joint costing, absorption (full)
costing, and variable (or direct) costing. For CVP analysis, variable costing provides the best information.
In variable costing, the fixed manufacturing overheads are expensed as incurred.
75
“Value engineering” is an evaluation of all the business functions in the value chain with the objective of reducing
costs while still satisfying customer needs. The term “value chain” refers to the steps a business goes through to trans-
form inputs such as raw materials into finished products by adding value to the inputs by means of various processes,
and to finally sell the finished products to customers. Value engineering may lead to design improvements, materials
specification changes, or modifications to manufacturing methods.
Contribution Margin
Contribution margin is an important concept in CVP analysis. It represents the amount of revenues minus
variable costs available to cover fixed costs. Once the fixed costs have been covered, further increases in
the contribution margin from increased sales volume flow straight to operating income.
CVP analysis is based on the assumption that there are two kinds of costs in producing a product: fixed and
variable.
• Fixed costs do not change in total. As long as the activity remains within the relevant range, the
level of production or sales has no effect on fixed costs.
• Variable costs are variable manufacturing costs or variable selling and administrative costs. Var-
iable manufacturing costs are costs per unit produced. Variable selling and administrative costs
are costs per unit sold. Variable costs change in total in response to fluctuations in the level of
activity, either production or sales.
The difference between an item’s selling price and the variable costs to produce and sell it is the amount
that goes toward covering a company’s fixed costs. The difference between the selling price of a unit and
its variable cost is the unit contribution margin (or simply contribution) and is calculated as follows:
Unit Contribution Margin = Selling Price per Unit – Variable Costs per Unit
The total contribution margin can be calculated in two ways:
1) Total Contribution Margin = Unit Contribution Margin × Number of Units Sold
Or
2) Total Contribution Margin = Total Revenue – Total Variable Costs
Example: Ray Company manufactures wireless routers and sells them to distributors for 60 each. Ray
Company’s variable cost is 35 per router. The unit contribution margin is:
60 − 35 = 25
If Ray Company sells 10,000 wireless routers, total revenue will be 10,000 × 60, or 600,000. Total
variable cost will be 10,000 × 35, or 350,000. The total contribution margin is:
25 × 10,000 = 250,000
Or
600,000 − 350,000 = 250,000
Contribution Margin Ratio

The unit contribution margin expressed as a percentage of the sales price is the Contribution Margin
Ratio or Contribution Margin Percentage. The formula is:
Unit Contribution Margin

Contribution Margin Ratio =
Unit Selling Price
The Contribution Margin Ratio can also be calculated using total contribution margin and total revenues
instead of per-unit amounts:
Total Contribution Margin

Contribution Margin Ratio =
Total Revenue
Company’s variable cost is 35 per router. The unit contribution margin is 60 − 35, or 25.
Ray Company’s Contribution Margin Ratio using the contribution margin per unit and the selling price
per unit is:
25
Contribution Margin Ratio = = 0.416667 or 41.6667%
60
If Ray Company sells 10,000 routers, Ray Company’s Contribution Margin Ratio using the total contri-
bution margin and total revenue is:
250,000
Contribution Margin Ratio = = 0.416667 or 41.6667%
600,000
Thus, the contribution margin is 41.6667% of the selling price. This contribution margin will first be used
to cover Ray’s fixed costs. Once the fixed costs have been covered, the additional contribution becomes
profit.
Contribution Margin Profit or Loss Statement

Under CVP analysis, the profit or loss statement shows variable expenses deducted from revenue, which
then produces a key line item that does not appear on the standard profit or loss statement, contribution
margin, as follows:
Sales revenue
− Variable expenses
= Contribution margin
− Fixed expenses
= Income from operations
All fixed costs are expensed below the contribution margin line.
Exam Tip: The preceding formula can be used to check an answer on the exam. At the breakeven point
number of units, the operating income will be 0.
Example: Carl Company sells its product for 100 per unit. Fixed costs are 120,000 and the variable cost
is 60 per unit. The unit contribution margin is 40 per unit (100 − 60), which is the contribution to the
coverage of fixed costs made by the sale of each unit. The following chart shows how the contribution
margin increases as sales volume increases, more of the fixed costs are covered, and operating income
changes from negative to positive:
Sales volume: 1,000 2,000 3,000 4,000 5,000
Revenues @ 100 100,000 200,000 300,000 400,000 500,000
Variable costs @ 60 60,000 120,000 180,000 240,000 300,000
Contribution margin 40,000 80,000 120,000 160,000 200,000
Fixed costs 120,000 120,000 120,000 120,000 120,000
Operating income ( 80,000) ( 40,000) -0- 40,000 80,000
Breakeven Analysis
Managers need to know the level of sales necessary to cover all costs, both fixed and variable, to avoid a
loss. Following is a graphic representation of the breakeven point.
Revenue
Total Costs
Revenues and Costs
Breakeven
Point Variable Costs
Fixed Costs
Units
The breakeven point can be calculated in terms of the sales volume (number of units sold) required to
break even, or it can be calculated in terms of the amount of revenue required to break even.
Breakeven Volume (Breakeven Point in Units)

In order to calculate the breakeven volume, divide the fixed costs by the contribution margin per unit:
Total Fixed Costs

BEP Volume (Units) =
In other words, each unit that is sold contributes to the coverage of fixed costs. Dividing total fixed costs
by the contribution per unit produces the number of units that must be sold in order to cover the fixed costs
and therefore break even.
Company’s variable cost is 35 per router.
Ray’s unit contribution margin is:

60 − 35 = 25
Ray Company’s fixed costs total 150,000. Ray’s breakeven volume is:
150,000
Breakeven volume = = 6,000 units
25
The calculated breakeven volume can be proven through use of the standard profit formula, which is
Profit = Total Revenue – Total Variable Costs – Total Fixed Costs:
Profit = (6,000 × 60) − (6,000 × 35) − 150,000
= 360,000 − 210,000 − 150,000 = 0
Breakeven Point in Revenue

The breakeven point in revenue is calculated by dividing total fixed costs by the unit contribution margin
ratio, which is the unit contribution margin divided by the selling price. Dividing total fixed costs by the
contribution margin ratio results in the breakeven point in terms of revenue rather than in terms of
volume. The formula is:
Total Fixed Costs

Breakeven Revenue =
Moreover, once the breakeven volume has been calculated, the breakeven volume can also be used to find
the breakeven revenue, because total revenue is equal to the total number of units sold multiplied by the
selling price per unit.
Breakeven Revenue = Selling Price per Unit × Breakeven Volume
Also, once the breakeven revenue has been calculated, breakeven revenue divided by price per unit equals
the breakeven volume.
Breakeven Revenue
Breakeven Volume =
Selling Price per Unit
Example #1: Ray Company manufactures wireless routers and sells them to distributors for 60 each.
Ray Company’s variable cost is 35 per router, the contribution margin is 25, and fixed costs total
150,000. Ray Company’s breakeven point (BEP) in revenue is calculated as follows.
Fixed Costs
Breakeven revenue =
Ray Company’s Contribution Margin Ratio is 0.416667 (25 ÷ 60).
150,000
Breakeven revenue = = 360,000
0.416667
The breakeven volume is the breakeven revenue divided by the selling price per unit.
360,000
Breakeven volume = = 6,000 units
60
Proof of both the breakeven volume and the breakeven revenue:
Profit = (6,000 × 60) – (6,000 × 35) – 150,000

= 360,000 – 210,000 – 150,000 = 0
Example #2: Given a selling price of 4.00 and variable costs of 2.20, what is the breakeven volume if
fixed costs are 4,600?
The unit contribution margin is 1.80 per unit (4.00 – 2.20). This 1.80 is the contribution to the coverage
of fixed costs that is made by the sale of each unit.
Fixed Costs
Breakeven volume =
4,600
Breakeven volume = = 2,556 units (rounded up)
1.80
The number of units that must be sold to break even is actually 2,555.55 units. However, it is not
possible to sell 0.55 of a unit; therefore, the number is rounded up to the next highest whole number,
which is 2,556.
What is the breakeven point in revenue?
Fixed Costs
Breakeven revenue =
1.80
Contribution Margin Ratio = = 0,45
4.00
4,600
Breakeven revenue = = 10,223 (rounded up)
0.45
Proof of both the breakeven point in number of units and the breakeven point in revenue:
Revenue (2,556 units × 4.00) 10,224

Less: Variable cost (2,556 units × 2.20) 5,623
Contribution margin 4,601
Less: Fixed cost 4,600
Operating income before tax 1 (difference due to rounding)
Exam Tip: In problems that ask for the breakeven point, net income will be zero, so any income tax
rate information given is irrelevant. At the breakeven level, taxable income is assumed to be zero, thus
no income tax is due.
Profit Requirement
In contrast to merely breaking even, most companies will have some kind of profit goal and will need a
specific revenue target to achieve that profit goal. Therefore, it is important to know how to use the break-
even formulas to determine how many units must be sold or how much revenue is needed to reach a
specific amount of profit.
This required profit level may be expressed either as a monetary amount (for example, “200,000”) or as a
percentage of total sales (for example, “15% of sales revenue”). Furthermore, the required amount of profit
may be an after-tax profit amount or a before-tax profit amount. The method for calculating the required
sales to attain a given profit will depend on the manner in which the profit is to be determined and on
whether the profit is a before-tax amount or an after-tax amount.
Target Monetary Pre-Tax Profit Requirement

When a firm has a specific pre-tax profit requirement, the same formulas are used as those used to calculate
the breakeven points in units sold and in revenues. However, in calculations, the target pre-tax profit is
treated as an additional fixed cost that must be covered by the contribution margin. The target amount
of pre-tax profit is treated as a fixed cost because not only do all fixed costs need to be covered, but also
the target amount of pre-tax profit needs to be met. The target profit is similar to a fixed cost because it
does not change as the level of sales changes.
Total Fixed Cost + Target Pre-Tax Profit

Target Volume =
Contribution Margin Per Unit

Target Revenue =
Example: The following illustrates the calculation of a required pre-tax profit.
The selling price is 4.00, variable costs are 2.20, fixed costs are 4,600.00, and the company must achieve
a minimum pre-tax profit of 5,000.00 (note that the effect of taxes is covered later). What sales level
is required to achieve a pre-tax profit of 5,000.00?
The contribution margin is 1.80 per unit. Since a specified pre-tax profit is required, the numerator is
Fixed Costs + Target Pre-Tax Profit. The target pre-tax profit is treated as another fixed cost.
Total Fixed Cost + Target Pre-tax Profit

Target Volume for Specific Pre-Tax Profit =
4,600 + 5,000
Target Volume for 5,000 Pre-Tax Profit = = 5,333.33, or 5,334 units
1.80
(continued)
The target revenue in order to earn a pre-tax profit of 5,000 can be calculated by using the contribution
margin ratio in the denominator of the calculation. The contribution margin ratio is:
Unit Contribution Margin 1.80

Contribution Margin Ratio = = = 0.45
Selling Price per Unit 4.00
Total Fixed Cost + Target Pre-tax Profit

Target Revenue for Specific Pre-Tax Profit =
Therefore, the target sales revenue with a 5,000 pre-tax profit requirement is:
4,600 + 5,000
Target Revenue for 5,000 Pre-Tax Profit = = 21,333.33 or 21,334
0.45
To prove the calculated target sales volume and target revenue, multiply 5,334 (the required number of
units) by the sales price of 4.00. The result is 21,336. (The difference from 21,334 is due to rounding.)
Below is the resulting contribution profit or loss statement showing the required operating income before
taxes of 5,000:
Revenue (4.00 × 5,334 units) 21,336

Variable costs (2.20 × 5,334 units) 11,735
Fixed costs 4,600
Operating income before taxes 5,001 (difference due to rounding)
Target Pre-Tax Profit as a Percentage of Sales Revenue

The target pre-tax profit may instead be stated as a percentage of sales revenue. In this case, first calculate
the target pre-tax profit required from each unit sold in order to achieve the appropriate level of profit using
the following formula:
Required pre-tax profit % of revenue

Target pre-tax profit per unit =
× Selling price per unit
The target pre-tax profit that each unit must generate is treated as an additional variable cost per unit,
since it changes in total with changes in the sales level. The additional “cost” reduces the “contribution
margin” from each unit because the contribution margin must cover the required profit per unit as well as
the variable cost per unit.
The target pre-tax profit requirement becomes an additional variable cost used in the calculation of an
adjusted contribution margin per unit.
Adjusted contribution Selling price per unit – Variable cost per unit
=
margin per unit – Target pre-tax profit per unit
To calculate the target volume, divide the total fixed cost by the adjusted contribution margin per unit. To
calculate the target revenue, divide the total fixed cost by the adjusted contribution margin ratio.
Total Fixed Cost

Target Volume =
Adjusted Contribution Margin Per Unit
(Selling price – Variable cost per unit
– Target pre-tax profit per unit)
Total Fixed Cost

Target Revenue =
Adjusted Contribution Margin Ratio
Example: The following illustrates the calculation of a required pre-tax profit expressed as a percentage
of sales.
The selling price is 4.00, variable costs are 2.20, and fixed costs are 4,600. The pre-tax profit require-
ment is 35% of sales.
The amount of pre-tax profit needed from each sale is 4.00 × 0.35, or 1.40. This required pre-tax profit
will be an adjustment (a decrease) to the contribution margin per unit that is used in the denominator
of the breakeven formula, so the adjusted contribution margin per unit will be lower than the contribu-
tion margin per unit.
The variable costs now consist of the actual variable costs of 2.20 per unit as well as the required pre-
tax profit, which is 35% of the sales price of 4.00, or 1.40 per unit. The adjusted contribution margin
per unit is 0.40, calculated as follows: 4.00 selling price − 2.20 variable cost − 1.40 profit requirement
= 0.40.
Thus, the sales volume required to achieve a pre-tax profit of 35% of sales is:
Required Sales Volume for Pre-Tax 4,600.00

= = 11,500 units
Profit of 35% of Sales (4.00 − 2.20 − 1.40)
The required amount of sales revenue for a pre-tax profit of 35% of sales, using the adjusted contribu-
tion margin ratio in the denominator, is:
Required Sales Revenue for Pre-Tax 4,600.00

= = 46,000
Profit of 35% of Sales (0.40 ÷ 4.00)
The following contribution profit or loss statement shows the proof of these figures:
Revenue (11,500 × 4.00) 46,000
Variable costs (11,500 × 2.20) 25,300
Fixed costs 4,600
Operating income before tax 16,100 = 35% of 46,000
Target After-Tax Profit

Thus far, the effect of taxes has not factored into the calculation of the target sales volumes and sales
revenue. However, taxes are relevant when a profit is earned because taxable income results in a require-
ment to pay income tax, and paying income tax decreases profit. A question might ask for the needed level
of sales revenue or sales volume in order to achieve a certain amount of after-tax profit. The after-tax
profit requirement could be expressed as either a target monetary amount of after-tax profit or as a target
amount of after-tax profit as a percentage of revenue.
Target Monetary Amount of After-Tax Profit

When calculating the target sales volume and target sales revenue with a specific after-tax profit goal,
convert the required after-tax profit to its equivalent pre-tax profit before beginning calculations. From
that point on, all calculations are the same as those used to calculate the volume or revenue required to
attain a target pre-tax profit.
To convert the target after-tax profit to target pre-tax profit, use the following formula:
Target After-Tax Profit

Target Pre-Tax Profit =
(1 – Tax Rate)
The resulting target pre-tax profit amount is then used to find the target sales volume and target revenue
to achieve the required after-tax profit. Use the same formulas as are used to achieve a specific pre-tax
profit:

Target Volume =

Target Revenue =
Example: The following illustrates the calculation of target volume and target revenue with a specific
target after-tax profit.
For a company with a sale price per unit of 4.00, variable costs of 2.20, fixed costs of 4,600, and a tax
rate of 40%, an after-tax net income requirement of 5,000 would lead to the following target volume
and target revenue to achieve the target after-tax net income:
Contribution margin per unit = 4.00 − 2.20 = 1.80
5,000
Target pre-tax net income = = 8,333
(1 − 0.40)
4,600 + 8,333
Target volume = = 7,185 units
1.80
1.80
Contribution margin ratio = = 0.45
4.00
4,600 + 8,333
Target revenue = = 28,740
0.45
(continued)
Proof:
Revenue: 7,185 × 4.00 28,740

Variable costs: 7,185 × 2.20 15,807
Fixed costs 4,600
Operating income before tax 8,333
Effective income tax @ 0.40 3,333
Operating income after tax 5,000
Target Percentage of Revenue as After-Tax Profit

If the target after-tax profit is a percentage of revenue, calculate the required after-tax profit per unit
and then convert that to its equivalent pre-tax profit per unit. Then solve the problem in the same manner
as was done when solving for the target sales volume and sales revenue with a pre-tax percentage of
revenue as the profit goal.
The target after-tax profit per unit is the specified percentage of the sales price per unit. The sales price
per unit is known, so calculate the target amount needed as after-tax profit per unit by multiplying the
specified percentage by the selling price. Convert the resulting target after-tax profit per unit to its pre-tax
equivalent by dividing it by 1 – the tax rate. The result will be the target pre-tax profit per unit.
The target pre-tax profit per unit is calculated as follows using the target after-tax net profit per unit:
Required after-tax profit % of

revenue × Selling price per unit
Target pre-tax profit per unit =
(1 – tax rate)
The target pre-tax profit per unit is then used as an additional variable “cost” per unit to calculate an
adjusted contribution margin per unit.
The adjusted contribution margin per unit to use in calculating the target number of units and the target
sales revenue is calculated as follows:
Adjusted contribution Selling price per unit – Variable cost per unit
=
margin per unit – Target pre-tax profit per unit
From this point on, the calculation is handled just like any breakeven calculation, except that the adjusted
contribution margin is used instead of the contribution margin.
The target sales volume is the total fixed cost divided by the adjusted contribution margin per unit.
Total Fixed Cost

Target Volume =
Adjusted Contribution Margin Per Unit
(Selling price – Variable cost per unit
– Target pre-tax profit per unit)
To determine the target sales revenue, divide the total fixed cost by the adjusted contribution margin
ratio.
Total Fixed Cost

Target Revenue =
Adjusted Contribution Margin Ratio
Example: For a company with a sale price per unit of 4.00, variable costs of 2.20, and fixed costs of
4,600.00, the after-tax net profit requirement is 20% of revenue. The tax rate is 30%. Here are the
steps to calculate the target sales volume and target sales revenue:
1. Calculate the target after-tax profit per unit by multiplying the required after-tax profit percentage
of revenue by the selling price per unit:
Target after-tax profit per unit = 0.20 × 4.00 = 0.80
2. Calculate the target pre-tax profit per unit by dividing the target after-tax profit per unit by 1 – the
tax rate:
0.80
= 1.14286
(1 – 0.30)
Each unit sold must include 1.14286 of pre-tax profit in order for the company to achieve an after-
tax profit equal to 20% of sales.
3. Calculate the adjusted contribution margin per unit required (including a deduction for the pre-tax
profit requirement):
Adjusted contribution margin per unit = 4.00 − 2.20 − 1.14286 = 0.65714
4. Calculate the target sales volume needed to achieve an after-tax profit equal to 20% of sales by
dividing the fixed costs by the adjusted contribution margin per unit:
4,600.00
Target volume = = 7,000 units
0.65714
5. Calculate the target sales revenue needed to achieve an after-tax net profit equal to 20% of sales by
dividing the fixed costs by the adjusted contribution margin ratio:
0.65714
Adjusted contribution margin ratio = = 0.164285
4.00
4,600.00
Target revenue = = 28,000
0.164285
Target revenue can also be calculated by multiplying the target sales volume by the sales price:
Target revenue = 7,000 × 4.00 = 28,000
Proof:
Revenue: 7,000 × 4.00 28,000
Variable costs: 7,000 × 2.20 15,400
Fixed costs 4,600
Profit before tax 8,000
Effective income tax @ 0.30 2,400
Profit after tax 5,600
5,600 profit after tax ÷ 28,000 revenue = 0.20 or 20%.
2 A 3. Responsibility Centers and Responsibility Accounting

A responsibility center is any part, segment, or subunit of an organization. A segment may be a product
line, a geographical area, or any other meaningful unit. Companies will have different segments based on
their activities. Responsibility accounting is an accounting system that measures accounting results of
each responsibility center separately. It is also used to measure the consolidated results of the company
as a whole.
A responsibility center’s plans are expressed in its budget, and the actual results for that responsibility
center are then compared against its budget to determine how well it is achieving its plans.
The budget is developed by the responsibility center and approved by top management. All of the respon-
sibility centers combined make up the consolidated budget. For instance, a Sales Budget is developed for
each individual responsibility center and all the responsibility centers’ budgets together make up the con-
solidated Sales Budget. Consolidating all the different budgets for all the different responsibility centers is
part of the process of developing the Master Budget.
The main purposes for responsibility centers and responsibility accounting are the evaluation of subunits’
performance and to contribute to measuring the performance of the subunits’ managers. Manager perfor-
mance measurement provides motivation for managers of the subunits, which in turn benefits the company
as a whole. The manager of a responsibility center should have the ability to control, or at least significantly
influence, the results of the center over which he or she has control. For example, a person responsible for
training in a company should not be granted or denied a bonus based on the world price of oil because the
training manager has no control over the world price of oil.
The main classifications of centers, listed in order of the most fundamental (or basic) to the most complex,
are:
1) A cost center is responsible only for the incurrence of costs. A cost center does not earn any
revenue and therefore generates no profit. An equipment maintenance department or an internal
accounting department is example of a cost center.
A cost center is the least complex type of center since it has no revenue or profit. Managers of
cost centers are best evaluated by variance analysis of their incurred costs. The key standard for
evaluating a cost center is its efficiency of operations, which measures whether or not the center
has provided the required services within the budget.
Note: A service department or service center within a larger company is usually a cost
center because it provides services to other departments, so it does not earn any revenue.
2) A revenue center is the opposite of a cost center in that it is responsible only for revenues. For
example, a sales department is a revenue center. Though every department will incur some costs,
the costs incurred by a revenue center are generally immaterial and may not even be controllable
by the center. For example, a revenue center’s costs may simply be allocated to them by the
central company. Managers in revenue centers are evaluated according to the level of revenue
that the center generates. Effectiveness, or the degree to which something is successful in pro-
ducing a desired result, is the key for their evaluation.
Note: Two terms that are related to the accomplishments of goals and objectives are efficiency and
effectiveness.
• Effectiveness has to do with the accomplishment of goals. If goals have been achieved, the effort
has been effective. Emphasis is on the accomplishment of the goals. An effective operation is one
that achieves or exceeds the goals set for the operation. Maximizing shareholder value is the ultimate
goal.
• Efficiency is the extent to which goals and objectives have been achieved while using the least
amount of resources. Emphasis is on the amount of resources used.
An efficient operation is one that makes effective use of its resources in carrying out the operation.
If a firm attains its goal of increasing sales but it spends more of its resources than necessary to
attain that goal, the firm may be effective but it is not efficient. Alternatively, a firm may be efficient
in its use of resources, spending less than planned per unit sold, but if the firm’s goals for profitability
and growth are not achieved because sales are too low, the firm’s operation was not effective. Both
efficiency and effectiveness are important for the overall firm.
3) A profit center is a department responsible for both revenues and expenses. A department within
a store, such as the hardware department, is an example of a profit center because it has both
revenues and cost of goods sold. Because a profit center is responsible for both costs and revenues,
the manager of a profit center should be evaluated on both costs and revenues generated by the
profit center. In a profit center, both efficiency and effectiveness are assessed, but priority
is given to effectiveness. In fact, the profit can be treated as the goal to be achieved.
4) An investment center is responsible for profit (revenues and costs) and for providing a return on
the capital that has been invested in it by the larger organization to which it belongs. Because it is
responsible for generating a return on investment, an investment center is the most like a complete
business by itself. However, it is still part of a larger organization. An example of an investment
center is a branch office. Effectiveness in achieving and exceeding predetermined criteria is the
key evaluation for an investment center manager.
In an investment center, the most important criterion for evaluation is the return on investment
provided by the investment center.
Note: Given the nature of the measurement of an investment center (return on investment), it
is preferable for a company to have as many investment centers as possible because the
goal of any business (and therefore any part of a business) should be return on invested capital.
Any responsibility center is effectively a unit for performance evaluation. That performance evaluation
may be for the unit itself, or it may be a part of the performance evaluation of the unit’s manager, or it
may be both. Responsibility centers exist to evaluate the performance of the various segments of the
business and the performance of their respective managers. Management uses this information to make
strategic decisions such as, “Should we expand that location?” or “Should we promote that manager?”
The choice of evaluating a given responsibility center as a cost center, a revenue center, a profit center, or
an investment center is a critical one. Although a designation may seem fairly clear-cut, in reality the choice
is not always a simple one. For example, nearly any responsibility center can be evaluated as an investment
center because every responsibility center uses fixed company assets. Even if those fixed assets are not
used to generate revenue, the fixed assets can still provide a return on investment if, for example, they
enable the company to do the same work at a lower cost.
The comparison of actual results against budgeted amounts by a responsibility center is important feedback.
The feedback inherent in the reporting of actual results, as compared to a plan, is the main link
between planning and control. Feedback lets the manager of the responsibility center and top manage-
ment know how well a manager has followed his or her plan and helps them make better-informed decisions
in the future. It is important for feedback to be available in a timely manner, both to the manager and to
top management. If it is not timely, it loses its relevance. Therefore, budget reports should be available as
rapidly as possible after the end of a reporting period.
When used properly, budgets established within the framework of a responsibility accounting system pro-
vide systematic feedback for managers. Reports of variances from the budget (that is, differences between
actual results and planned activity) should be used to direct attention to problems, and the emphasis should
be on evaluating information rather than assigning blame. If variance reports are used properly, they can
be helpful in evaluating a manager’s performance. However, variance reports should not be the sole basis
upon which managers are evaluated.
Note: Feedback is the main link between planning and control.
Evaluating the Manager vs. Evaluating the Business Unit

A company must always make a distinction between the performance of a manager and the performance
of the business unit that the manager manages. A company might assign one of its best managers to a
unit that has been unprofitable in an effort to turn the unit around. The manager might take some time to
effect a change, and in fact that unit might never be completely successful. The value of the manager’s
performance should not be judged only on the basis of the performance of the unit the manager manages.
When evaluating managers, a company should focus its attention only on those factors that the man-
ager can actually control. If a manager is evaluated based on something that he or she is unable to
control (either a cost or a revenue), the manager may be blamed for or given credit for something for which
he or she was not responsible. In other words, the performance evaluation of the manager should be the
performance evaluation of only the manager. For example, information on the unit’s performance can be
part of the performance appraisal of the manager, but it should not be the only information considered in
evaluating the manager.
Note: Because of the nature of the calculation of contribution (selling price minus variable costs), con-
tribution margin is something that is under the control of the manager of a profit center only if that
manager has the authority to set prices and make purchasing and other decisions. If managers cannot
set the price or do not control purchasing decisions, or both, they do not control the contribution margin.
If a responsibility accounting system with variance reporting is used as an evaluation tool, it should be
structured so that costs that are not under the manager’s control will be excluded or at least segregated
from the controllable costs.
In a larger sense, responsibility accounting should actually focus on information and knowledge more
than on control. A responsibility accounting system should be able to identify the person who can provide
the most information about an item in question, whether or not that person has any control over the item.
Example: A manager of a fast food restaurant that is part of a chain of restaurants may be held re-
sponsible for reporting on variances in the profits of the unit, even though he or she does not have
control over either the cost of the food or the price for which it is sold. Decisions outside of the manager’s
control should not be part of the manager’s performance evaluation. Even so, the manager can and
should still be held responsible for reporting on the results because he or she is in the best position to
explain the variances between actual and budgeted items.
For example, an unfavorable variance in the restaurant’s variable cost of goods sold may be due to food
provided by the company’s central warehouse that was spoiled and needed to be discarded. The fast
food manager knows the food was unacceptable, but the headquarters management needs to know it,
too, in order to have an opportunity to correct the problem.
Allocation of Common Costs

Common costs are costs of operating a business that cannot be allocated to any specific user or users on
any cause-and-effect basis. Examples of common costs are the chief executive officer’s salary, the costs of
the financial reporting function of the accounting department, and the costs of the budget department.
These examples are all administrative functions in the organization, and their services cannot be traced to
specific products or departments in any meaningful way. If any one segment of the business were to be
discontinued, the common costs would continue. For example, the CEO is concerned with the performance
of the whole organization, the CEO does not concentrate on any one department or product at a time, and
if one segment of the business were discontinued, the cost of the CEO’s salary would remain. Thus, the
CEO’s salary cannot be effectively traced to individual departments or products.
Common costs are different from shared services costs. Shared services are also administrative functions,
but shared services are used by internal departments and usage of the service by the individual depart-
ments or products can be allocated to user departments in a meaningful way based on a cost driver that
represents their usage of the service. For example, costs of shared service departments such as IT, mainte-
nance, legal, and accounting services such as invoicing, payroll, and accounts payable can be allocated to
users of the services on the basis of their usage.
The following discussion pertains to common costs that cannot be allocated on the basis of usage. Even
though they cannot be allocated on the basis of usage, the common costs do need to be allocated, internally
at least, primarily to provide accurate product costs for use in making decisions. The earnings from the
operating units need to be adequate to cover the common costs.
However, when a responsibility reporting system is used for managers’ performance evaluations, the sys-
tem should separate costs that are controllable by the responsibility center managers from costs that are
not controllable by them. Managers should not be held accountable in their performance reviews for costs
over which they have no control. Ordinarily, common costs are not controllable by the managers of the
segments that receive the allocated costs.
A company must make certain that all of the common costs are allocated to the operating departments,
regardless of the method it uses to allocate common costs. If all of the common costs are not allocated to
the production departments, the company runs the risk of not covering all of its costs as a whole because
it does not have the necessary information, even though each department may be covering its own indi-
vidual costs.
However, a company must consider the costs against the benefits of performing cost allocations. Costs of
the allocation include the research necessary to do the cost allocations and the time required to educate
the managers about cost allocations. The more complex the cost allocations are, the higher the costs to
educate will be.
Common Cost Allocation and Manager Evaluation

As stated previously, consideration of common cost allocation should play no role in the evaluation process
of managers. It is essential to evaluate a manager only on things that he or she can control. If the manager
cannot control the amount of common costs allocated to his or her department, then allocated common
costs should not be included in the evaluation of the manager.
Stand-Alone Allocation vs. Incremental Allocation

Once the company has the costs to allocate and the departments designated to receive allocations, math-
ematical allocation needs to be done. Common costs can be allocated in two ways: as stand-alone costs
or as incremental costs.
1) The stand-alone cost allocation method determines the weights for cost allocation by consid-
ering each user of the cost as a separate entity. When the stand-alone method is used, total
common costs are distributed among the operating units based on each unit’s proportion of the
entire organization, using an appropriate basis. The basis used could be each responsibility center’s
other costs as a proportion of the company’s total costs, or it could be the proportion of each
responsibility center’s sales in relation to total sales of the entire company, or anything else. Ad-
vocates of the stand-alone method maintain that it is fairer than the incremental cost-allocation
method because each responsibility center bears a proportionate share of total costs.
2) The incremental cost-allocation method ranks units according to their sizes or on some similar
basis. The largest unit is called the primary party. The primary party is charged for costs up to
what its cost would be if it were the only unit. The remaining cost is allocated to the other unit or
units, called incremental parties. The effect of the incremental method is that the largest unit
bears all the fixed common costs plus an allocation of the variable common costs, whereas the
incremental parties bear only an allocation of the variable common costs.
The primary advantage of the incremental method can be demonstrated in the example of a newly-
formed sales office. The office’s chances for survival may be greater if it is considered an incre-
mental party so that it will bear a relatively low allocation of common costs.
On the other hand, if there is no credible basis for designating one unit as the primary party and
others as incremental parties, the incremental method is not justified and can cause resentment
on the part of the primary party. Of course, all the parties in an incremental cost allocation system
will want to be designated incremental parties instead of the primary party.
An Alternative to Cost Allocation

An alternative to cost allocation is to assign some percentage of each department’s contribution to coverage
of common costs, rather than allocating common costs to each department. This procedure can help man-
agers of all the operating departments to see themselves as contributing to the overall success of the
company rather than paying expenses for a central administration that they do not perceive adds value to
their operations.
Note: Assigning some percentage of each operating department’s contribution to covering common
costs reminds each department that it is a part of a larger organization, and as such it has a responsibility
to the larger organization to maintain earnings that are adequate to cover a portion of the firm’s indirect
costs; and it formalizes their accountability for doing so.
The Contribution Profit or Loss Statement Approach to Evaluation

A contribution statement of profit or loss differs from a traditional statement of profit or loss. A traditional
statement of profit or loss uses absorption costing, and cost of goods sold includes both fixed and variable
costs of production that were allocated to the units that were sold during the period. On a contribution
profit or loss statement, fixed costs are segregated from variable costs and presented on separate lines.
Only variable costs are allocated to production and thus to the units sold. Variable expenses include not
only variable production costs but also variable selling, general, and administrative expenses. The contri-
bution margin is the difference between revenues and all variable expenses (both production and non-
production variable expenses). All fixed expenses, both production and non-production, are reported below
the contribution margin line as a reduction to the contribution margin.
A variation of the contribution profit or loss statement can be used to isolate controllable costs of a business
unit from its non-controllable costs, such as depreciation or allocated central costs. Thus, it is a way of
evaluating managers of profit and investment centers. The contribution profit or loss statement used for
evaluation has four “levels.” Each level enables the evaluation of a different aspect of performance.
• The segment manager’s performance is evaluated on the basis of revenues generated minus
variable costs and fixed costs that are controllable by the segment manager.
• The segment’s performance is evaluated on the basis of revenues generated minus variable costs,
fixed costs that are controllable, and fixed costs that are not controllable by the segment manager
but are traceable to the segment. A traceable fixed cost is a fixed cost that can be assigned to a
particular segment on a cause-and-effect basis. A traceable fixed cost is a cost that would be
eliminated if the segment were to be sold or closed.
• The last line on the statement includes fixed common costs that are not controllable by the seg-
ment manager and are not traceable to any specific segment. They are overall administrative costs
borne by the company as a whole. An untraceable cost is a cost that cannot be assigned to any
particular segment on a cause-and-effect basis. If a particular segment were sold or closed, the
untraceable cost allocated to it would continue and would simply be allocated to the remaining
segments. Untraceable costs are common costs, and they are not controllable by the segment
manager. These non-controllable, untraceable common costs are not included in the evaluation of
either the segment manager or the segment.
The various lines on the report are explained in more detail following the example below.
Company
as a whole Division 1 Division 2
Net revenues 10,000 3,000 7,000
Variable manufacturing costs 3,900 900 3,000

Manufacturing contribution margin (Level 1) 6,100 2,100 4,000
Variable nonmanufacturing costs (selling, admin.) 600 100 500

Contribution margin (Level 2) 5,500 2,000 3,500
Controllable fixed costs 1,250 500 750

Controllable margin or short-term segment
Manager performance (Level 3) 4,250 1,500 2,750
Non-controllable, traceable fixed costs 2,000 600 1,400

Contribution by strategic business
unit or segment performance
(segment margin) (Level 4) 2,250 900 1,350
Non-controllable, untraceable, common costs 1,000

Operating income 1,250
Level 1: Manufacturing Contribution Margin (Net Revenue Less Variable Manufacturing Costs)
Net revenues represent the sales value of all sales for the period.
Variable manufacturing costs include all of the variable costs of production (such as labor, materials
and variable overheads) that were incurred in the production of the units sold.
The manufacturing contribution margin of the company is the amount of money that is available to cover
nonmanufacturing variable costs, all fixed costs, and then flow to profit. After all nonmanufacturing variable
costs and all fixed costs have been covered, increases to the manufacturing contribution margin flow directly
to profit.
Level 2: Contribution Margin (Manufacturing Contribution Less Variable Nonmanufacturing Costs)

Variable nonmanufacturing costs include all variable costs that are not part of the production process.
These include, but are not limited to, marketing, selling, and general and administrative costs that are
variable in nature.
The contribution margin of the company is the amount of money that is available to cover fixed costs and
then flow to profit after all variable costs are covered.
Level 3: Controllable Margin (Contribution Margin Less Controllable Fixed Costs)

Controllable fixed costs are fixed costs that the segment manager is able to control and influence. Ex-
amples of controllable fixed costs include salaries of supervisors who report to the segment manager and
expenses incurred by the segment that only benefit that segment (such as sales promotions).
The controllable margin (also called short-term segment manager performance) is important because
it is a measurement of all the revenues and expenses (variable and fixed) that are controllable by the
individual managers on a short-term (that is, less than one year) basis. The controllable margin is a useful
measure of a manager’s short-term performance.
Level 4: Segment Margin (Controllable Margin Less Non-controllable, Traceable Fixed Costs)
Non-controllable, traceable fixed costs are fixed costs that cannot be controlled by the manager within
a time span of one year or less. “Traceable” fixed costs are costs that would be eliminated if the segment
were to be sold or closed. However, the decision to incur the costs may not be controllable by the segment
manager. Non-controllable, traceable fixed costs are usually facilities costs such as depreciation, taxes, and
insurance. They are included in the calculation of the segment margin but they are not included in calcu-
lating the controllable margin.
The segment margin (also called contribution by strategic business unit, or contribution by SBU) is
a measure of the performance of each business unit. It may also be used as a measure of the long-term
performance of the manager, if the manager can control the non-controllable traceable fixed costs over a
long-term period. However, in many cases, decisions that affect non-controllable traceable fixed costs are
made by others.
Non-controllable, untraceable common costs allocated to a segment must not be used in evaluating
the performance of the segment or the segment manager. Non-controllable, untraceable fixed costs are
costs that are incurred at the company level and would continue even if the individual segment were dis-
continued. The company needs to be able to cover these important costs. However, these costs should not
be a part of a segment manager’s performance evaluation, because the segment manager has no control
over them. For purposes of evaluation, they can be omitted from the individual segment reports. Omitting
them from the individual segment reports will prevent the sum of the individual segments’ net incomes
from reconciling to the company’s consolidated net income. To illustrate, in the above example the sum of
the two divisions’ contributions is 2,250 (900 + 1,350), but the company’s consolidated net income is only
1,250. The difference is 1,000 in untraceable, common costs that have not been allocated to either division
but that have reduced the consolidated net income.
Use of the Contribution Profit or Loss Statement

A contribution profit or loss statement (such as the example above) is very flexible. It can be used to
measure a manager’s performance. It can also be used to measure the performance of a profit or invest-
ment center to determine whether the segment should be dropped, retained, or expanded. The contribution
profit or loss statement analysis can be extended to the product level, with each segment’s total revenues
and expenses assigned to the various products produced by that division. This type of product profitability
analysis can be used to determine which products are contributing to the overall untraceable costs and
which are not.
In the above performance report, the segment margin for each division is equal to the segment’s total
sales minus all variable and fixed costs of the segment that are traceable to the segment, whether control-
lable by the segment manager or not.
The only expenses that are not included in the calculation of each division’s segment margin are the non-
controllable, untraceable common costs on the very last expense line. An example of untraceable, common
costs is the chief executive officer’s compensation. The CEO’s time is spent managing all the divisions of
the company, but the CEO’s compensation cannot be allocated according to the amount of time spent on
each division. The majority of the CEO’s time is spent managing the entire company, not just one division
at a time. Another example would be a company’s sponsorship of a sporting event such as the World Cup
or the Olympics. It is very difficult to determine how much any individual department or segment benefits
from such a sponsorship. Furthermore, the sponsorship decision would have been made at the top levels
of management without input from responsibility center managers. Therefore, this institutional market-
ing expense is not allocated to the individual responsibility centers on a contribution profit or loss
statement that will be used for performance evaluation.
The untraceable, common costs from the above example may actually have been allocated between the
two segments within the company’s accounting system on some reasonable basis. But for the purposes of
segment performance evaluation, any allocations of the non-controllable, untraceable common costs made
in the accounting system must be pulled out of the individual segments’ performance reports and shown
only as costs of the company as a whole.
2 A 4. Shared Services Cost Allocation

Shared services are administrative services provided by a central department to the company’s operating
units. Shared services are usually services such as human resources, information technology, maintenance,
legal, and many accounting services such as payroll processing, invoicing and accounts payable. Usage of
the services by the individual departments (cost objects) can be traced in a meaningful way based on a
cost driver that fairly represents each one’s usage of the service.
These shared services, or support, departments incur costs (salaries, rent, utilities, and so on). For internal
decision-making, the costs of shared service departments need to be allocated to the operating departments
that use their services in order to calculate the full cost of operations or production. Shared services costs
are allocated for each shared service department as a single cost pool containing all of the service depart-
ment’s costs, and the costs are allocated to user departments on the basis of a single cost driver, such as
hours of service used.
Note: The cost allocation methods that follow are all stand-alone cost allocation methods.
Reasons for allocating shared services costs include:
• Cost allocation provides accurate departmental and product costs for use in making decisions,
valuing inventory, and evaluating the efficiency of departments and the profitability of individual
products.
• It motivates managers and other employees to make their best efforts in their own areas of re-
sponsibility to achieve the company’s strategic objectives by reminding them that earnings must
be adequate to cover indirect costs.
• It provides an incentive for managers to make decisions that are consistent with the goals of top
management.
• It fixes accountability and provides a fair evaluation of the performance of segments and segment
managers.
• It can be used to create competition among segments of the organization and their managers to
stimulate improved performance.
• It justifies costs, such as transfer prices.
• It can be used to compute reimbursement when a contract provides for cost reimbursement.
Cost allocations may be performed for just one shared service or support department whose costs are
allocated to multiple user departments, or they may be performed for multiple shared service or support
departments whose costs are being allocated both to other service and support departments and to oper-
ating departments. But even when costs of shared service departments are allocated to other service
departments, ultimately all the shared service costs will be allocated fully to operating departments.
Allocating Costs of a Single (One) Service or Support Department to Multiple Users

Before allocating the costs of a shared service department to operating departments, management must
decide whether the shared service department’s fixed costs and its variable costs should be allocated as
one amount or whether the fixed and variable costs should be allocated separately, which would enable the
fixed costs to be allocated in a different manner from the variable costs. Allocating all costs as one amount
is called the single-rate method. Allocating the fixed and variable costs as two separate cost pools is called
the dual-rate method.
• Single-Rate Method – The single-rate method does not separate fixed costs of service depart-
ments from their variable costs. All of the service department costs are put into one cost pool and
the costs are allocated using one allocation base.
• Dual-Rate Method – The dual-rate method breaks the cost of each service department into two
pools, a variable-cost pool and a fixed-cost pool. Each cost pool is allocated using a different cost-
allocation base.
Allocation bases for either the single-rate method or the dual-rate method can be:
• Budgeted rate and budgeted hours (or other cost driver) to be used by the operating divisions.
• Budgeted rate and actual hours (or other cost driver) used by the operating divisions.
Following are examples of the single-rate method and the dual-rate method, using the same data for both.
Example #1: Single-rate method of allocation:
The following information is from the 20X0 budget for EZYBREEZY Co. EZYBREEZY has one service de-
partment, its Maintenance Department, that serves its Manufacturing and Sales departments. The
Maintenance Department has a practical capacity of 5,000 hours of maintenance service available each
year. The fixed costs of operating the Maintenance Department (physical facilities, tools, and so forth)
are budgeted at 247,500 per year. The wages for the maintenance employees and the supplies they
require are the variable costs, and those are budgeted at 25 per hour.
Budgeted Maintenance usage by the Manufacturing and Sales departments is as follows:

Manufacturing 3,500 hours
Sales 1,000 hours
Total budgeted usage 4,500 hours
Using the single-rate method, the budgeted total cost pool will be:
247,500 fixed cost + (4,500 hours × 25) variable cost = 360,000
The allocation rate for the total maintenance cost is 360,000 ÷ 4,500 hours, which is 80 per hour.
The single-rate method is usually used with the second allocation base option: budgeted rate and actual
hours used. The actual maintenance hours used by the Manufacturing and Sales departments are as
follows:
Sales 1,100 hours
Total actual usage 4,700 hours
Therefore, the amounts of Maintenance department costs that will be allocated to the Manufacturing and
Sales departments are:
Manufacturing 3,600 actual hours × 80 288,000
Sales 1,100 actual hours × 80 88,000
Total cost allocated 376,000
(continued)
The problem with the single-rate method is that, from the perspective of the user departments, the
amount they are charged is a variable cost because it is based on their activity level, even though it
includes costs that are fixed. The manager of the Manufacturing department could be tempted to cut his
department’s costs by outsourcing the maintenance function if he could find a company to supply mainte-
nance for less than 80 per hour.
Assume that an outside maintenance company offers to do the maintenance for the Manufacturing de-
partment for 60 per hour. The amount paid to the outside company will be 3,600 hours @ 60 per hour,
or 216,000. The Manufacturing department manager is happy, because he has saved 72,000 (288,000
− 216,000) for his department.
However, the fixed costs of the in-house Maintenance department do not go away just because Manu-
facturing is not using its services any longer. The total cost of the Maintenance department (now being
used only by the Sales department) will be 247,500 fixed cost + (1,100 hours used by the Sales depart-
ment × 25) variable cost = 275,000, assuming the actual costs incurred are equal to the budgeted
amounts. This is 85,000 less than was budgeted (360,000 − 275,000). However, the company as a
whole is paying an additional cost of 216,000 to the outside maintenance company. Thus, for the com-
pany as a whole, total maintenance cost is now 491,000 (275,000 for the internal maintenance
department + 216,000 for the outside company), which is 131,000 greater than the budgeted amount
of 360,000 for maintenance. The Manufacturing department’s actions have caused a variance in costs
for the company as a whole of 131,000 over the budgeted amount.
Example #2: Dual-rate method of allocation:
The following information is from the 20X0 budget for EZYBREEZY Co. EZYBREEZY has one service de-
partment, its Maintenance Department, that serves its Manufacturing and Sales departments. The
Maintenance Department has a practical capacity of 5,000 hours of maintenance service available each
year. The fixed costs of operating the Maintenance Department (physical facilities, tools, and so forth)
are budgeted at 247,500 per year. The wages for the maintenance employees and the supplies they
require are the variable costs, and those are budgeted at 25 per hour.
Budgeted Maintenance usage by the Manufacturing and Sales departments is as follows:

Sales 1,000 hours
Total budgeted usage 4,500 hours
Because a dual-rate method is being used, EZYBREEZY selects an allocation base for the variable costs
and an allocation base for the fixed costs. The company allocates the variable costs based on the budg-
eted variable cost per hour (25) and the actual hours used. It allocates fixed costs based on budgeted
fixed costs per hour and the budgeted number of hours for each department (option #1).
The actual maintenance hours used by the Manufacturing and Sales departments are as follows:
Sales 1,100 hours
Total actual usage 4,700 hours
The allocation rate for the fixed cost is 247,500 budgeted cost ÷ 4,500 budgeted hours, or 55 per hour.
The allocation rate for the variable cost is 25 per hour.
(continued)
The amounts allocated to each user department are now:
Manufacturing:
Fixed Costs: 55 × 3,500 budgeted hours 192,500
Variable Costs: 25 × 3,600 actual hours 90,000
Total allocated to Manufacturing 282,500
Sales:
Fixed Costs 55 × 1,000 budgeted hours 55,000
Variable Costs: 25 × 1,100 actual hours 27,500
Total allocated to Sales 82,500
Total cost allocated 365,000
Under the dual-rate method, the total costs allocated to each user department are different from the
costs allocated under the single-rate method because the fixed costs are allocated based on the budg-
eted usage under the dual-rate method and based on the actual usage under the single-rate method.
Under the dual-rate method, the Manufacturing and Sales departments would each be charged for its
budgeted fixed allocation of costs even if it does not use the internal Maintenance department.
That should discourage the manager of the Manufacturing department from contracting with an outside
maintenance service.
Benefits of the Single-Rate Method
• The cost to implement the single-rate method is low because it avoids the analysis needed to classify
all of the service department’s cost into fixed and variable costs.
Limitations of the Single-Rate Method
• The single-rate method makes fixed costs of the service department appear to be variable costs to
the user departments, possibly leading to outsourcing that hurts the organization as a whole.
Benefits of the Dual-Rate Method
• The dual-rate method helps user department managers see the difference in the ways that fixed
costs and variable costs behave.
• The dual-rate method encourages user department managers to make decisions that are in the best
interest of the organization as a whole, as well as in the best interest of each individual department.
Limitations of the Dual-Rate Method
• The cost is higher than the cost of the single-rate method because of the need to classify all of the
costs of the service department into fixed and variable costs.
Allocating Costs of Multiple Shared Service Departments

Special cost allocation problems arise when an organization has several shared service departments and
the shared service departments provide support not only to the operating departments but to the other
shared service departments as well. The factor that complicates the process is service departments using
the services of other service departments. For example, people in the maintenance department use the
services of the IT department and eat in the cafeteria.
Three different methods of allocating costs of multiple shared service departments are used when service
departments use the services of other service departments. All three methods are simply mathematical
allocations. The different methods of multiple shared service cost allocation treat these reciprocal services
differently.
The three methods of allocation are:
1) The direct method

2) The step (or step-down) method
3) The reciprocal method
Note: The following discussion of multiple service departments uses only the single rate method (fixed
and variable costs allocated together). However, the dual-rate method can also be used to allocate costs
of multiple service departments. To do so, a company would need to do two separate allocations, one of
fixed costs and one of variable costs.
1) The Direct Method – IGNORING Services Provided Between Service Departments

Under the direct method the reciprocal services provided by the different shared service departments to
each other are ignored. The company simply allocates all of the shared service departments’ costs directly
to the operating departments. The allocation is made on a basis that is reasonable and equitable to the
operating departments for each service department. For example, the costs of a subsidized employee caf-
eteria should be allocated to the operating departments based on the number of employees, while the
maintenance department’s costs may be allocated based on the number of maintenance hours used by
each operating department.
When calculating the usage ratios for the different operating departments under the direct method, count
only the usage of the shared service departments by the operating departments. The usage of
shared service departments that takes place in the other service departments is excluded because service
departments will not be allocated any costs from other service departments.
The direct method is the simplest and most common method. A very short example follows (the calculations
of the allocations are not shown).
Maintenance Cafeteria Production 1 Production 2 Production 3

Departmental
100 120 300 400 800
Costs Incurred
Allocation of
Maintenance (100) 20 30 50
Costs
Allocation of
Cafeteria (120) 30 30 60
Costs
TOTAL COSTS 0 0 350 460 910
2) The Step-Down or Sequential Method – Recognizing SOME Services Provided Between Service
Departments
The step-down method is also called the step method or the sequential method. In the step-down
method the services the shared service departments provide to each other are included, but only one
allocation of the costs of each service department is made. After the costs of a particular service department
have been allocated, that service department will not be allocated any additional costs from other service
departments. The step-down method leads to a stair step-like diagram of cost allocations. Because each
service department’s costs, including costs allocated to it by other service departments, are allocated in
turn, all service department costs ultimately end up allocated to the operating departments.
In order to use the step-down method, an order must be established in which the service department costs
are allocated. This order can be any order management chooses. A popular method is to determine
the order according to the percentage of each department’s services provided to other shared service de-
partments, although that is not the only possible way. If, for example, the costs of the department that
provides the highest percentage of its services to other shared service departments are allocated first, then
the costs of the department that provides the next highest percentage of its services to other shared service
departments comes next, and so forth.
The first shared service department’s costs are allocated to the other shared service departments and the
operating departments. The second shared service department’s costs (which now include its share of the
first shared service department’s costs) are allocated next to the other shared service departments (but
not to the first shared service department that has already been allocated) and the operating departments.
Once a shared service department’s costs have been allocated, no costs will be allocated to it from other
shared service departments.
A problem on the exam will give the allocation order to use if it is not obvious.
Following is an example of the step-down method.

Departmental
100 120 300 400 800
Costs Incurred
Allocation of
Maintenance (100) 10 16 28 46
Costs
Allocation of
Cafeteria (130) 36 32 62
Costs
TOTAL COSTS 0 0 352 460 908
The example of the step-down method is a bit different from the example of the direct method. Use of the
step-down method results in a slightly different result from the direct method, even though the operating
departments used the same amounts of services of the two shared service departments in both examples.
Again, the allocation calculations are not shown.
Note: In the step-down method, the costs allocated from the cafeteria include its own incurred costs
(120), plus the cafeteria’s share of the maintenance costs that were allocated to it from maintenance
(10). When the maintenance department’s costs are allocated, they are allocated on the basis of the
number of hours that the cafeteria utilized the services of the maintenance department. However, when
the cafeteria costs (including the cafeteria’s share of the maintenance costs) are allocated, none of its
costs are allocated to the maintenance department for its usage of the cafeteria.
3) The Reciprocal Method – Recognizing ALL Services Provided Between Service Departments
The reciprocal method is the most complicated and advanced of the three methods of shared services cost
allocation because it recognizes all of the services provided by the shared service departments to the other
shared service departments. Because of this detailed allocation between and among the shared service
departments, the reciprocal method is the most theoretically correct method to use. However, a company
will need to balance the additional costs of allocating costs this way against the benefits received. Graph-
ically the reciprocal method looks like the following.

Departmental
100 120 300 400 800
Costs Incurred
Allocation of
Maintenance (108) 10 20 29 49
Costs
Allocation of
Cafeteria 8 (130) 33 30 59
Costs
TOTAL COSTS 0 0 353 459 908
Notice that the shared service departments are each allocating some of their costs to the other shared
service department. As a result, the total amount allocated by each shared service department will be
greater than its own overhead costs, since each shared service department must allocate all of its own
costs plus some of the other shared service department’s costs that have been allocated to it. The math to
do this is the most complicated of the three methods, but even it is not too difficult.
To solve a problem using the reciprocal method, “simultaneous” or multiple equations are used. With two
shared service departments, the multiple equations are set up as follows:
Maintenance Costs (M) to Allocate = M’s Costs Incurred + M’s % of C’s Costs
Cafeteria Costs (C) to Allocate = C’s Costs Incurred + C’s % of M’s Costs
The first step is to solve for either “Maintenance Costs to Allocate” or “Cafeteria Costs to Allocate,” and
after that solve for the other number. These calculated amounts become the amounts that need to be
allocated from the maintenance department and cafeteria to all the other departments, including the other
service departments.
The process of solving the two equations is shown in detail in the example on the following pages.
Comprehensive Example of the Three Methods of Shared Service Cost Allocation
Example: The following information about Cubs Co. is used to demonstrate the three different methods
of allocating shared service costs. Cubs Co. has two shared service departments (A and B) and three
operating departments (X, Y and Z). Shared Service Department A allocates its overhead based on direct
labor hours and Shared Service Department B allocates its overhead based on machine hours. The fol-
lowing information is in respect to the service and operating departments:
Dept. A Dept. B Dept. X Dept. Y Dept. Z Total
Overhead Cost 100,000 50,000 200,000 300,000 250,000 900,000
Labor Hours -- 1,000 2,000 4,000 3,000 10,000
Machine Hours 2,000 -- 2,000 2,000 2,000 8,000
(continued)
Direct Method
Under the direct method each shared service department allocates overhead costs to only the operating
departments. The operating departments used a total of 9,000 labor hours of service from Department
A (2,000 + 4,000 + 3,000), so each department is allocated 11.11111 for each direct labor hour used
to the operating departments (100,000 in costs ÷ 9,000 total service hours provided). Department B
provided 6,000 machine hours of service to the operating departments (2,000 + 2,000 + 2,000), so it
allocates 8.33333 per machine hour used to the operating departments (50,000 in costs ÷ 6,000 ma-
chine hours provided). The services provided by each service department to the other service department
are ignored in the direct method. The numbers that are ignored are shaded below.

Overhead Cost 100,000 50,000 200,000 300,000 250,000 900,000
Labor Hours -- 1,000 2,000 4,000 3,000 10,000
Machine Hours 2,000 -- 2,000 2,000 2,000 8,000
The next step is to determine how much of the costs of the shared service departments will be allocated
to each operating department. The costs of Department A are allocated on the basis of direct labor hours.
Since the 1,000 labor hours provided to Department B by Department A are ignored, only 9,000 total
direct labor hours are used in the allocation. Of the total 9,000 direct labor hours used in the allocation,
Department X used 2,000 labor hours, Department Y used 4,000 labor hours, and Department Z used
3,000 labor hours. Therefore, Department X is allocated 11.11111 × 2,000 hours = 22,222.22 of costs
from Department A. Department Y is allocated 11.11111 × 4,000 hours = 44,444.45 (adjusted for
rounding difference), and Department Z is allocated 11.11111 × 3,000 hours = 33,333.33.
Department B’s costs are allocated on the basis of machine hours. Since 2,000 machine hours of service
were provided by Department B to Department A and those are ignored, 6,000 machine hours in total
are used in the allocation. Of the total 6,000 machine hours used in the allocation, Departments X, Y
and Z each used 2,000 machine hours. Therefore, each operating department is allocated 8.33333 per
hour × 2,000 hours = 16,666.66. (Two of the amounts will be adjusted for rounding differences.)
Below are the total overhead costs for each department after the allocation:
Dept. A Dept. B Dept. X Dept. Y Dept. Z

Own Overhead Cost 100,000.00 50,000.00 200,000.00 300,000.00 250,000.00
Allocated from A (100,000.00) 0.00 22,222.22 44,444.45 33,333.33
Allocated from B 0.00 (50,000.00) 16,666.67 16,666.66 16,666.67
Total OH 0.00 0.00 238,888.89 361,111.11 300,000.00
Step-Down Method
The first requirement for the step-down method is to determine which shared service department’s costs
will be allocated first. 25% of the service provided by Department B was provided to Department A, but
only 10% of Department A’s service provided was provided to Department B. Therefore, Department B’s
costs are allocated first. Department B’s cost of 50,000 is allocated on the basis of machine hours used
by all the other departments, including Department A. In total 8,000 machine hours were used, so
Department B’s cost to allocate per machine hour is 6.25 (50,000 ÷ 8,000).
(continued)
Department B’s costs are allocated among all the other departments, including Department A, based on
machine hours used by each. Department A is allocated 6.25 × 2,000 hours, or 12,500. This 12,500 is
added to the 100,000 of A’s own overhead, for a total 112,500 cost for Department A to allocate. De-
partment A’s 112,500 cost is allocated only to the operating departments based on the direct labor hours
used by each. The allocation of Department A’s costs is done the same way as in the direct method,
except that the amount of cost allocated by Department A is greater than it was in the direct method
because some costs allocated from Department B are included in Department A’s costs to allocate.
Department B’s costs are allocated first. As mentioned previously, Department A is allocated 12,500 of
Department B’s costs. Since Departments X, Y and Z each also used 2,000 machine hours, each of those
departments is also allocated 12,500 from Department B (6.25 × 2,000 machine hours).
Next, the costs of Department A are allocated to the operating departments only. The total costs to be
allocated for Department A are Department A’s own overhead of 100,000 plus the 12,500 allocated
overhead from Department B, for a total to allocate of 112,500. That 112,500 is allocated based on
direct labor hours, excluding the direct labor hours used by Department B. Therefore, a total of 9,000
direct labor hours (2,000 + 4,000 + 3,000) are used in allocating Department A’s total overhead of
112,500. 112,500 ÷ 9,000 = 12.50 to be allocated per direct labor hour used. Department X, which
used 2,000 machine hours, is allocated 12.50 × 2,000 = 25,000. Department Y, which used 4,000
machine hours, is allocated 12.50 × 4,000 = 50,000, and Department Z, which used 3,000 machine
hours, is allocated 12.50 × 3,000 = 37,500.
It is important to remember in the step-down method that the hours the second shared service depart-
ment provides to the first are ignored when allocating the second shared service department’s costs.
The ignored numbers are shaded below.
Overhead Cost 100,000 50,000 200,000 300,000 250,000 900,000
Labor Hours -- 1,000 2,000 4,000 3,000 10,000
Machine Hours 2,000 -- 2,000 2,000 2,000 8,000
Below are the total overhead costs for each department after the allocation:
Allocated from A (112,500.00) 0.00 25,000.00 50,000.00 37,500.00
Allocated from B 12,500.00 (50,000.00) 12,500.00 12,500.00 12,500.00
Total OH 0.00 0.00 237,500.00 362,500.00 300,000.00
Reciprocal Method
Under the reciprocal method some of Department A’s costs are allocated to Department B and some of
Department B’s costs are allocated to Department A using simultaneous equations. Since Cubs Co. has
two shared service departments, two equations will be needed. (If the company had three shared service
departments, three equations would be needed, and so forth.) The equations express how much each
shared service department needs to allocate to all the other departments, including the other shared
service departments.
Department A used 25% of Department B’s services (2,000 MH used ÷ 8,000 total MH). Therefore, A is
allocated 25% of B’s costs. A’s costs to allocate equal the 100,000 in costs incurred by A plus 25% of
the costs incurred by B. Department B used 10% of Department A’s services (1,000 DLH used ÷ 10,000
total DLH). Therefore, B is allocated 10% of A’s costs. B’s costs to allocate equal the 50,000 in costs
incurred by B plus 10% of the costs incurred by A. The equations needed are:
A = 100,000 + 0.25B
B = 50,000 + 0.10A
(continued)
Solve for A by substituting the right side of the second equation (B) into the first equation:
A = 100,000 + 0.25 (50,000 + 0.10A)
The resulting equation has only one variable (A) in the equation and can be solved for Dept. A, as follows.
A = 100,000 + 12,500 + 0.025A

0.975A = 112,500
A = 115,384.62
The result, 115,384.62, is the total cost for Department A to be allocated to all the other departments,
including B, the other shared service department.
The next step is to put the value found for A into the second equation in place of the variable A:
B = 50,000 + 0.1 (115,384.62)
B = 61,538.46
The total cost for Department B to be allocated to all the other departments, including A, the other
shared service department, is 61,538.46.
The total overhead cost for Department A, 115,384.61, is allocated among all the other departments on
the basis of the full 10,000 direct labor hours used, or 11.53846 per hour. The cost of Department A
allocated to Department B is 11.53846 × 1,000 = 11,538.46. Department X is allocated 11.52846 ×
2,000 = 23,076.92 of Department A’s costs, Department Y is allocated 11.53846 × 4,000 = 46,153.85,
and Department Z is allocated 11.53846 × 3,000 = 34,615.38.
The total overhead cost for Department B, 61,538.46, is allocated among all the other departments on
the basis of the full 8,000 machine hours used, or 7.69231 per machine hour. Departments A, X, Y and
Z each used 2,000 machine hours, so each will be allocated 7.69231 × 2,000 = 15,384.62. (Two of the
departments’ amounts will be adjusted for rounding differences.)
Below are the total overhead costs for each department after the allocations:
Allocated from A (115,384.61) 11,538.46 23,076.92 46,153.85 34,615.38
Allocated from B 15,384.61 (61,538.46) 15,384.61 15,384.62 15,384.62
Total OH 0.00 0.00 238,461.53 361,538.47 300,000.00
Notice that in all of the methods of overhead allocation, the total of the overhead amounts allocated to
the operating departments is equal to the total amount of overhead that the company as a whole—
including the shared service departments—incurred during the period (900,000).
2 B. Cost Management Systems

Cost management systems are used as basic transaction reporting systems and for external financial re-
porting. Cost management systems not only provide reliable financial reporting, but they also track costs
in order to provide information for management decision-making.
2 B 1. Cost Classifications
The Difference Between Costs and Expenses

Costs and expenses are two different things.
1) Costs are resources given up to achieve an objective.
2) Expenses are costs that have been charged against revenue in a specific accounting period.
“Cost” is an economic concept, while “expense” is an accounting concept. A cost need not be an expense,
but every expense is a cost or was a cost before it became an expense. Most costs eventually do become
expenses, such as manufacturing costs that reach the statement of profit or loss as cost of goods sold when
the units they are attached to are sold, or the cost of administrative fixed assets that have been capitalized
on the balance sheet and subsequently expensed over a period of years as depreciation.
However, some costs do not reach the statement of profit or loss. Implicit costs76 such as opportunity
costs77 never become expenses in the accounting records, but they are costs nonetheless because they
represent resources given up to achieve an objective.
Product Costs vs. Period Costs

Costs are classified according to their purpose. The two main classifications of costs based on purpose are
product (or production) costs and period costs.
Product Costs (also called Inventoriable Costs)

Product costs, or inventoriable costs, are costs for the production process without which the product could
not be produced. Product costs are “attached” to each unit and are carried on the statement of financial
position as inventory during production (as work-in-process inventory) and when production is completed
(as finished goods inventory) until the unit is sold. When a unit is sold, the item’s cost is transferred from
inventory to the statement of profit or loss where it is classified as cost of goods sold, which is an expense.
The main types of product costs are: 1) direct materials, 2) direct labor, and 3) manufacturing over-
head (both fixed and variable). These different product costs can be combined and given different names
as outlined in the tables below.
76
Implicit costs are costs that do not involve any specific cash payment and are not recorded in the accounting records.
77
An opportunity cost is the contribution to income that is lost by not using a limited resource in its best alternative
use. An opportunity cost is a type of implicit cost. Both implicit costs and opportunity costs are discussed in more detail
later.
Types of Product Costs

The costs that follow are the main costs incurred in the production process.
Direct labor Direct labor costs are the costs of labor that can be directly traced to the production
of a product. The cost of wages for production workers is a direct labor cost for a
manufacturing company.
Direct material Direct materials are the raw materials that are directly used in producing the fin-
ished product. The costs included in the direct material cost are all of the costs
associated with acquiring the raw material: the raw material itself, shipping-in
cost, and insurance during transit, among others. Common examples of direct
materials are plastic and components.
Manufacturing Manufacturing overhead costs are the company’s costs related to the production
overhead process that are not direct material or direct labor but are necessary costs of pro-
duction. Examples are indirect labor, indirect materials, rework costs, electricity
and other utilities, depreciation of plant equipment, and factory rent.
Indirect labor Indirect labor is labor that is part of the overall production process but does not
come into direct contact with the product. A common example is labor cost for
employees of the manufacturing equipment maintenance department. Indirect la-
bor is a manufacturing overhead cost.
Indirect material Similar to indirect labor, indirect materials are materials that are not the main
components of the finished goods. Examples are glue, screws, nails, and other
materials such as machine oils, lubricants, and miscellaneous supplies that may
not even be physically incorporated into the finished good. Indirect materials are
a manufacturing overhead cost.
Groupings of Product Costs

The five main types of product costs in the previous table can be further combined to create different cost
classifications. The three classifications that candidates need to be aware of are in the following table.
Prime costs Prime costs are the costs of direct material and direct labor. Direct material
and direct labor are the direct inputs, or the direct costs of manufacturing.
Manufacturing Manufacturing costs include the prime costs and manufacturing overhead ap-
costs plied. These are all of the costs that need to be incurred in order to produce the
product. Manufacturing costs do not include selling or administrative costs, which
are period costs.
Conversion costs Conversion costs include manufacturing overhead (both fixed and variable) and
direct labor. Conversion costs are the costs required to convert the direct ma-
terials into the final product.
Note: Direct labor is both a prime cost and a conversion cost.
Period Costs, or Nonmanufacturing Overheads

Period costs are costs for activities other than the actual production of the product. Period costs are ex-
pensed as they are incurred.
The number of period costs is almost unlimited because period costs include essentially everything other
than the product costs, since all costs must be either product costs or period costs. The more commonly-
used examples of period costs include selling, administration, and accounting, but period costs are all the
costs of any department that is not involved in production.
Period costs can be variable, fixed or mixed, but they are not included in the calculation of cost of goods
sold or cost of goods manufactured (both of which are covered later). For financial reporting purposes,
period costs are expensed to the statement of profit or loss as they are incurred.
However, for internal decision-making, some period costs may be allocated to the production
departments and then to the individual units. This allocation may be done internally so that the com-
pany can set a price for each product that covers all of the costs the company incurs. This type of allocation
was covered in the topic of Shared Services Cost Allocation.
Note: Overhead allocation of period costs to production is not reported as such in the external financial
statements issued by the company, because it is not proper to do so according to either IFRS or U.S.
GAAP. According to both IFRS and U.S. GAAP, period costs should be expensed in the period in which
they are incurred. Allocation of period costs to production is used for internal decision-making purposes
only.
The number of classifications of period expenses that a company uses on its statement of profit or loss will
depend on the company. Examples include general and administrative expense, selling expense, account-
ing, depreciation of administrative facilities, and so on.
Costs Based on Behavior (Fixed, Variable and Mixed Costs)

In the following table are the main groups of costs based on their behavior as the level of activity
changes.
An activity is an event, task, or unit of work with a specified purpose. “Activity” in production can refer to
the number of units of a resource used such as hours of direct labor, or it can refer to the number of units
of product produced. Both production costs and period costs can be classified based on their behavior as
the level of activity changes, though the type of activity used in the classification of period costs is different
from that used for production costs. For period costs, “activity” frequently refers to number of units sold,
though it can be used for any type of activity that incurs costs.
For the following three types of costs, candidates need to know both how the cost per unit of activity
changes and how the total cost changes as the level of activity changes.
Fixed, Variable, and Mixed Costs

Fixed costs Fixed costs do not change within the relevant range of activity. As long as the
activity level remains within the relevant range, the total amount of fixed
costs does not change with a change in activity level such as production vol-
ume. However, the cost per unit decreases as the activity level increases and
increases as the activity level decreases. If the activity level moves out of the
relevant range for a given fixed cost, the fixed cost increases or decreases in
total.
Variable costs Variable costs are costs such as material and labor (among production costs)
or shipping-out costs (among period costs) that are incurred only when the
activity takes place. The per unit variable cost remains unchanged as the
activity increases or decreases while total variable cost increases as the ac-
tivity level increases and decreases as the activity level decreases.
Note: Because discounts are often received when more units are purchased, it
may appear that variable costs per unit decrease as activity increases. How-
ever, companies do not order units of production inputs one at a time. As part
of the budgeting process a company determines how many of a particular input
it will need to purchase during the year, and the cost per unit for that particular
quantity of inputs is used in the budget for all units to be purchased. Therefore,
budgeted variable costs per unit do not change as the production levels change
for the company.
Mixed costs Mixed costs have both a fixed and a variable component. An example of a mixed
cost is a contract for electricity that includes a basic fixed fee that covers a
certain minimum number of kilowatts of usage per month whether that amount
is used or not, and usage over that allowance is billed at a specified amount
per kilowatt used. The electricity plan has a fixed component and a variable
component. A mixed cost could also be an allocation of overhead cost that con-
tains both fixed and variable overheads.
Cost Behavior in the Production Process

Fixed costs, variable costs, and mixed costs behave in fundamentally different ways in the production pro-
cess as the production level changes. Although cost behavior is not inherently difficult, it is such an
important underlying element of the production process that it will be discussed in detail.
Variable Costs
Variable production costs are incurred only when the company actually produces something. If a company
produces no units (sits idle for the entire period), the company will incur no variable costs. Direct material
and direct labor are usually variable costs.
• As the production level increases, total variable costs will increase, but the variable cost per
unit will remain unchanged.
• As the production level decreases, total variable costs will decrease, but the variable cost
per unit will remain unchanged.
Note: The selling price per unit minus all unit variable costs is equal to the unit contribution. The unit
contribution is the amount from each sale available to cover fixed costs or to generate operating income
after the fixed costs have been covered. Contribution margin is a measure of contribution as a per-
centage of the sales price.
Fixed Costs
Fixed costs are costs that do not change in total as the level of production changes, as long as production
remains within the relevant range. The relevant range is the range of production within which the fixed
cost remains unchanged. As long as the production activity remains within the relevant range, an increase
in the number of units produced will not cause an increase in total fixed costs and a decrease in the number
of units produced will not cause a decrease in total fixed costs.
Fixed costs are best explained by using production in a factory as an example. A factory has the capacity
to produce a certain maximum number of units. As long as production is between zero and that maximum
number of units, the fixed cost for the factory will remain unchanged. However, once the level of production
exceeds the capacity of the factory, the company will need to build (or otherwise acquire) a second factory.
Building the second factory will increase the fixed costs as the company moves to another relevant range.
Within the relevant range of production, the total fixed costs will remain unchanged, but the fixed
costs per unit will decrease as the level of production increases.
Note: Over a large enough time period, all costs will behave like variable costs. In the short
term, some costs are fixed (such as a factory), but over a longer period of time, the company may be
able to change its factory situation by expanding or moving to another facility so that the factory cost
also becomes variable.
Note: Period costs can be fixed or variable, and production costs can also be fixed or variable.
Mixed Costs
In reality, many costs are mixed costs. Mixed costs have a combination of fixed and variable elements.
Mixed costs may be semi-variable costs or semi-fixed costs, which are also called step costs or step variable
costs.
A semi-variable cost has both a fixed component and a variable component. It has a basic fixed amount
that must be paid regardless of the amount of activity or even in the event of no activity, and added to that
fixed amount is an amount that varies with activity. Utilities provide an example. Some basic utility ex-
penses are required just to maintain a factory building, even if no production is taking place. Electric service,
water service, and other utilities usually must be continued, so that basic amount is the fixed component
of utilities. If production begins (or resumes), the cost for utilities increases by a variable amount, depend-
ing on the production level, because machines are running and using electricity and people are using the
water. The fixed component does not change, but the total cost increases incrementally by the amount of
the variable component when production activity increases. Another example of a semi-variable cost is the
cost of a salesperson who receives a base salary plus a commission for each sale made. The base salary is
the fixed component of the salesperson’s salary, and the commission is the variable component.
A semi-fixed cost, also called a step cost or a step variable cost, is fixed over a given, small range of
activity, and above that level of activity, the cost suddenly jumps. It stays fixed again for a while at the
higher range of activity, and when the activity moves out of that range, it jumps again. A semi-fixed cost
or step variable cost moves upward in a step fashion, staying at a certain level over a small range and then
moving to the next level quickly. All fixed costs behave this way, and a wholly fixed cost is also fixed only
as long as activity remains within the relevant range. However, a semi-fixed cost is fixed over a smaller
range than the relevant range of a wholly fixed cost.
Example: The nursing staff in a hospital is an example of a semi-fixed cost. The hospital needs one
nurse for every 25 patients, so each time the patient load increases by 25 patients an additional nurse
will be hired. When each additional nurse is hired, the total cost of nursing salaries jumps by the amount
of the additional nurse’s salary.
In contrast, hospital administrative staff salaries remain fixed until the patient load increases by 250
patients, at which point an additional admitting clerk is needed. The administrative staff salaries are
wholly fixed costs over the relevant range, whereas the nursing staff salaries are semi-fixed costs be-
cause the relevant range for the administrative staff (250 patients) is greater than the relevant range
for the nursing staff (25 patients).
Note: The difference between a semi-variable and a semi-fixed cost (also called a step cost or a step
variable cost) is that the semi-variable cost starts out at a given base level and moves upward smoothly
from there as activity increases. A semi-fixed cost moves upward in steps.
Total Costs
Total costs consist of total fixed costs plus total variable costs. The lowest possible total cost occurs when
nothing is produced or sold, because at an activity level 78 of zero, the only cost will be fixed costs. Total
costs begin at the fixed cost level and rise by the amount of variable cost per unit for each unit of increase
in activity. In theory at least, total costs graph as a straight line that begins at the fixed cost level on
the Y intercept and rises at the rate of the variable cost per unit for each unit of increase in activity.
The cost function for total manufacturing costs is
y = F + Vx
Where: y = Total costs

F = Fixed costs
V = Variable cost Per unit
x = Total production
Note: The cost function can also be written as y = Vx + F. The order of the two terms on the right side
of the equals sign is not important.
To illustrate, following is a graph of total manufacturing costs for a company with fixed manufacturing costs
of 700,000 and variable manufacturing costs of 20 per unit produced. Total cost is on the y-axis, while total
production is on the x-axis. The cost function for this company’s total manufacturing costs is
y = 700,000 + 20x
78
“Activity level” or “level of activity” can be used to refer to various types of activity. It can refer to production volume
in number of units of output, the number of units of inputs to the production process, sales volume, or to any other
activity being performed.
The total cost line on the graph is a straight line beginning at 700,000 on the y-axis where x is zero and
increasing by 200,000 for each production increase of 10,000 units (because 10,000 units multiplied by 20
equals 200,000). The graph of the preceding cost function follows.
Total Manufacturing Costs

2,100,000
1,900,000
y = 700,000 + 20x
1,700,000
1,500,000
1,300,000
1,100,000

900,000
700,000
500,000
Production Volume
Direct Versus Indirect Costs

Direct costs are costs that can be traced directly to a specific cost object. A cost object is anything
for which a separate cost measurement is recorded. It can be a function, an organizational subdivision, a
contract, or some other work unit for which cost data are desired and for which provision is made to
accumulate and measure the cost of processes, products, jobs, capitalized projects, and so forth. Examples
of direct costs that will be covered in detail are direct materials and direct labor used in the production of
products.
Indirect costs are costs that cannot be identified with a specific cost object. In manufacturing, overhead
is an indirect cost. Indirect manufacturing costs are grouped into cost pools for allocation to units of
product manufactured. A cost pool is a group of indirect costs that are grouped together for allocation on
the basis of the same cost allocation base. Cost pools can range from very broad, such as all plant overhead
costs, to very narrow, such as the cost of operating a specific machine.
Other indirect costs are nonmanufacturing, or period, costs. Examples are support functions such as IT,
maintenance, security, and managerial functions such as executive management and other supervisory
functions.
Other Costs and Cost Classifications

In addition to all of the costs and classifications listed above, candidates need to be familiar with several
other types of costs.
Explicit costs Explicit costs are also called out-of-pocket costs. Explicit costs involve payment of
cash and include wages and salaries, office supplies, interest paid on loans, payments
to vendors for raw materials, and so forth. Most explicit costs eventually become ex-
penses, though the timing of their recognition as expenses may be delayed, for example
when inventory is purchased and its cost does not become an expense until it is sold.
Explicit costs are the opposite of implicit costs.
Implicit costs An implicit cost, also called an imputed cost, is a cost that does not involve any specific
cash payment and is not recorded in the accounting records. Implicit costs are also
called economic costs. Implicit costs do not become expenses. They cannot be specif-
ically included in financial reports, but they are needed for use in a decision-making
process. For example, interest not earned on money that could have been invested in
an interest-paying security but instead was invested in manufacturing equipment is a
frequent implicit or imputed cost. The “lost” interest income is an opportunity cost of
investing in the machine. The lost interest is not reported as an expense on the state-
ment of profit or loss, but it is a necessary consideration in making the decision to invest
in the machine, because it will be different if the machine is not purchased.
Opportunity An opportunity cost is a type of implicit cost. “Opportunity cost” is an economics term,
costs and an opportunity cost is considered an economic cost. It is the contribution to income
that is lost by not using a limited resource in its best alternative use. Opportunity cost
includes the contribution that would have been earned if the alternative decision had
been made less any administrative expenditures that would have been made for the
other available alternative but that will not be made.
Anytime money is invested or used to purchase something, the potential return from
the next best use of that money is lost. Often times, the lost return is interest income.
If money were not used to purchase inventory, for example, it could be deposited in a
bank and could earn interest. The lost interest can be calculated only for the time period
during which the cash flows are different between the two options.
Carrying Carrying costs are the costs the company incurs when it holds inventory. Carrying costs
costs include: rent and utilities related to storage; insurance and taxes on the inventory; costs
of employees who manage and protect the inventory; damaged or stolen inventory; the
lost opportunity cost of having money invested in inventory (called cost of capital); and
other storage costs.
Because storage of inventory does not add value to the inventory items, carrying costs
are expensed on the statement of profit or loss as incurred. They are not added to the
cost of the inventory and thus are not included on the statement of financial position.
Sunk costs Sunk costs are costs that have already been incurred and cannot be recovered. Sunk
costs are irrelevant in any decision-making process because they have already been
incurred and no present or future decision can change that fact.
Committed Committed costs are costs for the company’s infrastructure. They are costs required to
costs establish and maintain the readiness to do business. Examples of committed costs are
intangible assets such as the purchase of a franchise and the purchase of fixed assets
such as property, plant, and equipment. They are fixed costs that are usually on the
balance sheet as assets and become expenses in the form of depreciation and amorti-
zation.
Discretionary Discretionary costs, sometimes called flexible costs, are costs that may or may not be
costs, also incurred by either engaging in an activity or not engaging in it, at the discretion of the
sometimes manager bearing the cost. In the short term, not engaging in a discretionary activity
called flexible will not cause an adverse effect on the business. However, in the long run the activities
costs are necessary and the money does need to be spent. Discretionary cost decisions are
made periodically and are not closely related to input or output decisions. Furthermore,
the value added and the benefits obtained from spending the money cannot be precisely
defined. Advertising, research and development (R&D), and employee training are usu-
ally given as examples of discretionary costs. Discretionary costs, or flexible costs, may
be fixed costs, variable costs, or mixed costs.
Marginal The marginal cost of one unit is the additional cost necessary to produce that one more
costs unit. The marginal cost of a batch is the additional cost necessary to produce that one
additional batch.
Note: When overtime is worked by production employees, the overtime premium paid to the workers
is considered to be factory overhead. The overtime premium is the amount of increase in the wages
paid per hour for the overtime work.
For example, direct labor is paid 20 per hour for regular hours and is paid and time and-a-half, or 30
per hour, for overtime hours worked in excess of 40 hours per week. Ten hours of overtime are needed
in a given week to complete the week’s required production. The regular rate of 20 per hour multiplied
by 10 hours, or 200, is classified as a direct labor cost, even though it is worked in excess of regular
hours. The half-time premium of 10 additional paid per hour multiplied by 10 hours, or 100, is clas-
sified as factory overhead.
The half-time premium of 100 is not charged to the particular units worked on during the overtime hours,
because the units worked on during the overtime hours could just as easily have been different units if
the jobs to be done had simply been scheduled differently. As overhead, the overtime premium paid is
allocated equally among all units produced during the period.
However, if the need to work overtime results from a specific job or customer request, the overtime
premium should be charged to that specific job as part of the direct labor cost of that job and not
included in the overall overhead amount to be allocated.
2 B 2. Cost of Goods Sold (COGS) and Cost of Goods Manufactured (COGM)

The various classifications of costs are used in the calculation of cost of goods sold (COGS) and cost of
goods manufactured (COGM).
• Cost of goods sold (COGS) is the total of the costs directly attributable to producing items that
were sold during the period. For each unit sold, cost of goods sold includes the direct material
and direct labor costs of the unit and an allocation of a portion of manufacturing overhead costs.
• Cost of goods manufactured (COGM) is the total of the costs directly attributable to producing
items that were brought to completion in the manufacturing process during the period,
whether manufacturing on them was begun before the current period began or during the current
period. For each unit brought to completion, cost of goods manufactured includes the direct ma-
terial and direct labor costs of the unit and an allocation of a portion of manufacturing overhead
costs.
Neither cost of goods sold nor cost of goods manufactured includes indirect selling and administrative costs
such as sales, marketing and distribution, as those are period costs.
Though COGS and COGM are somewhat similar, they are very different in one key aspect. COGS is an
externally reported figure and it is reported on the statement of profit or loss. It is the cost of producing
the units that were actually sold during the period. COGM, on the other hand, is an internal number and is
not reported on either the statement of financial position sheet or the statement of profit or loss. COGM
represents the cost of producing the units that were completed during the period. COGM is, however, used
in the calculation of cost of goods sold for a company that produces its own inventory. The calculation of
both numbers is covered in more detail below.
The process of calculating the cost of producing an item is a very important one for any company. It is
critical for the calculated cost to represent the complete cost of production. If the company does not calcu-
late the cost of production correctly, it may charge a price for the product that will be incorrect. The result
will be either low sales volume if the price is too high or low profits if the price is too low.
The calculated production cost per unit is reported on the statement of financial position as the value of
each unit of finished goods inventory when the items are completed. As the items in inventory are sold, the
cost of each item sold is transferred to the statement of profit or loss as cost of goods sold.
Note: Costs that are not production costs are period costs, and period costs are generally expensed as
incurred (for example, inventory carrying costs, general and administrative costs, and so on).
Calculating Cost of Goods Sold

Cost of goods sold represents the cost to produce or purchase the units that were sold during the period.
It is perhaps the largest individual expense item on the statement of profit or loss, so it is important for
cost of goods sold to be calculated accurately.
Cost of goods sold is calculated using the following formula:
Cost of beginning finished goods inventory

+ Net cost of purchases* (for a reseller) or
+ Cost of goods manufactured (for a manufacturer)
− Cost of ending finished goods inventory
= Cost of goods sold
*Net cost of purchases means the cost of purchases minus the cost of returns plus
landing costs. Landing costs include incoming freight costs, insurance on the inven-
tory while in transit, taxes, tariffs and duties on the shipment, and any other costs
without which the company could not receive the inventory.
The formula above is a simplification of what is actually occurring because it assumes all of the units in
finished goods inventory at the beginning of the period were either sold during the period or were still in
finished goods inventory at the end of the period, which does not always happen. In reality, some units
may be damaged, stolen or lost. However, for purposes of the exam, the above formula is sufficient.
Calculating Cost of Goods Manufactured

The cost of goods manufactured represents the cost of the units completed and transferred out of
work-in-progress inventory during the period. COGM does not include the cost of work that was done
on units that were not finished during the period.
Cost of goods manufactured is calculated using the following formula:
Cost of direct materials used*

+ Cost of direct labor used
+ Manufacturing overhead applied
= Total manufacturing costs
+ Cost of beginning work-in-progress inventory
− Cost of ending work-in-progress inventory
= Cost of goods manufactured
*Direct materials used = Cost of beginning direct materials inventory + Net cost of
purchases – Cost of ending direct materials inventory.
The cost of goods manufactured of a manufacturing company will be part of its calculation of cost of goods
sold.
As with the calculation of cost of goods sold, the calculation of cost of goods manufactured\ simplifies reality
because it assumes that all items of work-in-progress inventory were either completed during the period
or are in ending work-in-progress inventory. In reality, some of the work-in-progress inventory may have
been lost, damaged or otherwise not used during the period, and therefore some of the raw materials
entered into production or items worked on during the period will not be in ending inventory. However, for
the exam, the formula above is sufficient.
2 B 3. Costing Systems
Product costing involves accumulating, classifying and assigning direct materials, direct labor, and factory
overhead costs to products, jobs, or services. In developing a costing system, choices need to be made in
three categories of costing methods:
1) The cost measurement method to use in allocating costs to units manufactured (standard, nor-
mal, or actual costing).
2) The cost accumulation method to use (job costing, process costing, or operation costing).
3) The method to be used to allocate overhead.

Cost Measurement Systems

There are three main ways in which costs are measured for allocation to units manufactured:
1) Standard costing systems
2) Normal costing systems
3) Actual costing systems
These costing systems are used for allocating both direct manufacturing costs (direct labor and direct ma-
terials) and indirect manufacturing (overhead) costs in order to value the products manufactured.
1) Standard Costing
In a standard cost system, standard, or planned, costs are assigned to units produced. The standard cost
of producing one unit of output is based on the standard cost for one unit of each of the inputs required to
produce that output unit, with each input multiplied by the number of units of that input allowed for one
unit of output. The inputs include direct materials, direct labor and allocated overhead. The standard cost
is what the cost should be for that unit of output.
Standard costing enables management to compare actual costs with what the costs should have been for
the actual amount produced. Moreover, it permits production to be accounted for as it occurs. Using actual
costs incurred for manufacturing inputs would cause an unacceptable delay in reporting, because those
costs are not known until well after the end of each reporting period, when all the invoices have been
received.
The emphasis in standard costing is on flexible budgeting, where the flexible budget amount for the actual
production is equal to the standard cost per unit multiplied by the actual production volume.
Standard costing can be used in either a process costing or a job-order costing environment. Process costing
and job-order costing are covered in the next topic, Cost Accumulation Systems.
Note: The standard cost for each input per completed unit is the standard rate per unit of input multiplied
by the standard amount of inputs allowed per completed unit, not multiplied by the actual amount of
inputs used per completed unit.
Standard costing is applicable to a wide variety of companies. Manufacturing companies use standard cost-
ing with flexible budgeting to control direct materials and direct labor costs. Service companies such as
fast-food restaurants use standard costs, too, mainly to control their labor costs since they are labor-
intensive.
Direct Materials and Direct Labor in a Standard Cost System

In a standard cost system, direct materials and direct labor are applied to production by multiplying the
standard price or rate per unit of direct materials or direct labor by the standard amount of direct mate-
rials or direct labor allowed for the actual output. For example, if three direct labor hours are allowed
to produce one unit and 100 units are actually produced, the standard number of direct labor hours for
those 100 units is 300 hours (3 hours per unit × 100 units). The standard cost for direct labor for the 100
units is the standard hourly wage rate multiplied by the 300 standard hours allowed for the actual output
regardless of how many direct labor hours were actually worked and regardless of what actual
wage rate was paid. The cost applied to the actual output is the standard cost allowed for the actual
output.
Overhead in a Standard Cost System

In a standard cost system, overhead is generally allocated to units produced by calculating a predeter-
mined, or standard, manufacturing overhead rate that is applied to the units produced on the basis of the
standard amount of the allocation base allowed for the actual output. When a traditional method of over-
head allocation is used, the standard manufacturing overhead application rate is calculated as the budgeted
overhead cost divided by the budgeted activity level of the allocation base.
Standard Manufacturing Budgeted Annual Manufacturing Overhead

=
OH Application Rate Budgeted Activity Level of Allocation Base
The most appropriate cost driver to use as the allocation base is the measure that best represents what
causes overhead. The most frequently used allocation bases are direct labor hours, direct labor costs, or
machine hours. For a labor-intensive manufacturing process, the proper base is probably direct labor hours
or direct labor costs. For an equipment-oriented manufacturing process, number of machine hours is the
better allocation base.
To apply overhead cost to production, the predetermined overhead rate is then multiplied by the standard
amount of the allocation base allowed for producing one unit of product, and then that standard overhead
amount for one unit is multiplied by the number of units actually produced to calculate the standard over-
head cost to be applied to all the units produced.
2) Normal Costing
In a normal cost system, direct materials costs, direct labor costs, and also overhead costs are applied
to production differently from the way they are applied in standard costing.
• Direct materials and direct labor costs are applied at their actual rates multiplied by the actual
amount of the direct inputs used for production.
• To allocate overhead, a normal cost system uses the same predetermined rate as calculated under
standard costing. (When used for normal costing, it is called the normalized manufacturing over-
head application rate, but it is calculated the same way as the predetermined rate under standard
costing.)
However, under normal costing, that predetermined rate is multiplied by the actual amount of
the allocation base that was used in producing the product, whereas under standard costing,
the predetermined rate is multiplied by the amount of the allocation base allowed for producing
the product.
Normal costing is used mainly in job costing. Job costing accumulates costs and assigns them to specific
jobs, customers, projects, or contracts. Job costing is used when units of a product or service are distinct
and separately identifiable.
Normal costing is not appropriate in a process costing environment because it is too difficult to determine
the actual costs of the specific direct materials and direct labor used for a specific production run. Process
costing is used when many identical or similar units of a product or service are being manufactured, such
as on an assembly line. Costs are accumulated by department or by process.
The purpose of using a predetermined annual manufacturing overhead rate in normal costing is to normalize
factory overhead costs and avoid month-to-month fluctuations in cost per unit that would be caused by
variations in actual overhead costs and actual production volume. It also makes current costs available. If
actual manufacturing overhead costs were used, those costs would not be known until well after the end of
each reporting period, when all the invoices had been received.
3) Actual Costing
In an actual costing system, no predetermined or estimated or standard costs are used. Instead, the actual
direct labor and materials costs and the actual manufacturing overhead costs are allocated to the units
produced. The cost of a unit is the actual direct cost rates multiplied by the actual quantities of the direct
cost inputs used and the actual indirect (overhead) cost rates multiplied by the actual quantities used of
the cost allocation bases.
Actual costing is practical only for job-order costing for the same reasons that normal costing is practical
only for job-order costing. However, actual costing is seldom used because it can produce costs per unit
that fluctuate significantly from month to month. This fluctuation can lead to errors in management deci-
sions such as pricing of the product, decisions about adding or dropping product lines, and performance
evaluations.
Below is a summary of the three cost measurement methods:
Cost DM/DL Overhead Overhead

Measure- Usually DM/DL Application Application Allocation
ment Method Used With Application Rate Base Rate Base
Standard
Standard
Process Amount of
Amount
Standard Costing or Standard Allocation Base
Allowed
Costing Job-Order Rate Allowed
for Actual Predetermined
Costing for Actual
Production Standard
Production
Rate
Normal Job-Order Actual Actual Actual Amount

Costing Costing Rate Amount of Allocation
Used Base Used
for Actual for Actual
Actual Job-Order Actual Actual
Production Production
Costing Costing Rate Rate
Note: The following points should be noted when comparing the costing systems:
1) All of the costing systems record the cost of inventory based on actual output (note the use of the
words “actual production” for every costing system in the Overhead Allocation Base column in the
summary chart).
2) Direct labor and direct materials are treated the same under normal and actual costing.
3) Standard costing is typically used with a flexible budget system. Standard costing is based entirely
on the inputs (i.e., direct materials, direct labor and factory overhead) that should have been used
for the actual output produced.
Benefits and Limitations of Each Cost Measurement System
Benefits of Standard Costing
• Standard costing enables management to compare actual costs with what the costs should have
been for the actual production.
• It permits production to be accounted for as it occurs, since standard costs are used to apply costs
to units produced.
• Standard costing prescribes expected performance and provides control. Standard costs establish
what costs should be, who should be responsible, and what costs are under the control of specific
managers. Therefore, standard costs contribute to management of an integrated responsibility
accounting system.
• Standards can provide benchmarks for employees to use to judge their own performance, as long
as the employees view the standards as reasonable.
• Standard costing facilitates management by exception, because as long as the costs remain within
standards, managers can focus on other issues. Variances from standard costs alert managers
when problems require attention, which enables management to focus on those problems.
Limitations of Standard Costing
• Using a predetermined factory overhead rate to apply overhead cost to products can cause total
overhead applied to the units produced to be greater than the actual overhead incurred when
production is higher than expected; and overhead applied may be less than the amount incurred
if actual production is lower than expected.
• If the variances from the standards are used in a negative manner, for instance to assign blame,
employee morale suffers and employees are tempted to cover up unfavorable variances and to do
things they should not do in order to make sure the variances will be favorable.
• Output in many companies is not determined by how fast the employees work but rather by how
fast the machines work. Therefore, direct labor quantity standards may not be meaningful.
• The use of standard costing could lead to overemphasis on quantitative measures. Whether a
variance is “favorable” or “unfavorable” and the amount of the variance is not the full story.
• There may be a temptation on the part of management to emphasize meeting the standards
without considering other non-financial objectives such as maintaining and improving quality, on-
time delivery, and customer satisfaction. A balanced scorecard can be used to address the non-
financial objectives as well as the financial objectives.
• In environments that are constantly changing, it may be difficult to determine an accurate stand-
ard cost.
• The usefulness of standard costs is limited to standardized processes. The less standardized the
process is, the less useful standard costs are.
Benefits of Normal Costing
• The use of normal costing avoids the fluctuations in cost per unit that occur under actual costing
because of changes in the month-to-month volume of units produced and in month-to-month fluc-
tuations in overhead costs.
• Manufacturing costs of a job are available earlier under a normal costing system than under an
actual costing system.
• Normal costing allows management to keep direct product costs current because actual materials
and labor costs incurred are used in costing the production, while the actual incurred overhead
costs that would not be available until much later are applied based on a predetermined rate.
Limitations of Normal Costing
• Using a predetermined factory overhead rate to apply overhead cost to products can cause total
overhead applied to the units produced to be greater than the actual overhead incurred when
production is higher than expected; and overhead applied may be less than the amount incurred if
actual production is lower than expected.
• Normal costing is not appropriate for process costing because the actual costs would be too difficult
to trace to individual units produced, so it is used primarily for job costing.
Benefits of Actual Costing
• The primary benefit of using actual costing is that the costs used are actual costs, not estimated
costs.
Limitations of Actual Costing
• Because actual costs must be computed and applied, information is not available as quickly after
the end of a period as it is with standard costing.
• Actual costing leads to fluctuations in job costs because the amount of actual overhead incurred
fluctuates throughout the year.
• Like normal costing, actual costing is not appropriate for process costing because the actual costs
would be too difficult to trace to individual units produced. Therefore, it is used primarily in a job
costing environment.
Cost Accumulation Systems

Cost accumulation systems are used to assign costs to products or services. Job-order costing (also called
job costing), process costing, and operation costing are different types of cost accumulation systems used
in manufacturing.
• Process costing is used when many identical or similar units of a product or service are being
manufactured, such as on an assembly line. Costs are accumulated by department or by process.
• Job-order costing (also called job costing) is used when units of a product or service are distinct
and separately identifiable. Costs are accumulated by job.
• Operation costing is a hybrid system in which job costing is used for direct materials costs while
a departmental (process costing) approach is used to allocate conversion costs (direct labor and
overhead) to products or services.
Process Costing
Process costing is used to allocate costs to individual products when the products are all relatively similar
and are mass-produced (the term “homogeneous” is used to describe the products, and it means “identical
to each other”). Process costing is basically applicable to assembly lines and products that share a similar
production process. In process costing, all of the costs incurred by a process (a process is often referred to
as a department) are collected and then allocated to the individual goods that were produced, or worked
on, during that period within that process (or department).
The basic exercise is to allocate all of the incurred costs to either the completed units that left the
department or to the units in ending work-in-progress inventory (EWIP) that are still in the depart-
ment at the end of the reporting period. It is largely a mathematical operation and some basic formulas
are used to make certain that everything is accounted for.
All of the costs incurred during the current period and during all previous periods for the units worked on
during the period are allocated to either finished goods (or to the next department for more work to be
done) or to ending work-in-progress inventory at the end of the current period.
The costs in the department, usually materials and conversion costs79 and sometimes transferred-in costs,
that require allocation can come from one of three places:
1) The costs are incurred by the department during the period. Materials and conversion costs are
accounted for separately.
2) The costs are transferred in from the previous department. Transferred-in costs include total
materials and conversion costs from previous departments that have worked on the units. Trans-
ferred-in costs are transferred in as total costs. They are not segregated according to direct
materials and conversion costs.
3) The costs were in the department on the first day of the period as costs for the beginning work-
in-progress inventory (BWIP). They were incurred by the department during the previous period
to begin the work on the units in the current period’s BWIP.
In reality, the categories of costs within a department can be numerous. They may include more than one
type of direct materials, more than one class of direct labor, indirect materials, indirect labor or other
overheads. However, for this purpose, generally only two classifications of costs are tested: direct mate-
rials and conversion costs. Conversion costs include everything other than direct materials—specifically
direct labor and overhead—and are the costs necessary for converting the raw materials into the finished
product.
Note: Conversion costs is a term used in process costing questions to refer to direct labor and
factory overhead. It encompasses everything except raw materials. Conversion costs are the costs
necessary to convert the raw materials into the finished product. Placing direct labor and factory over-
head into a single category reduces the number of individual allocations needed.
Note: Transferred-in costs are the total costs that come with the in-progress product from the previ-
ous department. They are similar to raw materials but they include all of the costs (direct materials and
conversion costs) from the previous department or departments that worked on the units. The costs of
the previous department’s “completed units” are the current department’s transferred-in costs, and the
transferred-in costs and work are 100% complete (even though the units themselves are not complete
when received) because the work done in the previous department is 100% complete.
At the end of the period all of the costs within the department—including direct materials, conversion costs,
and transferred-in costs, if applicable—must either be moved to Finished Goods Inventory (or to the next
department if further work is required) if the work on them in the current department was completed, or
79
Conversion costs include direct labor and overhead costs.
they will remain in Ending WIP if they are not complete. The Ending WIP Inventory for the current period
will be the Beginning WIP Inventory for the next period.
When the goods that have been completed and transferred to Finished Goods Inventory are sold, the costs
associated with the units that were sold will end up in COGS. The costs of the units that have been com-
pleted but have not been sold will remain in Finished Goods Inventory until they are sold.
Thus, the cost of every unit that passes through a particular process in a given period must be recorded in
one of the four following places at the end of the period:
1) Ending WIP Inventory in the department or process
2) The next department in the assembly process
3) Ending Finished Goods inventory
4) Cost of Goods Sold
Items 2 and 3 in the preceding list are classified together as completed units transferred out of the
department. The costs for all units on which the current process’s work has been completed are transferred
either to Finished Goods Inventory or to the next department or process for further work.
Whether the units have been sold (and the costs are in COGS), or are still being worked on (are in ending
WIP for the company), or finished but not sold (are in ending Finished Goods Inventory for the company)
is irrelevant to the process in a given department. The objective of process costing is to allocate costs
incurred to date on products worked on in one department during one period between units on which
work was completed in that department and units still in ending work-in-progress inventory in that de-
partment.
Basic Accounting for a Process Costing System

The basic accounting for a process costing system is as follows:
Manufacturing costs incurred are debited to a WIP Inventory account for each department as units are
worked on in that department. The “costs incurred” are usually the standard costs allowed for the units
worked on.
Manufacturing costs include direct material, direct labor, and factory overhead consisting of indirect
materials, indirect labor, and other factory overhead such as facility costs. Direct materials are
usually added to units in process in a different pattern from the way conversion costs (direct labor and
overhead) are added to units in process, so they are usually accounted for separately.
The costs in each department’s WIP then need to be allocated between units completed during the period
and units remaining in the department’s ending WIP at the end of the period. Costs for units completed
during the period are transferred to either Finished Goods Inventory or, if more work is needed on them,
to the next department’s WIP inventory. This cost allocation is done based on a per unit allocation basis
called equivalent units.
Equivalent Units
In a process costing environment, some units will be incomplete when a reporting period ends. Those units
have costs because direct materials and conversion costs have been expended on them, even though they
are not complete. The cost of the incomplete units needs to be computed and reported at the end of the
period as work-in-progress inventory. Costs are allocated to incomplete units on the basis of their equiv-
alent units.
Example: At the end of a month a manufacturing company has 1,000 units in ending work-in-progress
inventory and those units have had all of the direct materials added to them that they need, but only
50% of the work needed to complete the units has been done.
● The equivalent units of direct materials in ending work-in-progress inventory is 100% of 1,000 units,
or 1,000 equivalent units.
● The equivalent units of conversion costs in ending work-in-progress inventory is 50% of 1,000 units,
or 500 equivalent units.
● The cost of the ending work-in-progress inventory is the standard cost incurred for direct materials
for 1,000 units plus the standard cost allowed for conversion costs for 500 units.
● The cost of the completed units is the remainder of the standard cost incurred during the period.
Those costs are transferred either to Finished Goods Inventory or to the next department for more
work to be added.
Usually the standard costs are used in a process costing environment.
The ending work-in-progress inventory becomes the beginning work-in-progress inventory for the next
period, and the partially completed units in the beginning work-in-progress inventory are completed during
the following period using costs incurred during the following period.
Two methods are used to account for the work done on the units in beginning work-in-progress inventory:
FIFO (first-in, first-out) and Weighted Average cost (WAVG). Costs for direct materials are allocated sepa-
rately from conversion costs.
• Under FIFO, it is assumed that the units in beginning work-in-progress inventory are completed
before any other work is begun on new units. Thus, the costs for the units in beginning WIP (the
costs incurred during the previous period that were allocated to ending WIP at the end of that
period) are allocated 100% to units completed and transferred out during the current period. Only
the costs added during the current period are allocated between units transferred out and units in
ending work-in-progress inventory, on the basis of equivalent units.
• Under Weighted Average, it is assumed that the units in beginning work-in-progress inventory
are completed at the same time as work on newly-started units is begun. As a result, all of the
units (units in BWIP and those started on this period) are treated the same way. The costs of the
work done during the previous period on beginning WIP and the costs of the work done during the
current period are combined (separately for direct materials and for conversion costs) for allocation
between units transferred out and units in ending WIP, on the basis of equivalent units.
Note: The main difference between FIFO and WAVG is the treatment of the costs that are assigned
to the units in beginning WIP.
● Under FIFO, the costs for the equivalent units in beginning WIP go 100% to units completed and
transferred out during the current period.
● Under WAVG, the costs for the equivalent units in beginning WIP are combined with the costs incurred
for the current period to calculate a weighted average cost per equivalent unit for all the units worked
on, whether they were in beginning WIP or whether they were started on during the current period.
Benefits of Process Costing
• Process costing is the easiest, most practical costing system to use to allocate costs for homogeneous
items. It is a simple and direct method that reduces the volume of data that must be collected.
• Process costing can aid in establishing effective control over the production process. Process costing
can be used with standard costing by using standard costs as the costs to be allocated. Use of stand-
ard costing with process costing makes it possible to track variances and to recognize inefficiency in
a specific process.
• It is flexible. If the company adds or removes a process, it can adapt its process costing system
easily.
• The amounts of materials and labor used in each process can be reviewed to look for possible cost
savings.
• Process costing enables obtaining and predicting the average cost of a product, an aid in providing
pricing estimates to customers.
Limitations of Process Costing
• Process costing can introduce large variances into the costing system if standard costs allocated to
the units are not up to date. Depending on how the variances are resolved, the variances could cause
the product to be over- or under-costed, which could lead to pricing errors.
• Process costing can be time-consuming.
• Calculating the equivalent units for beginning and ending work-in-progress inventory can lead to
inaccuracies, since the percentage of completion of those inventories may be subjective (an estimate
or even a guess).
• Process costing cannot provide an accurate cost estimate when a single process is used to produce
different (joint) products.
• Process costing is not suitable for custom orders or diverse products.
• Since the work of an entire department is combined in the process costing system, process costing
makes it difficult to evaluate the productivity of an individual worker.
Job-Order Costing
Job-order costing is a cost system in which all of the costs associated with a specific job or client are
accumulated and charged to that job or client. The costs are accumulated on what is called a job-cost sheet.
All of the job sheets that are still being worked on equal the work-in-progress at that time. In a job-order
costing system, costs are recorded on the job-cost sheets and not necessarily in an inventory account.
Job-order costing can be used when all of the products or production runs are unique and identifiable from
each other. Audit firms and legal firms are good examples of job-order costing environments. As employees
work on a particular client or case, they charge their time and any other costs to that specific job. At the
end of the project, the company simply needs to add up all of the costs assigned to it to determine the
project’s cost. Performance measurement can be done by comparing each individual job to its budgeted
amounts or by using a standard cost system.
While direct materials and direct labor are accumulated on an actual basis, manufacturing overhead must
be allocated to each individual job. Overhead allocation is done in much the same manner as has already
been explained. A predetermined overhead rate is calculated and applied to each product based either on:
• Actual usage of the allocation base (as in normal costing)
• Standard usage of the allocation base (as in standard costing)
Multiple cost allocation bases may be used if different overheads have different cost drivers. For example,
in a manufacturing environment, machine hours for each job may be used to allocate overhead costs such
as depreciation and machine maintenance, whereas direct labor hours for each job may be used to allocate
plant supervision and production support costs to jobs. If normal costing is being used, actual machine
hours and actual direct labor hours will be used to allocate the overhead. If standard costing is being used,
the standard machine hours allowed and the standard direct labor hours allowed for the actual output on
each job will be used for overhead allocation.
Note: Under job-order costing, as with other forms of costing, selling and administrative costs are
not allocated to the products in order to determine the COGS per unit. Selling and administrative costs
are expensed as period costs.
Benefits of Job-Order Costing
• Job-order costing is best for businesses that do custom work or service work.
• Job-order costing enables the calculation of gross margin on individual jobs, which can help man-
agement determine in the future which kinds of jobs are desirable.
• Managers are able to keep track of the performance of individuals for cost control, efficiency, and
productivity.
• The records kept result in accurate costs for items produced.
• Management can see and analyze each cost incurred on a job in order to determine how it can be
better controlled in the future.
• Costs can be seen as they are added, rather than waiting until the job is complete.
Limitations of Job-Order Costing
• Employees are required to keep track of all the direct labor hours used and all the materials used.
• The focus is on direct costs of products produced. The focus on direct costs can allow for inefficiencies
and increasing overhead costs.
• Depending on the type of costing being used, overhead may be applied to jobs on the basis of
predetermined rates. If the overhead application rates are out of date, the costing can be inaccurate.
• If overhead is applied on the basis of predetermined rates and the rates are not calculated on any
meaningful basis, the cost of each job will not be meaningful.
• To produce meaningful results, job-order costing requires a lot of accurate data entry. Because of
the massive amount of data recording required, input errors can occur and if not corrected, the
errors can lead to poor management decisions.
• The use of job-order costing is limited to businesses that do custom manufacturing or service work.
It is not appropriate for high volume manufacturing or for retailing.
Operation Costing
Operation costing is a hybrid, or combination, of job-order costing and process costing. In operating
costing, a company applies the basic operation of process costing to a production process that produces
batches of items. The different batches all follow a similar process, but the direct materials input to each
batch are different.
Examples of manufacturing processes where operation costing would be appropriate are clothing, furniture,
shoes and similar items. For each of these items, the general product is the same (for example, a shirt),
but the materials used in each shirt may be different and have different costs.
In operation costing the direct materials are charged to the specific batch where they are used, but con-
version costs are accumulated for all the batches worked on during the period and are allocated to each
batch according to a predetermined conversion cost per unit.
An operation costing worksheet would look very much like a process costing worksheet, except it would
require a separate column for each product’s direct materials, while the worksheet would have one con-
version costs column that would pertain to the conversion of all the products.
Life-Cycle Costing
Life-cycle costing is another type of costing that is useful only for internal decision-making.
In life-cycle costing a company does not determine the production cost in the short-term sense of the cost
to produce one unit. Rather, the company takes a much longer view of the cost of a product and attempts
to allocate to each product all of the research and development, marketing, after-sale service and support
costs, and any other cost associated with the product during its life cycle. The life cycle of the product may
be called its value chain.80
The longer-term view used in life-cycle costing is of particular importance when the product has significant
research and development (R&D) costs or other non-production costs such as after sale service and support
costs associated with it. For the product to be profitable over its life, these non-production costs also need
to be covered by the sales price. If the company fails to take into account the large costs of R&D, it runs
the risk of the sales price covering the costs of the actual production of each unit sold but not covering the
costs of R&D, marketing, after-sale service and support, and other costs.
In the process of looking at all of the costs, the company should be able to determine the ultimate value of
developing a better product. In addition to R&D, costs include after-sale costs such as warranties and repair
work and product support expense. It may be that a larger investment in the design or development of the
product will be recovered through smaller after-sale costs. Alternatively, the company may realize that
additional design costs will not provide sufficient benefit later to make the additional investment in design
and development feasible.
Note: Life-cycle costing is different from other costing methods because it treats pre-production and
after-sale costs as part of the product costs, whereas other methods treat those costs as period expenses
that are expensed as incurred. Therefore, under other methods, pre-production and after-sale costs are
not directly taken into account when determining the profitability of a product or product line.
All of the costs in the life cycle of a product can be broken down into three categories. The three categories
and the types of costs included in each are:
Upstream Costs (before production)
• Research and Development
• Design – prototyping (the first model), testing, engineering, quality development
Manufacturing Costs
• Purchasing
• Direct and indirect manufacturing costs (labor, materials and overhead)
Downstream Costs (after production)
• Marketing and distribution
• Services and warranties
For external financial reporting under IFRS, research costs, costs for most development activities, design
costs, and other life-cycle costs other than manufacturing costs are expensed as incurred. However, for
internal decision-making purposes, it is important for the company to view all of these costs as product
costs that need to be recovered from the sale of the product.
Life-cycle costing plays a role in strategic planning and decision-making about products. After making the
life-cycle cost calculations, management can make an assessment as to whether or not the product should
80
The term “value chain” refers to the steps a business goes through to transform inputs such as raw materials into
finished products by adding value to the inputs by means of various processes, and finally to sell the finished products
to customers. The goal of value chain analysis is to provide maximum value to the customer for the minimum possible
cost.
be manufactured. If management believes the company will not be able to charge a price high enough to
recover all the life-cycle product costs for the product, then it should not be produced.
Furthermore, by looking at all of the costs expected to be incurred in the process of developing, producing
and selling a given product, the company can identify any non-value-adding costs, which can then be
reduced or eliminated without reducing the value of the product to the customer.
Benefits of Life-Cycle Costing
• Life-cycle costing provides a long-term, more complete perspective on the costs and profitability of
a product or service when compared to other costing methods, which typically report costs for a
short period such as a month or a year.
• When long-term costs are recognized in advance, life-cycle costing can be used to lower those long-
term costs.
• Life-cycle costing includes research and development costs as well as future costs such as warranty
work, enabling better pricing for profitability over a product’s lifetime.
• Life-cycle costing can be used to assess future resource requirements such as needed operational
support for the product during its life.
• Life-cycle costing can help in determining when a product will reach the end of its economic life.
Limitations of Life-Cycle Costing
• When life-cycle costing is used to spread the cost of fixed assets over the life of a product, the
assumption may be made that the fixed assets will be as productive in later years as they were
when they were new.
• Accurate estimation of the operational and maintenance costs for a product during its whole lifetime
can be difficult.
• Cost increases over the life of the product need to be considered.
• Life-cycle costing can require considerable time and resources, and the costs may outweigh the
benefits.
Manufacturing Overhead Allocation Systems

In general, overheads are costs that cannot be traced directly to a specific product or unit. Overheads are
actually of two main types: manufacturing (or factory) overheads and nonmanufacturing overheads. Man-
ufacturing overheads are overheads related to the production process (factory rent and electricity, for
example), whereas nonmanufacturing overheads are not related to the production process. Examples of
nonmanufacturing overheads are accounting, advertising, sales, legal counsel and general corporate ad-
ministration costs. Allocation of nonmanufacturing costs was covered in Responsibility Centers and
Responsibility Accounting and Shared Services Cost Allocation.
The allocation of manufacturing overheads is covered in the topic that follows.
Manufacturing Overhead Allocation
Note: In order to help the following explanations flow more easily, the term “overhead” will be used in
the majority of situations, even though the term “manufacturing overhead” would be more technically
accurate. If “manufacturing overhead” were used in every situation, the language would become cum-
bersome and be more difficult to read. Also, the term “factory overhead” can be used in place of
“manufacturing overhead” because the two are interchangeable terms.
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To review, the three main classifications of production costs are:
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1) Direct materials
2) Direct labor
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3) Manufacturing (or factory) overhead
Direct materials (DM) and direct labor (DL) are usually simple to trace to individual units or products be-
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cause direct materials and direct labor costs are directly and obviously part of the production process.
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Manufacturing overhead costs are production costs that a company cannot trace to any specific product or
unit of a product. Because overhead costs are incurred and paid for by the company and are necessary for
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the production process, it is essential that the company know what these costs are and allocate them to
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the various products being manufactured. Allocation to products manufactured must occur so that the full
costs of production and operation are known in order to set the selling prices for the different products. If
on
a company does not take overhead costs into account when it determines its selling price for a product, it
runs a significant risk of pricing the product at a loss because while the price the company charges may
do
cover the direct costs of production, it may not cover the indirect costs of production.
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Note: GAAP requires the use of absorption costing for external financial reporting. In absorption costing,
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all overhead costs associated with manufacturing a product become a part of the product’s inventoriable
cost along with the direct costs. Therefore, all manufacturing overhead costs must be allocated to the
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units produced. Absorption costing is covered in the next topic, Variable and Absorption Costing for
Manufacturing Costs.
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The categories of costs included in factory overhead (OH) are:
1) Indirect materials – materials not identifiable with a specific product or job, such as cleaning
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supplies, small or disposable tools, machine lubricant, and other supplies.

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2) Indirect labor – salaries and wages not directly attributable to a specific product or job, such as
those of the plant superintendent, janitorial services, and quality control. An overhead premium
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paid for overtime work that cannot be traced to a particular product is also classified as factory
overhead.
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3) General manufacturing overheads, such as facilities costs (factory rent, electricity, and utili-
do
ties) and equipment costs, including depreciation and amortization on plant facilities and
equipment.
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Overheads may be fixed or variable or mixed.

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• Fixed overhead, like any fixed cost, does not change with changes in activity as long as the
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activity remains within the relevant range. Examples of fixed manufacturing overhead are factory
rent, depreciation on production equipment, and the plant superintendent’s salary.
• Variable overheads are costs that change as the level of production changes. Examples of vari-
able manufacturing overheads are indirect materials and equipment maintenance.
• Mixed overheads contain elements of both fixed and variable costs. Electricity is an example of
a mixed overhead cost because electricity may be billed as a basic fixed fee that covers a certain
number of kilowatts of usage per month and usage over that allowance is billed at a specified
amount per kilowatt used. A mixed overhead cost could also be an allocation of overhead cost from
a cost pool containing both fixed and variable overhead costs.
The traditional and activity-based costing methods of allocating overheads are discussed next. However, it
is important to remember that no matter which manner of allocation used, overhead allocation is simply a
mathematical exercise of distributing the overhead costs to the products that were produced
using some sort of basis and formula.
Traditional (Standard) Allocation Method

Traditionally, manufacturing overhead costs have been allocated to the individual products based on
either the direct labor hours, machine hours, materials cost, units of production, weight of production or
some similar measure that is easy to measure and calculate. The measure used is called the activity base.
For example, if a company allocates factory overhead based on direct labor hours, for every hour of direct
labor allowed per unit of output (under standard costing) or used per unit of output (under the normal or
actual cost measurement systems), a certain amount of factory overhead is allocated to, or applied to,
each unit actually produced. The determination of how much overhead is allocated per unit is covered
below.
The total cost of producing each specific unit of product is the sum of its costs for direct materials, direct
labor, and allocated manufacturing overhead.
Determining the Basis of Allocation

When choosing the basis of allocation (for example, direct labor hours or machine hours), the basis used
should closely reflect the reality of the way in which the costs are actually incurred. For example, in a
highly-automated company, direct labor would most likely not be a good allocation basis for factory over-
head because labor would not be a large part of the production process. The allocation basis does not need
to be direct labor hours or machine hours, though those are the most common bases used. For example,
in a company that produces very large, heavy items (such as an appliance manufacturer), the best basis
on which to allocate overhead may be the weight of each product.
Plant-Wide versus Departmental Overhead Allocation

A company can choose to use plant-wide overhead allocation or departmental overhead allocation.
Plant-wide overhead allocation involves putting all of the plant-wide overhead costs into one cost pool
and then allocating the costs in that cost pool to products using one allocation basis, usually machine hours
or labor hours.
Alternatively, a company can choose to have a separate cost pool for each department that the products
pass through in production. This second method is called departmental overhead allocation. Each de-
partment’s overhead costs are put into a separate cost pool, and then the overhead is allocated according
to the cost basis that managers believe is best for that department.
In both plant-wide and departmental overhead allocation, fixed overhead costs can be segregated in a
separate cost pool from variable overhead costs and the fixed and variable overheads can be allocated
separately. The fixed and variable overheads can be allocated using the same cost basis, or they can be
allocated using different cost bases. For planning purposes and in order to calculate fixed and variable
overhead variances, it is virtually essential to segregate fixed and variable overhead costs.
For example, if Department A uses very little direct labor but a lot of machine time, Department A’s over-
head costs would probably be allocated to products on the basis of machine hours. If Department B uses a
lot of direct labor and very little machine time, Department B’s overhead costs would probably be allocated
to products on the basis of direct labor hours. If Department C is responsible for painting the products,
Department C’s overhead costs might be allocated based on the area of the painted products. A department
that assembles products may allocate overhead costs based on the number of parts in each product.
To best reflect the way that manufacturing overhead is incurred, departmental overhead allocation is
preferable to plant-wide overhead allocation. The greater the number of manufacturing overhead allocation
rates used, the more accurate or more meaningful the overhead allocation will be. However, departmental
overhead allocation requires a lot more administrative and accounting time and thus is costlier. The more
bases used to allocate overhead, the more costs will be incurred to obtain the needed information for the
allocation. Therefore, a company needs to find a balance between the usefulness of having more than one
overhead allocation basis against the cost of making the needed calculations for the additional bases.
Departmental overhead allocation would be chosen by a company’s management if it felt the benefit of the
additional information produced would be greater than the cost to produce the information. For example,
the additional information could be used to develop more accurate product costs for use in setting prices
and making other decisions.
Note: The only time that it may be applicable to use only one overhead application rate for the
factory is when production is limited to a single product or to different but very similar products.
Calculating the Manufacturing Overhead Allocation Rate

Once the method, or basis, of manufacturing overhead allocation is determined, the predetermined man-
ufacturing overhead allocation rate is calculated. The predetermined rate is the amount of
manufacturing overhead that will be charged (allocated) to each unit of a product for each unit of the
allocation basis (direct labor hours, machine hours, and so on) used by that product during production.
The predetermined overhead rate may be a combined rate including both variable and fixed overheads; or
it may be calculated separately for variable overhead and fixed overhead and applied separately. Whichever
way it is done, the total overhead allocated to production will be the same if the same allocation base is
used for both fixed and variable overhead.
The rate used to allocate overhead is usually calculated at the beginning of the year, based on budgeted
overhead for the coming year and the budgeted level of activity for the coming year.
Unless material changes in actual overhead costs incurred during the year necessitate a change to the
predetermined rate, that rate (or those rates, if fixed and variable overheads are allocated separately) will
be used to allocate manufacturing overheads throughout the year. Because the manufacturing overhead
allocation rate is set before the production takes place, it must use budgeted, or expected, amounts. The
manufacturing overhead allocation rate is called the predetermined rate because it is calculated at the
beginning of the period.
Note: It is important to remember that the manufacturing overhead allocation rate is calculated at the
beginning of the year and then used throughout the year unless it becomes necessary to change it during
the year.
The predetermined overhead rate is calculated as follows:
Budgeted Monetary Amount of Manufacturing Overhead

Budgeted Activity Level of the Allocation Base
The budgeted activity level of the allocation base is the number of budgeted direct labor hours, direct
labor cost, material cost, or machine hours—whatever is being used as the allocation base—allowed for the
budgeted output. The budgeted activity level will be discussed in greater detail next in this explanation.
The application rate should be reviewed periodically and adjusted if necessary so that the amount applied
is a reasonable approximation of the current overhead costs per unit.
Note: Clearly, the budgeted rate is not going to be the actual rate that occurs during the year. However,
in order to determine the cost of goods produced throughout the year so their cost can flow to inventory
as produced and then to cost of goods sold when they are sold, an estimated rate must be used. A
company cannot wait until the end of the year to determine what its cost of production was. As long as
the rate is reviewed periodically and adjusted when necessary, however, variances can be minimized.
Determining the Level of Activity

In relation to the allocation rate, the company must decide what level of activity to use for its budgeted
activity level of the allocation base in the denominator of the overhead predetermined rate calculation. The
level of activity used is the number of machine hours, direct labor hours, or whatever other activity base
the company plans to use during the year. The activity level is estimated in advance. As the activity level
is one of the two figures used in the determination of the manufacturing overhead rate, it will greatly impact
the allocation rate.
A company has several choices for the activity level to use in calculating a predetermined allocation rate
for overhead. IAS 2, Inventories, specifically prescribes that normal capacity should be used for external
financial reporting. The other activity levels can be used for internal reporting and decision-making.
The choices and impact of using each option are in the table below. The table also references the best use
of each measure.
Activity Level What it is Impact of Using It Best Used For

Normal capac- The level of activity that Normal capacity utilization External financial re-
ity utilization will be achieved in the long is the level of activity that porting. It is required
run, taking into account will satisfy average cus- by IFRS and U.S. GAAP.
seasonal changes in the tomer demand over a
Also used for long-
demand as well as cyclical long-term period such as 2
term planning.
changes. to 3 years.
Theoretical, or The level of activity that A company will not be able No real uses because it
ideal, capacity will occur if the company to achieve the theoretical is not practical.
produces at its absolute level of activity, which will
most efficient level at all cause manufacturing over-
times. head to be under-applied
because the resulting ap-
plication rate will be too
low.
Practical (or The theoretical activity The practical capacity ba- Pricing decisions
currently at- level reduced by allow- sis is greater than the
tainable) ances for unavoidable level that will be achieved
capacity interruptions such as shut- and will result in an un-
downs for holidays or der-application of
scheduled maintenance manufacturing overhead.
but not decreased for any
expected decrease in sales
demand.
Master budget The amount of output ac- Results in a different over- Developing the mas-
capacity utiliza- tually expected during the head rate for each budget ter budget
tion (expected next budget period based period because of in-
Current performance
actual capacity on expected demand. creases or decreases in
measurement
utilization) planned production due to
expected increases or de-
creases in demand.
Allocating Manufacturing Overhead to the Units

Once the overhead allocation rate has been determined, the company can allocate overhead to the individ-
ual units produced. Overhead is allocated by multiplying the predetermined rate by the number of units
of the allocation basis that were either allowed to be used (under standard costing) or were actually
used (under other costing methods) in the production of each unit.
Overhead allocation is a very simple mathematical operation, but it becomes a little more involved because
the company must make a decision about which cost allocation method to use: standard, normal, or actual.
The three methods were discussed earlier, so they will just be reviewed quickly here as they apply to
overhead application.
Overhead Overhead
Application Rate Allocation Base
Standard Amount of Alloca-

Standard Costing tion Base Allowed for
Predetermined Actual Production
Standard
Rate
Amount of Allocation Base
Normal Costing
Actually Used for
Actual Production
Actual
Actual Costing
Rate
Example: A company allocates overhead on the basis of machine hours. Two machine hours are allowed
for each unit. The company had the following budgeted amounts for 20XX:
Budgeted
Overhead cost 250,000
Production volume (normal capacity in units) 100,000
Total machine hours 200,000
The company’s actual results for 20XX were as follows:

Actual
Overhead cost 288,000
Production volume (actual units produced) 125,000
Total machine hours used 240,000
How much overhead would be allocated to the production under standard, normal and actual costing?
Standard Normal Actual
1
Predetermined overhead rate: 250,000 ÷ 200,000 1.25 1.25
Actual overhead rate: 288,000 ÷ 240,000 1.20
Allocation Base:
Standard number of machine hours2 250,000
Actual number of machine hours 240,000 240,000
Overhead applied to production 312,500 300,000 288,000
1
Two machine hours are allowed for each unit, so 200,000 hours were allowed for the budgeted pro-
duction volume of 100,000.
2
The standard number of machine hours is the actual production volume of 125,000 multiplied by 2
machine hours allowed per unit.
(Continued)
Why would the company not want to use actual costing, since the amount of overhead applied under
that system is correct whereas the amounts applied under the other systems create variances?
The total actual costs for the year are not known until sometime after the end of the reporting period
because of the delay in receiving and recording invoices. In most cases, overhead needs to be applied
to production as the production takes place. It cannot wait until the year has been closed out and the
total actual costs are known. Therefore, an estimated rate is used throughout the year.
The difference between the actual amount of overhead incurred and the amount applied (called over-
applied or under-applied overhead, or the variance) is closed out after the total costs for the year are
known by either debiting or crediting cost of goods sold for the total amount of the variance or by pro-
rating the variance between inventories and cost of goods sold according to the amount of overhead
included in each for the current period that was allocated to the current period’s production.
Activity-Based Costing
Activity-based costing (ABC) is another way of allocating overhead costs to products, and in ABC the method
of allocation is based on cost drivers.81 As with other overhead allocation methods, ABC is a mathematical
process. It requires identification of the costs to be allocated, followed by some manner of allocating them
to departments, processes, products, or other cost objects. ABC can be used in a variety of situations and
can be applied to both manufacturing and nonmanufacturing overheads. It can also be used in service
businesses.
Activity-based costing measures the cost and performance of activities, resources, and cost objects based
on their use. ABC recognizes the causal relationships of cost drivers to activities.
Activity-based costing is a costing system that focuses on individual activities as the fundamental cost
objects to determine what the activities cost.
• An activity is an event, task or unit of work with a specified purpose. Examples of activities are
designing products, setting up machines, operating machines, making orders or distributing prod-
ucts.
• A cost driver is anything (for example, an activity, an event, or a volume of some substance) that
causes costs to be incurred each time the driver occurs.
• A cost object is anything for which costs are accumulated for managerial purposes. Examples of
cost objects are a specific job, a product line, a market, or certain customers.
Traditional Overhead Allocation versus ABC

The fundamental difference between the traditional method and the ABC method is how many allocations
are done. Under the traditional method, there is one allocation of overhead for the factory, or one allocation
for each department of the production process. Under ABC, however, there will be an overhead allocation
made for each cost driver that causes costs to be incurred. Therefore, under ABC we will follow the same
process as under the traditional method, but that allocation process will be done many times instead of just
once (or a few times in the case of departmental rates.).
81
Direct costs such as direct materials and direct labor can easily be traced to products, so activity-based costing focuses
on allocating indirect, or overhead, costs to departments, processes, products, or other cost objects.
Allocations Based On Activities in ABC

There is a slight difference between the two methods in how the allocations of overhead are made.
Traditional costing systems allocate costs according to general usage of resources, such as machine hours
or direct labor hours. The resources on which the allocations are based may or may not have a connection
with the costs being allocated.
With ABC, the cost allocations are instead based on activities performed and the costs of those activities.
ABC is much more detailed than traditional costing, because it uses many more cost pools and each cost
pool has its own cost driver.
Costs Attached to Low-Volume Products

The use of activity-based costing can result in greater per-unit costs for products produced in low volume
relative to other products than would be reported under traditional overhead allocation.
If a product is produced in low volume, it will require fewer resources used as cost drivers in traditional
overhead allocation, such as machine hours or direct labor hours, than will a product that is produced in
high volume. Therefore, under traditional overhead costing, that low-volume product would be allocated a
small amount of total overhead costs. However, a low-volume product may require just as much time and
cost per production run as a high-volume product.
One example of this is product setups. Production setup time is the same for a low-volume production run
as it is for a high-volume production run. If the cost of product setups is included in total overhead and is
allocated according to machine hours or direct labor hours as in traditional costing, not much product setup
cost will be allocated to the low-volume product because the volume of products produced and the cost
drivers used to produce them are low relative to other products. However, if the cost of product setups is
segregated from other overhead costs, as in ABC, and is allocated according to how many product setups
are done for each product instead of how many units of each product are produced and the machine hours
or direct labor hours per unit, then a more realistic amount of cost for product setups will be allocated to
the low-volume product. The amount of product setup cost allocated to the low-volume product will prob-
ably be higher than it would be under traditional overhead allocation, so overhead cost per unit allocated
to the low-volume product will probably be higher under ABC than under traditional costing.
Note: ABC is becoming more of a necessity for many companies, since traditional systems may use
direct labor to allocate overheads and direct labor is becoming a smaller part of the overall production
process. Essentially, activity-based costing is very similar to the traditional or standard method of
overhead allocation, except for the fact that there are many cost pools, each with a different cost
driver, and the cost drivers should have a direct relationship to the incurrence of costs by an individual
product. Therefore, in the application of ABC, many different overhead allocations are performed. The
main difference is the determination of the allocation bases.
The ABC Process

Setting up an ABC system is more difficult, time-consuming, and costly than setting up a traditional system.
Thus, management must consider the cost-benefit tradeoff in instituting an ABC system, particularly if the
system as it is used will not be able to be used for external financial reporting. Setting up an ABC system
involves the
1) Identification of activities
2) Identification of cost drivers
3) Identification of cost pools
1) Identification of Activities
The company must first analyze the production process and identify the various activities that help to
explain why the company incurs the costs it considers to be indirect costs.
As part of analyzing the production process and looking at all of the activities that cause costs to be incurred,
the company may identify some non-value-adding activities. Non-value-adding activities are activities
that do not add any value for the end consumer, and the company should try to reduce or eliminate them.
Reducing non-value-adding costs provides an additional benefit to the company because it can lead to a
reduction in the cost of production. Because the costs were related to activities that do not add value to
the customer, it is probable that the company will not need to lower the price if it eliminates these non-
value-added activities because the customer will notice no difference in the product. This cost reduction
can enable the company to either reduce the sales price or to recognize more gross margin from the sale
of each unit.
Value-adding activities are the opposite of non-value-adding activities. As the name suggests, value-
adding activities are activities (and their costs) that add value to the customer, and that the customer is
willing to pay for. Even though these activities are value-adding activities, they must be monitored to make
certain that their costs are not excessive.
Note: The identification of non-value adding activities is potentially one of the greatest benefits a com-
pany can receive from implementing an ABC system. Some companies decide to analyze their costs as
value adding or non-value adding activities even if they choose to not fully implement ABC.
2) Identification of Cost Drivers and Cost Pools

The company must evaluate all of the tasks performed and select the activities that will form the basis of
its ABC system. Each activity or cost driver identified requires the company to keep records related to that
activity and increases the complexity of the ABC system. Therefore, an activity-based costing system that
includes many different activities can be overly detailed and difficult to use. On the other hand, an activity-
based costing system with too few activities may not be able to measure cause-and-effect relationships
adequately between the cost drivers and the indirect costs.
3) Calculation of the Allocation Rate and Allocation

After the activities have been identified and the cost pools and cost drivers determined, an allocation rate
is calculated for each of the cost allocation bases. The identified cost drivers should be used as the
allocation bases for each cost pool.
The calculation of the allocation rate is done the same way as it is done under the traditional method:
budgeted costs in each cost pool are divided by the budgeted usage of the cost allocation base (cost driver)
for the cost pool. The costs in the cost pools are then allocated to the products based upon the usage of
the cost allocation base/driver for each product.
Because of the increased number of allocation bases, ABC provides a more accurate costing of products
when the company produces multiple products. If a company produces only one product, it does not need
to use ABC because all of the costs of production are costs of that one product. ABC is meaningful only if a
company produces more than one product, because ABC affects how much overhead is allocated to each
product.
Note: ABC uses multiple cost pools and multiple allocation bases to more accurately reflect the different
consumptions of overhead activities between and among products.
ABC will provide the most benefits to companies that produce very diverse products or have com-
plex activities. For companies that produce relatively similar products or have fairly straightforward
processes that are consumed equally by all products, the costs of ABC would probably outweigh the bene-
fits.
Below are two examples of how activity-based costing might be used in a real situation.
Example #1: A manufacturing firm. In a manufacturing environment, machine setup is required

every time the production line changes from producing one product to producing another product.
The cost driver is machine setups. An engineer might be required to supervise the setup of the machine
for the product change. The engineer spends 20% of his or her time supervising setups. Therefore, 20%
of the engineer's salary and other expenses will be costs to be allocated according to the amount of time
the engineer spends supervising each product's machine setup as a percentage of the amount of time
spent supervising all product setups (the resource driver).
In addition to the engineer, other personnel are required for machine setups. Production supervisors are
also needed to supervise machine setups, and they spend 40% of their time doing that (the resource
driver again).
All of the costs of machine setups are collected in a "machine setups" cost pool. Setup time spent on
each product as a percentage of setup time spent on all products is the activity driver. The total costs
in the pool are allocated to the different products being produced based on the percentage of total setup
time used for each product.
Example #2: A service firm. Bank tellers process all kinds of transactions. The transactions relate to
the many different banking services the bank offers. Transactions processed are the cost drivers. How
should the tellers' time, the teller machines used by the tellers, the supplies used by the tellers and the
space occupied by the tellers be allocated among the various services offered by the bank (checking
accounts, savings accounts, and so forth) in order to determine which services are most profitable?
The bank does time and motion studies to determine the average time it takes tellers to process each
type of transaction (checking account transactions, savings account transactions, and so forth). Then,
information on how many of each type of transactions are processed by tellers is captured. The average
time for each type of transaction is multiplied by the number of transactions processed. The percentage
of teller time spent on each type of transaction as a percentage of the amount of teller time spent on all
types of transactions is the activity driver.
The tellers spend 90% of their time performing teller transactions and 10% of their time doing something
else like answering telephones, 90% of the tellers' salaries will be put into the "tellers" cost pool along
with 100% of the costs of their teller machines, their supplies, and the square footage occupied by their
teller stations. Then the percentage of tellers' time spent on each type of transaction in relation to their
total time spent on all teller transactions (the activity driver) is used to allocate the teller costs in the
cost pool proportionately among the bank's various services.
Benefits of Activity-Based Costing
• ABC provides a more accurate product cost for use in pricing and strategic decisions because over-
head rates can be determined more precisely and overhead application occurs based on specific
actions.
• By identifying the activities that cause costs to be incurred, ABC enables management to identify
activities that do not add value to the final product.
Limitations of Activity-Based Costing
• Not everything can be allocated strictly on a cost driver basis. In particular, facility-sustaining costs
cannot be allocated strictly on a cost driver basis.
• ABC is expensive and time consuming to implement and maintain.
• Activity-based costing systems cannot take the place of traditional overhead costing systems without
significant adaptation because pure ABC is not acceptable under generally accepted accounting prin-
ciples or for tax reporting.
2 B 4. Variable and Absorption Costing for Manufacturing Costs

Variable and absorption costing are two different methods of manufacturing costing. Under both variable
and absorption costing, all variable manufacturing costs (both direct and indirect) are inventoriable costs.
The only two differences between the two methods are in:
1) Their treatment of fixed manufacturing overhead
2) The presentation on the statement of profit or loss of the different costs
Note: All other costs except for fixed factory overheads are treated in the same manner under both
variable and absorption costing, although they may be reported in a slightly different manner on the
statement of profit or loss.
Note: Variable costing can be used only internally for decision-making. Variable costing is not acceptable
under generally accepted accounting principles for external financial reporting. In the U.S., it is also not
acceptable under tax regulations for income tax reporting.
Fixed Factory Overheads Under Absorption Costing

Under absorption costing, fixed factory overhead costs are allocated to the units produced during the
period according to a predetermined rate. Fixed manufacturing overhead is therefore a product cost
under absorption costing. Product costs are inventoried and they are expensed as cost of goods sold only
when the units they are attached to are sold.
The predetermined fixed overhead rate is calculated as follows:
Budgeted Monetary Amount of Fixed Manufacturing Overhead

Budgeted Activity Level of Allocation Base
The budgeted activity level of the allocation base is the number of budgeted direct labor hours, direct
labor cost, material cost, or machine hours—whatever is being used as the allocation base.
When standard costing is being used, the fixed overhead is applied to the units produced on the basis of
the standard number of units of the allocation base allowed for the actual output.
Example: Fixed overhead is applied to units produced on the basis of direct labor hours. The standard
number of direct labor hours allowed per unit produced is 0.5 hours. The company budgets 1,500,000
in fixed overhead costs for the year and budgets to produce 750,000 units.
Since 0.5 hours of direct labor are allowed per unit produced, the standard number of direct labor hours
allowed for the budgeted number of units is 750,000 × 0.5, or 375,000 DLH. The fixed overhead appli-
cation rate is therefore 1,500,000 ÷ 375,000, or 4.00 per DLH.
The company actually produces 800,000 units, incurring 1,490,000 in actual fixed factory overhead. The
amount of fixed overhead applied to the units produced is 4.00 × (800,000 × 0.5), which equals
1,600,000. Fixed factory overhead is over-applied by 110,000 (1,600,000 applied − 1,490,000 actual
incurred cost).
Note that the fixed factory overhead incurred did not increase because a greater number of
units was produced than had been planned. In fact, fixed overhead incurred was actually lower
than the budgeted amount. That can occur because fixed factory overhead does not change in total
because of changes in the activity level, as long as the activity level remains within the relevant
range.
In contrast, variable factory overhead, which is applied to production in the same way as fixed factory
overhead, does change in total because of changes in the activity level.
Note: Fixed factory overheads are allocated to the units produced as if they were variable costs,
even though fixed factory overheads are not variable costs.
When absorption costing is being used, the income from operations reported by a company is influenced
by the difference between the level of production and the level of sales. For example, when the level of
production is higher than the level of sales, some of the fixed manufacturing overhead costs incurred during
the current period are included on the statement of financial position as inventory at year-end. As a result,
the fixed costs that are in inventory are not included on the statement of profit or loss as expenses.
Fixed Factory Overheads Under Variable Costing

Under variable costing (also called direct costing), fixed factory overheads are reported as period costs
and are expensed in the period in which they are incurred. Thus, no matter what the level of sales, all of
the fixed factory overheads will be expensed in the period when incurred.
Furthermore, as long as production remains within the relevant range, the fixed factory overhead cost will
not change with increases or decreases in production volume. Therefore, the amount of fixed factory over-
head expensed will remain the same regardless of how many units are produced.
Variable costing does not conform to generally accepted accounting principles under either IFRS
or U.S. GAAP. For external reporting purposes, generally accepted accounting principles require the use
of absorption costing, and therefore variable costing cannot be used for external financial reporting.
However, many accountants feel that variable costing is a better tool to use for internal analysis, and
therefore variable costing is often used internally.
Note: It is important to remember that the only difference in operating income between absorption
costing and variable costing relates to the treatment of fixed factory overheads. Under absorption
costing, all manufacturing costs including fixed factory overhead costs are included, or absorbed, into
the product cost and reach the statement of profit or loss as part of cost of goods sold when the units
the costs are attached to are sold. Under variable costing, only variable direct costs (direct materials
and direct labor) and variable indirect costs (variable overhead) are included as product costs. Fixed
factory overhead costs are excluded from product costs and treated as period costs.
Effects of Changing Inventory Levels

Because fixed factory overheads are treated differently under absorption and variable costing, it is virtually
certain that variable and absorption costing will result in different amounts of operating income (or operat-
ing loss) for the same period of time.
Note: In addition to producing different amounts of operating income, variable costing and absorption
costing will always produce different values for ending inventory because different costs are included in
each unit of inventory. Ending inventory under absorption costing will always be higher than it would be
if variable costing were used during the same period because under absorption costing, each unit of
inventory will include some fixed factory overhead costs. In contrast, under variable costing fixed over-
head costs are not allocated to production and so are not included in inventory. Instead, they are
expensed in the period incurred.
Only when production and sales are equal during a period (meaning no change takes place in inventory
levels and everything that was produced was sold) will there not be a difference between the income from
operations reported under variable costing and under absorption costing. If sales and production are equal,
the fixed factory overheads will have been expensed as period costs under the variable costing method,
and the fixed factory overheads will have been “sold” and included in cost of goods sold under the absorption
costing method.
Whenever inventory changes over a period of time, the two methods will produce different levels of oper-
ating income.
Production Greater than Sales (Inventory Increases)

Whenever production is greater than sales, the operating income calculated under the absorption
costing method will be greater than operating income under variable costing because some of the
fixed factory overheads incurred were inventoried under absorption costing. Under absorption costing, fixed
factory overheads are allocated to each unit. When a unit that was produced but not sold during the period
remains on the balance sheet as inventory, its inventory cost includes the fixed factory overhead applied
to that unit. As a result, that amount of fixed factory overhead is temporarily reported on the statement of
financial position instead of on the statement of profit or loss. When the unit is sold during the following
period, that amount of fixed factory overhead moves to the statement of profit or loss as cost of goods
sold.
Under variable costing, all of the fixed factory overheads incurred are expensed on the statement of profit
or loss in the period incurred.
Sales Greater than Production (Inventory Decreases)

If production is lower than sales, the variable costing method will result in a greater operating in-
come than absorption costing will because under the variable method, the only fixed factory overheads
included as expenses in the current period were those that were incurred during the current period. Because
sales were greater than production, some of the products that were produced in previous years were sold
during the current period. Thus, under the absorption method, some of the fixed factory overhead costs
that had been inventoried in previous years will be expensed in the current period—in addition to all the
costs incurred during the current period—as cost of goods sold.
Note: Over a long period of time, the total income from operations that will be presented
under both methods will be essentially the same. In the long term, income from operations will be
the same under variable and absorption costing, because in the long term the company will not produce
more than it can sell and therefore sales will equal production. Rather, the difference between the two
methods will appear in the allocation of operating income to the different periods within that longer time
period.
The following table summarizes the effect on operating income of changing inventory levels (production
compared to sales) under the two methods:
Production & Sales Operating Income
Production = Sales Absorption = Variable
Production > Sales Absorption > Variable
Production < Sales Absorption < Variable
Note: Ending inventory under absorption costing will always be higher than ending inventory under
variable costing, because more costs are applied to each unit under absorption costing than under vari-
able costing, and the number of units in ending inventory are the same under both methods. The units
in ending inventory under absorption costing will always contain some fixed costs, whereas the units in
ending inventory under variable costing will always contain no fixed costs.
Statement of Profit or Loss Presentation

The presentation of the statement of profit or loss will also be different under absorption costing and vari-
able costing.
The Statement of Profit or Loss under Absorption Costing

Under absorption costing, gross margin is calculated by subtracting from revenue the cost of goods sold,
which includes all variable and fixed manufacturing costs for goods sold. All variable and fixed non-
manufacturing costs (period costs) are then subtracted from the gross margin to calculate income from
operations.
The statement of profit or loss (through income from operations) under absorption costing is as follows:
Sales revenue
− Cost of goods sold – variable and fixed manufacturing costs of items sold
= Gross margin
− Variable non-manufacturing costs (expensed)
− Fixed non-manufacturing costs (expensed)
The Statement of Profit or Loss Under Variable (Direct) Costing

Under variable costing a manufacturing contribution margin is calculated by subtracting all variable
manufacturing costs for goods that were sold from revenue. From this manufacturing contribution
margin, non-manufacturing variable costs are subtracted to arrive at the contribution margin. All fixed
costs (manufacturing and non-manufacturing) are then subtracted from the contribution margin to calculate
income from operations.
The statement of profit or loss (through income from operations) under variable costing is as follows:
Sales revenue
− Variable manufacturing costs of items sold
= Manufacturing contribution margin
− Variable non-manufacturing costs (expensed)
= Contribution Margin
− All fixed manufacturing costs (expensed)
− All fixed non-manufacturing costs (expensed)
Note: The difference in presentation between the two methods does not affect the difference in the
treatment of fixed manufacturing overheads under the two different methods. Candidates need to know
that under the absorption method a gross margin is reported, while under the variable method a con-
tribution margin is reported; and the two are different.
Absorption Costing versus Variable Costing: Benefits and Limitations

While absorption costing is required for external reporting and income tax reporting in the U.S., it is
generally thought that variable costing is better for internal uses.
Benefits of Absorption Costing
• Absorption costing provides matching of costs and benefits.

• Absorption costing is consistent with IFRS and U.S. generally accepted accounting princi-
ples and also with U.S. Internal Revenue Service requirements for the reporting of income on
income tax returns.
Limitations of Absorption Costing
• Because of the way that fixed costs are allocated to units under absorption costing, managers have
an opportunity to manipulate reported operating income by overproducing in order to keep some
of the fixed costs capitalized in the statement of financial position in inventory. Thus, the effect of
this manipulation is to move operating income from a future period to the current period. It also
creates a buildup of inventories that is not consistent with a profitable operation.
• When the number of units sold is greater than the number of units produced, inventory decreases.
Operating income under absorption costing will be lower than it would be under variable costing,
because some prior period fixed manufacturing costs will be expensed under absorption costing
along with the current period’s fixed manufacturing costs.
Benefits of Variable Costing
• The impact on operating income of changes in sales volume is more obvious with variable costing
than with absorption costing.
• By not including fixed costs in the calculation of cost to produce, companies are able to make better
and more informed decisions about profitability and product mix.
• Operating income is directly related to sales levels and is not influenced by changes in inventory
levels due to production or sales variances.
• Variance analysis of fixed overhead costs is less confusing than it is with absorption costing.
• The impact of fixed costs on operating income is obvious and visible under variable costing because
total fixed costs are shown as expenses on the statement of profit or loss.
• It is easier to determine the “contribution” to fixed costs made by a division or product—and thereby
helps determine whether the product or division should be discontinued.
• Variable costing tends to be less confusing than absorption costing because it presents costs in the
same way as they are incurred: variable costs are presented on a per-unit basis and fixed costs
are presented in total.
• Advocates argue that variable costing is more consistent with economic reality, because fixed costs
do not vary with production in the short run.
Limitations of Variable Costing
• Variable costing does not provide proper matching of costs and benefits and so is not acceptable
for external financial reporting under generally accepted accounting principles. Variable costing is
also not acceptable for income tax reporting.
• Since only variable manufacturing costs are charged to inventory, variable costing requires sepa-
rating all manufacturing costs into their fixed and variable components.
• To prepare a statement of profit or loss based on variable costing, it is also necessary to separate
the selling and administrative costs into their fixed and variable components.
Note: The issue of absorption costing versus variable costing is relevant only for a manufacturing com-
pany. A company that does not do any manufacturing, for example a reseller or a service company,
would have only non-manufacturing fixed overhead. Non-manufacturing fixed overhead for such a com-
pany would simply be expensed as incurred.
2 C. Decision Making
Marginal analysis examines how benefits and costs respond to incremental changes in production. Any
incremental change (for example, the production of one more unit) results in additional benefits but it also
incurs additional costs. According to economic theory, rational persons “think at the margin”; that is, in
making any decision, a given action is undertaken only if the expected additional (or marginal) benefit
exceeds the additional (or marginal) cost of doing so. Marginal analysis is used to determine whether or
not the expected added benefit of an action is greater than the expected added cost of the action.
Example: The following illustrates the factors involved in marginal analysis.
A clothing buyer is purchasing clothing for the new season. A wholesaler offers a 10% discount for
purchases over 10,000 and a 14% discount for purchases costing over 20,000. After the buyer selects
the desired items, the total price comes to 19,000, qualifying for the 10% discount (1,900), and making
the net cost 17,100. However, if an additional 1,000 in items are ordered, the base cost increases to
20,000 and qualifies the purchase for the 14% discount, or 2,800 off. With 2,800 off the total price of
20,000, the net cost for all the items becomes 17,200. The marginal cost of that additional 1,000 in
purchases is only 100, 90% less than the value of the additional purchases. The added benefit of pur-
chasing the additional items (1,000) is greater than the added cost (100) of those additional items.
Marginal Revenue and Marginal Cost

The terms “marginal revenue” and “marginal cost” when applied to production refer to the addition to
total revenue and the addition to total cost that result from a one-unit increase in production.
• The marginal revenue resulting from an increase in production is the incremental revenue
from the sale of the additional production. The incremental revenue is total revenue after the
production increase minus total revenue before the production increase.
• The marginal cost resulting from an increase in production is the incremental cost that is in-
curred for the increased production. The incremental cost is total cost after the production increase
minus total cost before the production increase.
“Marginal revenue” and “marginal cost” can also refer to the addition to total revenue and the addition to
total cost, respectively, that would result from a project that is under consideration.
Relevant Information
One of the primary challenges in the decision-making process is distinguishing between factors that are
relevant to the decision and factors that are not relevant to the decision. In general, the following two
considerations can help to identify which factors are relevant:
• Factors that focus on the future are relevant. Events or costs incurred in the past (that is,
sunk costs) cannot be changed, and therefore are not relevant.
• Factors that differ among possible alternatives are relevant. Revenues and costs that are
the same for all the options under consideration are not relevant because they will be the same
no matter which option is selected.
Relevant Revenues and Relevant Costs

Relevant revenues and relevant costs are revenues and costs that differ between or among alterna-
tives. For example, when a decision is being made about whether or not to invest in a new project, the
forecasted additional revenues that the project would generate are relevant revenues and the forecasted
additional costs of the project are relevant costs.
Note: Revenues and costs are relevant if:
 They occur in the future, and
 They differ between or among the various alternatives available.
Differential and Incremental Costs

Relevant revenues and costs are also classified as “differential revenues” and “differential costs” or “incre-
mental revenues” and “incremental costs.” The terms “differential” and “incremental” are often used
interchangeably; however, they are not the same.
• Differential revenues and costs are those that differ between two alternatives.
• Incremental revenues and costs are incurred additionally as a result of an activity.
Example: The following illustrates the factors involved in differential and incremental costs.
A company’s machine has worn out, cannot be repaired, and must be replaced (that is, keeping it is not
an option). Management has two choices: it can either replace the worn-out machine with an updated
model of the same type or it can upgrade to a fully automated, totally different system. The difference
in costs between the replacement machine and the upgraded machine is the differential cost. (The
cost of doing nothing is not relevant because it is not an option.)
On the other hand, if the machine had not yet worn out, then the choice would be between keeping it at
its existing cost or upgrading to a new machine. The relevant cost is the difference between the current
cost for the old machine and the cost for the upgraded machine. The additional cost of the upgraded
machine, over and above the current cost for the existing machine, represents the incremental cost.
It is the cost the company would incur by upgrading that is in addition to the present cost of keeping
the old machine.
Avoidable and Unavoidable Costs

Avoidable and unavoidable costs are another classification of relevant and irrelevant costs used in decision
making.
• An avoidable cost is an existing cost that can be avoided because the cost will go away if a
particular option is selected. Avoidable costs are relevant to the decision-making process because
they will continue if one course of action is taken but they will not continue if a different course of
action is taken.
• An unavoidable cost is an expenditure that cannot be avoided and will not go away, regardless
of which course of action is taken. Unavoidable costs are not relevant to the decision at hand
because they do not differ between alternatives.
Example 1: A decision to outsource or not to outsource.
A company is considering outsourcing its production. If production is outsourced, the variable cost to
produce the product in-house will go away and be replaced by the cost to purchase the product exter-
nally. In addition, a portion of the company’s fixed manufacturing costs will go away. These in-house
variable costs and the fixed costs that would go away if the production is outsourced are avoidable
costs. Those avoidable costs are relevant costs to the decision-making process because such costs
will continue if one course of action is taken (production is maintained in-house) but they will not con-
tinue if another course of action is taken (production is outsourced).
However, this decision also includes unavoidable costs. For example, the company has non-cancelable
leases for in-house equipment. Even if production is outsourced and the machines are no longer being
used, the company is still obligated to continue the lease payments. Unlike avoidable costs, unavoida-
ble costs are not relevant costs to the decision-making process because they will be the same
regardless of which decision is made.
Example 2: A decision to close a plant.
Avoidable and unavoidable costs are important to a decision to close a plant or other business unit. If
closing the unit would avoid certain costs, those avoidable costs are relevant to the decision. Una-
voidable costs, however, are irrelevant because they do not differ between the two alternatives. If
some of the fixed plant costs would continue even if the plant were closed, those costs are unavoidable
costs and they are not relevant to the decision.
A central administrative cost that has been allocated to a division is another example of an unavoidable
cost that would continue if the division were closed. Even if that division were to be closed, the cost
would continue to be incurred by central administration. It would simply be allocated to another division
or divisions. So, for the company as a whole, the central administrative cost would not differ between
the two alternatives of closing the division or keeping it open.
Only costs that would be avoided (costs that would go away) if the division were closed are relevant to
the decision to close a division or not to close it.
Sunk Costs
A sunk cost is a cost for which the money has already been spent and cannot be recovered. Sunk costs
are not relevant to decision-making because they are past costs that cannot be changed regardless of any
decisions made for the future.
Economic Versus Accounting Concepts of Costs and Opportunity Costs

In the accounting perspective, only explicit costs are considered. An explicit cost is a cost that can be
identified and accounted for. Explicit costs represent obvious cash outflows from a business.
For the economists, not only the typical costs such as monetary expenditures are part of all the costs that
a company or an individual incurs, but the potential earnings from a forgone alternative that had to be
dismissed in order to achieve a particular goal are also considered. For example, in order to make a deal,
a businessperson needs to devote time to negotiations and to preparing the contracts, and that is forgone
time that cannot be used for another deal. Hence, the potential earnings from this lost time is part of the
costs that should be considered. Similarly, a truck that is loaded with aluminum cannot simultaneously (at
the same time) transport iron. The contribution to profits the trucking company is giving up if it chooses to
transport aluminum instead of iron is a cost of transporting the aluminum.
The potential earnings from the forgone alternative are an opportunity cost of the chosen option. The
concept of opportunity cost is one of the major distinguishing features between the way accountants eval-
uate situations and the way economists evaluate them.
An opportunity cost is the benefit that could have been gained from an alternative use of the same resource.
It is the contribution to income that is lost when a limited resource is not used in its best alternative use.
Opportunity cost is calculated only from the revenues that would not be received and expenditures that
would not be made for the other available alternative.
An opportunity cost is an implicit cost. The word “implicit” comes from the root word “implied.” An implicit
cost is an implied cost that does not appear in the statement of profit or loss, but it affects the company’s
net income just as if it were in the statement of profit or loss. An implicit cost is more difficult to identify
than an explicit cost because it does not clearly show up in the accounting records. An opportunity cost is
an economic cost but not an accounting cost.
Accountants ignore opportunity costs because opportunity costs are hard to calculate due to a lack of precise
numbers and costs. However, opportunity costs guide decisions on how to allocate resources in the most
efficient way. Opportunity costs highlight the forgone earnings that could have resulted from the best al-
ternative use of the resources, creating a bigger picture of the total effort that must be undertaken.
Opportunity Costs are Relevant Costs

Both explicit and implicit costs must be used in making decisions. Therefore, relevant costs may include
opportunity costs. Opportunity costs can and should be estimated in any decision where they are a factor.
For instance, in a make-or-buy decision, if the facilities being used to make one product could be used in
the production of an alternative item, the contribution to income from the alternative item (the item that
would be foregone to continue to use the facilities to make the current item) is an opportunity cost of
continuing to manufacture the current product in-house.
Opportunity costs are relevant in decision making because opportunity costs differ between alternatives
just as surely as accounting costs do.
Example 1: A company manufactures Item A; however, the company could have used the same facilities
to produce Item B. The opportunity cost of producing Item A is the contribution to income that Item B
would have provided if the company had manufactured Item B instead.
Example 2: A company takes 50,000 out of its invested funds and uses it to buy some new equipment
to manufacture a new product. The company is giving up the investment income it could have earned
on that 50,000 if it had left the funds invested. That loss of income needs to be considered against the
net cash flow the company expects to earn from the manufacture and sale of the new product. The lost
investment income on the 50,000 is an opportunity cost of manufacturing the new product, and the
opportunity cost should be included in any incremental analysis used to decide whether or not to buy
the new equipment.
Opportunity cost is calculated only from the revenues that would not be received and expenditures
that would not be made for the other available alternative(s). Similarly, any interest cost that is part of
the opportunity cost can be calculated only for the time period when the cash flows are different between
or among the options.
Note: Opportunity costs exist only when the availability of a resource is limited or constrained. If re-
sources are not constrained, no opportunity cost can exist because all available opportunities are
options that can be selected and no opportunities need to be forgone.
For example, if a company has unused production capacity, it can accept a new order without having to
stop producing other orders. However, if the company is already producing at capacity, accepting a new
order would mean stopping the production of some existing orders. Although the company would earn a
contribution margin by producing the new order, it would need to give up the contribution margin it
could have earned on the orders that it could not produce. The surrendered contribution margin is an
opportunity cost that should be included in the calculation of the cost of the new order when deciding
whether or not to accept the new order.
Income Tax Effects in Decision Making

In any analysis that involves incremental or differential revenues or costs, the income tax effects must be
factored into the analysis. A net incremental revenue should be reduced by the resulting tax liability. A net
incremental expense is also reduced by the tax benefit that results from the fact that the expense is tax
deductible. Depreciation expense is a tax-deductible expense. The amount of tax savings that results
is called a depreciation tax shield, which is usually calculated as the amount of the depreciation multiplied
by the company’s tax rate. The amount of change in tax-deductible depreciation will cause an equal and
opposite change in the company’s taxable income (that is, an increase in tax-deductible depreciation causes
a decrease in taxable income and vice versa). The change in taxable income will, in turn, cause a change
in the amount of income tax that will be due.
Differences in depreciation expense between one alternative and another alternative should be used to
calculate the difference in the depreciation tax shield between the two alternatives.
Marginal Analysis Applications

Marginal analysis is the process of choosing between or among two or more alternatives, and companies
make these decisions based upon which opportunities will provide the most benefit. Management must
focus only on the incremental or differential revenues and costs because those are the only relevant rev-
enues and costs.
Marginal analysis can be used in a number of different situations, including make-or-buy decisions (that is,
insourcing versus outsourcing products and services), accepting or rejecting a one-time special order, sell
or process further decisions, disinvestment (that is, dropping a product line, selling a segment, or reducing
funding allocated to a product line or segment), or a change in output levels for existing products.
Note: In marginal analysis, total costs per unit are irrelevant because they include some costs that
are not incremental, such as fixed overhead costs or other costs that are common to both (or all) alter-
natives. Generally, variable costs per unit are relevant, but if a variable cost will be the same in total
regardless of the decision, that variable cost is not relevant to the decision. Furthermore, generally fixed
costs are not relevant, but some fixed costs may be relevant if they will be changed by the decision.
Make-or-Buy Decisions
Management of a company must sometimes decide whether it wants to produce a particular product or
component in-house or purchase it from an outside vendor. Such choices are known as make-or-buy
decisions. For these decisions, as for all marginal analysis decisions, only relevant costs should be
considered. Relevant costs are the costs that differ between the two options and usually consist of the
variable costs and avoidable fixed costs. Relevant costs may also include opportunity costs. For exam-
ple, if a company could rent its facilities if it were to outsource some production, the rental income that it
would not receive is an opportunity cost of continuing to produce the product in-house.
Fixed costs for the company as a whole that will be allocated to another department are not avoidable
because the company will still incur those costs. These unavoidable costs are therefore irrelevant to the
decision-making process.
Sunk costs are also ignored. Because they are historical costs that cannot be changed, they will be the
same for every option and thus are not relevant.
Management must compare the relevant costs for each option (that is, the costs that would be incurred
only if that particular option is chosen) and then select the option with the lowest incremental costs. If the
cost to purchase the product from outside is lower than the avoidable costs of producing the item inter-
nally, the company should buy the product from the outside supplier.
Exam Tip: Variable costs are not always avoidable, and fixed costs are not always unavoidable.
Some variable costs may be unavoidable, meaning that they will continue to be incurred even if the
product is purchased. The unavoidable variable costs should not be treated as relevant costs, since they
will not be any different between or among the options.
On the other hand, some fixed costs may be avoidable if the company outsources the manufacturing.
The avoidable fixed costs should be treated as relevant costs because they will be different between or
among the options.
In determining relevant costs for a make-or-buy decision, keep the following in mind:
• The purchasing costs such as purchase price, ordering costs, transportation costs, and carrying
costs relating to the purchase from an outside vendor are all relevant variable costs and must be
included in the calculation of the overall cost of purchasing the item.
• Only avoidable fixed and variable costs of in-house production are relevant and need to be in-
cluded in the cost of producing the item internally.
• Income that could be earned from using the facilities in an alternate manner is a relevant cost of
producing in-house.
The maximum price the company would be willing to pay an outside supplier for a product that it currently
makes is the amount of internal production costs that will not be incurred (that will be avoided)
by buying, not making, the product.
Usually, the maximum price that a company would be willing to pay for purchasing outside the company
is:
Maximum Price to Pay = Total Internal Production Costs – Unavoidable Fixed and Variable Costs
In making decisions, managers must consider not only quantitative factors but also qualitative factors.
Qualitative considerations such as overall product quality, reliability of delivery, service, flexibility in deliv-
ery terms, and even public relations are also potentially very important to any decision. Unfortunately, it is
often difficult to assign a monetary value to qualitative factors. For example, if the product purchased from
the outside company is of poor quality, dissatisfied customers may well cause a loss of profits, from both
lost sales and returns of defective items. However, precisely quantifying the financial impact of this quali-
tative issue can be a difficult and complicated process.
Example: Medina Co. produces football goal posts for sale to college and professional football teams.
The variable and fixed costs to produce a goal post are as follows:
Direct materials 200

Direct labor 150
Indirect variable costs 75
Fixed costs 125
Selling and administrative costs 100
Total 650
Butler Corp. has offered to supply Medina with finished goal posts that Medina would then resell under
the Medina name. The price of one goal post from Butler is 490.
If Medina purchases goal posts from Butler, it will continue to incur all of its fixed costs, but Medina will
be able to eliminate half of the selling and administrative costs associated with the production and sale
of its own goal posts. The other variable costs will not be incurred because Medina will not need to pay
any production costs if it purchases goal posts from Butler.
Medina must consider two important questions:
Should Medina accept Butler’s offer, and if not, at what price would Medina be willing to ac-
cept the offer?
Medina should not accept the offer from Butler. If Medina accepts the offer, its total costs incurred will
be 665 per goal post, as follows.
Goal post 490

Unavoidable costs that would continue:
Fixed costs 125
Selling and administrative costs (1/2) 50
Total 665
Purchasing the goal posts from Butler would cost 15 more per goal post (665 − 650) than producing
them internally.
What is the maximum price Medina would be willing to pay Butler?

The maximum price Medina would be willing to pay Butler is the total cost of producing the goal posts
internally minus the unavoidable costs that would continue if the production is outsourced.
Total cost of producing internally 650

Less: Unavoidable costs (125 FC + 50 S&A) 175
Maximum price Medina would pay 475
Other Considerations:
Even if Butler’s offer had been acceptable from a quantitative standpoint, Medina would need to deter-
mine if it is acceptable from a qualitative standpoint. Medina is going to put its own name on these goal
posts. Therefore, before letting another company do the manufacturing, Medina would need to evaluate
other aspects, such as the quality of Butler’s manufacturing processes, the reliability of its delivery, and
the availability of service if necessary.
Special Order Decisions

In a special order situation, a company is asked to produce a special one-time order. Before accepting
the special order, the company must decide the minimum price to charge.
Two factors must be considered in any special order decision:
1) the direct (or avoidable) costs of production, and
2) the level of capacity at which the company can operate, in order to determine if opportunity cost
is a factor.
Direct (or Avoidable) Costs of Production

The minimum price for a special order must include all of the costs that will be directly incurred in fulfilling
it. Costs directly incurred are the costs that would be avoidable if the company did not produce the order.
Generally, the costs that would be incurred directly as a result of the order include the variable costs of
production, such as direct materials, direct labor, and variable overheads. Nonmanufacturing costs and
fixed manufacturing costs will usually be the same whether the special order is produced or not, so those
costs are usually not relevant.
Note: Variable overhead is usually considered to be an avoidable cost for special orders as well as for
make-or-buy decisions.
Level of Operating Capacity

The minimum price will also be affected by the percentage of capacity at which the company is operating.
If the company is operating at full capacity, to produce the units for the special order it will need to not
produce some other order that it could have produced and sold instead. Therefore, if the company chooses
to manufacture the special order, it will need to recover the direct costs of producing the special order plus
the contribution that is lost on the other units that it cannot produce and sell.
Note: Contribution is the difference between the selling price and the variable costs associated with
the unit.
Operating at Less than Full Capacity

If the factory is operating at less than full capacity and has enough unused capacity to produce the special
order, the company should accept the special order if the price is greater than the avoidable (direct) costs
of production. Only the avoidable (direct) costs of production are used to determine the minimum
price to be charged for the order. Technically, if the company can sell the product for any amount greater
than the avoidable cost of production, then the order will add to the company’s profits.
Note: From a quantitative standpoint, charging just a little more than its costs for a special order might
make financial sense for a company. However, it might not make sense from a qualitative standpoint.
For example, the company’s existing customers could find out about the deeply discounted sale, straining
business relationships with existing clients and leading some to seek out a new supplier.
Operating at Full Capacity

If the company’s factory is operating at full capacity when it receives a special order, then management
must include the opportunity cost of producing the order as a cost in determining the price to charge. In
other words, because it is producing at full capacity, in order to produce the special order, the company
will not be able to produce something else. Thus, it will lose the contribution associated with the sale of
the other items not produced, and that is a “cost” that needs to be covered by the contribution from the
special order. Therefore, when operating at full capacity, the company needs to make sure it recovers the
direct (avoidable) costs of producing this order and the contribution lost from the products that will not be
sold as a result of accepting the special order.
Scenario: Athens Co. produces refrigerators and microwave ovens. Athens has the following information
regarding each unit produced of each product:
Refrigerator Microwave
Units produced/week 500 500
Machine hrs. required/unit 1 hr. 2/3 hr.
Sales price 300 200
Variable costs (100) ( 75)
Contribution per unit 200 125
Fixed costs per unit ( 75) ( 50)
Profit per unit 125 75
All of the variable costs will be avoided if a unit is not produced. However, all of the fixed costs will
continue if a unit is not produced, because fixed costs do not change in total as production volume
changes, as long as production remains within the relevant range. Since the fixed costs will continue
without change, they will simply be allocated to other units produced.
Example 1: A one-time customer comes to Athens and offers to buy 200 refrigerators if Athens is able
to provide the refrigerators at a lower price than its competition. At this time, Athens is operating at
60% capacity and has the ability to produce these refrigerators without affecting current production.
The minimum price that Athens should charge for the 200 refrigerators is 100.01, or the amount of the
variable costs that will be incurred to produce this order plus 0.01. If the price were only 100.00, then
Athens would be indifferent between producing the refrigerators or not producing them because it would
receive no additional contribution from their sale.
Example 2: A one-time customer comes to Athens and offers to buy 200 refrigerators if Athens can
provide the refrigerators at a lower price than its competition. At this time, Athens is operating at 100%
capacity and in order to produce these 200 refrigerators it would need to not produce 300 microwaves.
In this case, the minimum price that Athens must charge will include the variable costs of production
of the refrigerators and also the contribution that will be lost by not producing and selling the 300
microwaves.
The variable costs for one refrigerator are 100. The contribution per microwave is 125 per unit, and since
300 microwaves will not be produced, the total lost contribution is 37,500 (300 × 125). The revenue
from the 200 refrigerators in the special order will need to cover this lost 37,500. Dividing 37,500 by the
200 refrigerators equals 187.50 per refrigerator, bringing the cost per unit to produce the 200 refriger-
ators to 287.50. Athens’ price per refrigerator will need to cover 100 of variable cost plus the lost
contribution of 187.50 per unit plus 0.01. Athens will need to charge at least 287.51 per refrigerator in
order to accept this order.
Proof: Currently, Athens has 162,500 of total contribution (500 × 200) + (500 × 125). If it were to set
the price at 287.50 for the new refrigerator order and sell 300 fewer microwaves, its contribution would
still be exactly 162,500, calculated as follows:
Original refrigerators 500 units × 200 = 100,000

Remaining microwaves 200 units × 125 = 25,000
New refrigerator order 200 units × 187.50 = 37,500
Total contribution 162,500
Therefore, Athens must receive more than 287.50 per refrigerator to be willing to accept the order. If
Athens were to sell the refrigerators for less than 287.50 each, its total contribution would be less than
it is currently.
Sell or Process Further Decisions

A company may face a choice between selling a product “as is” or processing it further, presumably in order
to sell it for a higher price, also known as a sell or process further decision. The decision to sell or
process further should be based on the incremental net operating income that is attainable beyond the “as
is” sale point, that is, on whether the incremental revenue from processing further is greater than the
incremental cost of doing so. This kind of situation may be encountered when dealing with a joint production
process or with obsolete inventory.
Joint Production Process

A joint production process is a single production process (and its associated costs) that yields more than
one product. For example, crude oil is processed into gasoline, diesel fuel, jet fuel, heating fuel, motor oils,
kerosene, and various petrochemicals. Joint production costs are costs that are shared by the products
produced by the joint production process. When a joint production process has joint costs, the split-off
point is the point in the production process where the various products become individually identifiable.
• Costs incurred up to the split-off point are joint costs.
• Costs incurred for each individual product after the split-off point are separable processing
costs.
A product of a joint manufacturing process may or may not be able to be sold at the split-off point. If a
product cannot be sold at the split-off point, it must be processed further to be sold. Even if a product can
be sold at the split-off point, if the incremental revenue to be gained from processing it further exceeds the
incremental cost to process further, it will have greater value when processed further as a separate product.
Management must decide whether to sell each product at the split-off point or to process it further and
then sell it.
When joint costs have already been incurred, the decision of whether or not to sell at the split-off point
should not include any consideration of the joint costs or the portion of the joint costs already allocated to
the individual products because those are sunk costs. Only incremental revenues and costs are relevant
factors. The increased revenues from further processing should be balanced against the increased costs of
the further processing. If the increase in revenues from further processing is greater than the increase in
costs, net operating income will increase. The expected increase in net operating income as a result of the
additional processing should be the only basis for the decision.
Obsolete Inventory
The original cost of obsolete inventory is a sunk cost and is therefore irrelevant. If the choice is between
selling the inventory “as is” for whatever price it can bring versus re-working it to update it and make it
saleable, compare the revenue from selling it as re-worked inventory minus the costs of re-working with
the proceeds from selling it “as is” (or the disposal costs if the inventory has no scrap value).
It is better to incur additional costs to re-work the inventory only if the sale of the re-worked product at
the expected price is certain, and if either of the following conditions is met:
• If the obsolete inventory has some scrap value: If the revenue for the re-worked inventory
minus the cost of re-work is positive (a net gain), and the net gain is greater than the proceeds
would be from selling it “as is.”
• If the obsolete inventory has no scrap value and if the company would need to pay to
dispose of it: If the revenue for the re-worked inventory minus the cost of re-work is either
positive (a net gain of any amount) or, if negative, the net loss is less than the cost to dispose of
the obsolete inventory.
If income tax is a consideration, then the difference in the net cash flow will need to be adjusted for the
tax effects of each option, which would require calculation of taxable income or loss. However, the book
value of the inventory is used only to calculate the taxable income or loss. It is not a factor in the comparison
of relevant revenues and costs because it is a sunk cost.
Example 1: CCC has ten obsolete computers in inventory. CCC purchased the computers four years ago
at a cost of 800 each but has never been able to sell them. The company has a customer who would buy
them for 175 each if CCC upgrades them; otherwise, CCC could sell them to another customer “as is”
for 100 each. The cost to upgrade would be 100 per computer, including labor. CCC’s tax rate is 40%.
Would the company be better off selling the computers now for 100 each or upgrading them and selling
them for 175 each? And how much is the difference?
A B B−A
Sell Now Upgrade & Sell Difference
Revenue 1,000 1,750 + 750
Less: Cost to upgrade 0 1,000 + 1,000
Cash flow from sale 1,000 750 − 250
Less: Cost of goods sold 8,000 8,000 0
Taxable income/(loss) (7,000) (7,250) − 250
Income tax benefit 2,800 2,900 + 100
Net cash flow after tax 3,800 3,650 − 150
The tax loss is relevant to the decision only because it will shelter other income from tax. The loss will
be used to offset other taxable income and will reduce the total tax liability of the company.
After the tax considerations, CCC would be better off selling the computers now because its net after-
tax cash flow would be 150 greater than it would be if CCC upgrades the computers and sells them.
Example 2: Assume the same conditions as in Example 1, except that CCC has no customer to purchase
the computers “as is.” However, CCC could sell the upgraded computers for 175. In addition, CCC must
get rid of the computers to make room for new merchandise. Since the computers contain toxic compo-
nents, they would need to be sent to a recycling center that charges 15 per computer. For this example,
the choice is between upgrading and selling the computers or paying a recycler to accept them. Which
is the better choice for CCC, and by what amount?
A B B−A
Recycle Upgrade & Sell Difference
Revenue 0 1,750 + 1,750
Less: Additional cost 150 1,000 − 850
Cash flow from sale (150) 750 + 900
Less: Cost of goods sold 8,000 8,000 0
Taxable income/(loss) (8,150) (7,250) + 900
Income tax benefit 3,260 2,900 − 360
Net cash flow after tax 3,110 3,650 + 540
Because CCC would need to pay to dispose of the computers, it is better off upgrading and selling them.
Disinvestment Decisions
Disinvestment can refer to selling or liquidating an asset, such as a product or product line or a segment
of the business such as a subsidiary. Disinvestment can also refer to capital expenditure reductions (without
selling or liquidating the asset) and re-allocation of the resources to more productive areas within the
organization or project.
Note: Disinvestment is not a synonym for divestment. Divestment, or divestiture, is the process of
selling or otherwise disposing of an asset. Disinvestment, on the other hand, can take place without any
sale of the asset.
When deciding whether to terminate or reduce funding to a product or a segment, the decision-making
process is very similar to that of other decisions. The process includes determining what the profit (or cost,
depending on the circumstances) would be under both the current situation and what it would be if the
funding were reduced or the product or segment were terminated. The decision is then based on which
option provides a greater benefit.
It is important to remember, however, that certain fixed costs may continue even after a product or seg-
ment has been terminated because some fixed costs may be allocations of central fixed costs or unavoidable
costs such as a non-cancelable lease. Because such costs will continue to be paid by the company after the
disinvestment, they are unavoidable costs.
In a disinvestment decision that involves termination, a company must follow three main steps:
1) Identify all unavoidable fixed costs that are allocated to or incurred by the product or segment
that would continue even if the product or segment were terminated.
2) Identify all unavoidable variable costs that would continue even if the product or segment
were terminated.
3) Identify all avoidable costs, both fixed and variable, that will be incurred only if the division
continues to operate and compare this to the revenue generated by the product or segment.
The result of Step 3 is the product or segment’s contribution. If the marginal revenue from the product
or segment is greater than the marginal costs (both variable and fixed) that will be incurred only if the
product or segment is continued, the company as a whole is better off continuing the product or segment
because it is providing a contribution to covering the fixed costs of the company as a whole. If the marginal
costs are greater than the marginal revenues, then the product should be eliminated or the segment closed.
The product or segment does not need to be profitable from a “bottom-line” perspective for it to be con-
sidered beneficial. As long as the product or segment is providing some amount of contribution to covering
the company’s continuing fixed costs, it should be maintained, at least in the short-run, because the com-
pany’s overall profitability is greater with the product or segment than it would be without it.
Exam Tip: To determine the amount by which a company’s contribution (profit), or in some cases costs,
will increase or decrease as a result of a specific action such as the termination of a segment, the best
approach is to calculate the requested information, such as a statement of profit or loss, for both op-
tions (to discontinue or to not discontinue) and then compare the results.
Note: In the decision-making process, nonfinancial considerations need to be included along with nu-
merical calculations about the benefit or cost. Nonfinancial considerations may include the impact on the
local community, public opinion, longer-term corporate goals, and other similar matters.
Time Value of Money CIA Part 3
Appendix A – Time Value of Money Concepts (Present/Future Value)

The time value of money refers to interest rates and the effect they have on the value of money over time.
Interest is the fee paid for having the use of money. Interest is earned by investors on money that has
been invested in interest-earning securities (usually bonds) and by savers in bank accounts that earn in-
terest. Borrowers pay interest to lenders. For businesses, the lenders are their bondholders and/or their
banks. Individuals pay interest on school loans, car loans, mortgages, and credit card debt (purchases not
paid off within the credit card’s grace period).
When money is borrowed or lent/invested, the amount of the loan or investment is called the principal.
Interest is calculated as a proportion of the principal for the period of time that the money is used. The
interest rate is the rate at which the interest accumulates. It is usually stated as a percentage of the
principal per period of time. Usually interest rates are quoted as annual interest rates (for example, 6% per
annum) but they may also, particularly for consumer debt, be quoted per month (such as 1% per month).
An interest rate of 1% per month is equivalent to 12% per annum.
Simple Interest
Simple interest is interest that is incurred only on the amount of principal that is outstanding. Unpaid
interest is not added to the principal, and interest is not charged on unpaid interest.
Simple interest for any amount of time can be calculated with this formula:
I = P × IR ÷ DY × DO
Where: I = Simple interest incurred

P = Principal outstanding
IR = Interest rate per year (per annum), in decimal form
DY = Number of days in year (usually 360, but may be 365)
DO = Number of days the principal is outstanding
Example: The principal of a loan is 100,000. The annual simple interest rate is 6%. Therefore, if the
entire 100,000 were to remain outstanding (not repaid) for one full year, the amount of simple interest
owed by the borrower for the year would be 100,000 × 0.06, or 6,000.
For each day the 100,000 remains outstanding, the amount of simple interest owed by the borrower
would be 100,000 × 0.06 ÷ 360, or 16.67 (rounded).
Usually in finance, interest is based on a 360-day year, although it may also be based on a 365-day
year. Or, if interest is to be calculated monthly, the annual amount of interest may be divided by 12 to
calculate the monthly interest amount.
If the 100,000 loan is outstanding for 15 days and is then repaid, the total simple interest owed by the
borrower will be 100,000 × 0.06 ÷ 360 × 15, or 250. The amount the borrower would repay would be
100,250.
If the loan is outstanding for one full year, the interest will be 100,000 × 0.06 ÷ 360 × 360, or simply
100,000 × 0.06, which is 6,000. The borrower would repay 106,000.
Simple interest for a period that is greater than one year can be calculated using the above formula, or it
can be calculated more simply. Using the above formula, a 100,000 loan for 2 years (720 days) at 6%
simple interest would incur interest of 100,000 × 0.06 ÷ 360 × 720, which equals 12,000. However, a
simpler way to calculate the same amount would be 100,000 × 0.06 × 2 = 12,000. Once one year’s interest
has been calculated (here, 100,000 × 0.06), it can be adjusted to a period of less than one year or to a
period of greater than one year.
Appendix A Time Value of Money
Compound Interest
Usually, interest is compounded at regular intervals. When interest is compounded, interest that has
accrued (been incurred) and has not yet been paid by the borrower is added to the outstanding principal
at the end of each stated compounding period. Then the interest incurred for the next period is calculated
based on the increased principal balance that consists of the previous principal plus the compounded
(added) interest. The amount of interest calculated using this procedure is called compound interest, and
it is higher than interest calculated using simple interest.
Example: 100,000 has been deposited in a bank that pays 2% interest per annum, compounded quar-
terly. At the end of the first quarter, interest will be calculated as follows:
I = P × IR ÷ DY × DO
I = 100,000 × 0.06 ÷ 360 × 90, or I = 500
Alternatively, one quarter’s interest can be calculated this way:
I = 100,000 × 0.06 × 0.25, or I = 500
or
I = 100,000 × 0.06 ÷ 4, or I = 500
Whichever way the interest is calculated, the 500 interest accrued at the end of the first quarter will be
added to the 100,000 to create a new principal balance of 100,500 at the beginning of the second
quarter. Interest for the second quarter the funds are on deposit will be based on this new, increased
principal amount:
I = 100,500 × 0.02 × 0.25 = 502.50.
After the second quarter’s interest has been added to the principal, the principal on deposit during the
third quarter will be 100,500.00 + 502.50 = 101,002.50.
Interest for the third quarter will be
101,002.50 × 0.02 × 0.25 = 505.01
The new principal balance after compounding of the interest will be 101,002.50 + 505.01 = 101,507.51.
Interest for the fourth quarter will be
101,507.51 × 0.02 × 0.25 = 507.54
The new principal after compounding of the interest will be 101,507.51 + 507.54 = 102,015.05.
If the depositor withdraws the full balance in the account after one year and closes the account, the
deposit will have earned a total of 2,015.05 on the original 100,000 deposit. The Annual Percentage Rate
(APR), or effective annual interest rate, earned is 2.015% (2,015.05 ÷ 100,000.00). The APR is higher
than the simple interest rate of 2% because of the compounding. Compound interest means interest on
interest.
If the interest had been compounded monthly instead of quarterly, the total interest earned and the effec-
tive annual interest rate would have been even greater.
Note: For a stated interest rate and a stated period, compound interest is greater than simple interest,
because interest is earned on interest; and the more frequently interest is compounded, all other things
being equal, the greater will be the amount of interest earned.
Present Value
Present value computations are used to look for an unknown present value of a known single amount of
money or stream of equal payments that will be either paid or received in the future, when the interest
rate that could be received by investing the receipts or payments (if they were owned or paid now instead
of in the future) is known. Calculating the present value of a future amount is called discounting the future
amount from the future to the present. The present value of an amount or amounts to be received or paid
in the future is less than the future amount or amounts because of the forgone interest. The present value
of an amount to be received in the future is the amount that would grow to the future, known, amount, if
it were owned today and could be invested at the specific known interest rate.
The present value of future cash flows is an underlying concept used in capital budgeting and many other
finance and accounting processes. On the exam, if there is a question that requires the use of present value
tables, the tables should be made available in the question. The tables, called Time Value of Money tables,
are included in this appendix for reference. The factors in the present value tables are for the present values
of amounts of 1, so the appropriate factor for the given term and interest rate is multiplied by the future
amount to find the present value of that future amount.
The present and future value tables are usually used under the assumption that the periods are one year
in length, that is, the interest rates are for one year and the interest is compounded once a year, at the
end of the year. However, the tables can be used for more frequent compounding and (for annuities) for
more frequent payments. The interest rate used simply needs to be adjusted to its equivalent for the period
being used. For example, an annual interest rate of 12% is equivalent to an interest rate of 1% per month.
If the factor needed is not available in a table, the factor can be calculated. The formulas needed to calculate
the factors are given in this appendix. Present value can also be calculated on a financial calculator.
Present Value of 1 (A Single Sum)

The present value (PV) of 1 is the current value of a future monetary receipt, assuming that if one has to
wait to receive the future amount, the opportunity to earn interest is lost because the money is not available
to deposit or invest now. Waiting to receive the money causes a loss in its value because of the lost return,
so the current worth of the future monetary receipt will be lower than the future receipt amount. How much
lower it will be will depend on the interest rate at which the forgone return could have been earned. The
higher the forgone interest rate is, the lower the current value, or present value, is of the future receipt.
The interest rate used is called the discount rate, and the present value of the future amount is also called
a discounted amount.
Exam Tip: The present value of a future cash flow decreases as the interest rate used to discount it
increases. The present value of a future cash flow also decreases as the time to wait before receiving it
increases.
Example: Jane Brown will receive 10,000 in one year’s time, but if she had the money today, she could
earn 3% annual interest on it. The present value of that 10,000 is the amount she could invest today at
3% if she had it, and with the interest added, it would grow to 10,000 in one year’s time.
If she had the money and could invest it today at 3%, the amount she would invest today in order to
have 10,000 in one year’s time would be lower than the amount she would need to invest today to have
10,000 in one year’s time if she could earn only 2% on the money. For that reason, the present value
of a future cash flow decreases as the discount rate increases. The present value of a future cash
flow discounted at 3% is lower than the present value of the same amount discounted for the same term
at 2%.
The amount of time to wait before receiving a future cash flow also affects the present value of the
future cash flow. If Jane Brown would not receive the 10,000 for a period of five years, the amount that
she would need to invest today at 3% in order to have 10,000 in five years would be less than the
amount she would need to invest today at 3% in order to have 10,000 in one year, because the oppor-
tunity loss is five years of compound interest not earned instead of only one year. Thus, the present
value of a future cash flow decreases as the time to the receipt of the money increases.
Note: Present value depends on both the discount rate and the number of periods from the present
date to the future date when the money will be received.
To calculate the present value of any amount, use the Present Value of 1 table. This table is set up to give
the PV factor, given a certain interest rate and a certain number of periods. Look across the top of the
columns to find the interest rate and then look down that column to find the number of periods. The factor
at the intersection represents the present value of 1 at that rate and for that time period. To calculate the
present value of an amount of X, multiply that X amount by the appropriate PV of 1 factor obtained from
the table.
Present Value of 1 Factor for

Present Value = Future Amount ×
n periods at i interest
In the factor tables, a compounding period is equal to one year; in other words, the interest is assumed to
be compounded annually. However, the factor tables can be adjusted for use with compounding periods of
less than one year (such as quarterly or monthly) by adjusting the rate and the number of periods, as
follows:
• The annual rate is divided by the number of compounding periods per year. For example, a 12%
annual rate compounded monthly becomes 1% per monthly compounding period.
• The number of periods is the number of years to receipt multiplied by the number of compounding
periods per year. The present value of an amount to be received in two years discounted at a 12%
annual rate compounded monthly would be the amount to be received discounted for 24 periods at
1% per period.
Example: The annual interest rate is 4% and the cash flow from the interest is received and reinvested
(compounded) quarterly at the same interest rate. One year’s time is equal to four quarterly periods, so
the rate of return per quarter is 4% ÷ 4, or 1% per quarter. To find the present value of 10,000 to be
received in one year’s time when the forgone interest rate is 4% per annum and the interest is com-
pounded quarterly, on the Present Value of 1 table look for the discount rate of 1% and then look down
the column under 1% to the line for four periods. The factor there is the present value of 1, invested
at 4% and compounded quarterly for one year. The factor for 1% for four periods is 0.961. Therefore,
the present value of 10,000 discounted at 4% for one year with interest compounded quarterly is 10,000
× 0.961, or 9,610. An investment of 9,610 invested at 4% for one year with interest compounded
quarterly would grow to 10,000 in one year with the interest earned compounded each quarter.
Contrast that with the present value of 10,000 discounted at 4% but compounded annually. The present
value factor for 4% for one period is 0.962, so the present value of 10,000 discounted at 4% for one
year with interest compounded annually is 10,000 × 0.962, or 9,620. An investment of 9,620 invested
at 4% interest with interest compounded annually would grow to 10,000 in one year with the interest
earned compounded at the end of the year.
In this example, the size of the required investment (the present value) is 10 greater when the interest
will be compounded annually than when the interest will be compounded quarterly, yet both investments
will be worth 10,000 after one year’s time. That occurs because less interest will be earned on the
investment when the interest is compounded annually than when it is compounded quarterly.
If annual amounts are to be received and the amounts vary each year, as they do in many capital budgeting
situations, the present value of the varying cash flows is the sum of the present values for each of the cash
flows, calculated individually, using the Present Value of 1 factor for the interest rate and the number of
years until the receipt of each individual cash flow.
Example: Annual amounts to be received are 8,000 the first year, 9,000 the second year, 10,000 the
third year, 11,000 the fourth year, and 12,000 the fifth and final year. The discount rate is 5%. The
present value of the varying cash flows is the sum of the present values for each of the individual cash
flows, as follows:
Year 1: 8,000 × 0.952 = 7,616

Year 2: 9,000 × 0.907 = 8,163
Year 3: 10,000 × 0.864 = 8,640
Year 4: 11,000 × 0.823 = 9,053
Year 5: 12,000 × 0.784 = 9,408
Present value 42,880
Derivation of the Factor for the Present Value of 1

The present value of a future amount can be calculated without resorting to a factor table. If the discount
rate or the term needed does not appear in a factor table, it can be calculated as follows:
1
Present Value of 1 =
(1 + i)n
Example: The present value of 100,000 discounted for one year at 9% is:
1
100,000 × = 91,743
1.09
The present value of 100,000 discounted for two years at 9% is:

1
100,000 × = 84,168
1.092
Of course, it would be simpler to divide 100,000 by 1.09 for one year and by 1.092 for two years:
100,000
= 91,743
1.09
100,000
= 84,168
1.092
However, it would not be quite so easy to calculate present or future values for amounts other than a
single amount without using a factor.
If the present value factors for one year and two years at 9% are carried out to five decimal places, the
result of using the factors to calculate the present values is exactly the same as the present values
calculated above.
For one year:

100,000 × 0.91743 = 91,743
For two years:

100,000 × 0.84168 = 84,168
This is true because 1/1.09 = 0.91743, and 1/1.092 = 0.84168.
If the factors in the table are rounded to fewer than five decimals, the resulting present values will be
slightly different due to the rounding differences, but the rounding differences are not material. The
factor tables presented in this textbook are rounded to fewer than five decimals.
Note: All of the time value of money factors (Present Value of 1, Present Value of a 1 Annuity, Future
Value of 1, Future Value of a 1 Annuity) represent the present or future value of 1. Therefore, to use
one of them for an amount greater than 1, multiply the amount by the appropriate factor.
Present Value of an Annuity (a Stream of Cash)

An annuity is a constant stream of the same amount of cash either paid or received regularly over a period
of time and at the same point in each period. The present value of an annuity is the current value of a
stream of equal payments that will be received over time.
The Present Value of a 1 Annuity factor can be used to calculate the present value of an annuity if and
only if all the following are true:
1) The amount to be received or paid is a constant (that is, the same) amount for each and every
payment.
2) The amount to be received or paid will be received or paid at the same point in every period.
3) The interest will be compounded once each period.
Example: The Present Value of a 1 Annuity factor can be used to calculate the present value on January
1, Year 1, of an amount of 10,000 to be received each year beginning on December 31, Year 1 and
continuing for five years when the interest rate is 4%. The present value of the annuity is the factor for
the interest rate and the term of the payments multiplied by 10,000.
The Present Value of a 1 Annuity for five years at 4% is 4.452. Thus, the present value of five annual
payments of 10,000 received for five years at the end of each year at a discount rate of 4% is 10,000 ×
4.452 = 44,520.
Ordinary Annuity and Annuity Due

There are two types of annuities, presented here with their respective formulas:
1) An annuity in arrears (also called an ordinary annuity) is an annuity with payments made or
received at the end of each period. The factors in a Present Value of a 1 Annuity table are for
ordinary annuities.
Present value of an Periodic payment × PV of a 1 Ordinary Annuity

=
ordinary annuity Factor for n periods at i interest
2) An annuity due is an annuity with payments made or received at the beginning of each
period. To calculate the present value of an annuity due, use the ordinary annuity factor for the
interest rate and one period less and add 1.000 to the factor.
Present value of an Periodic payment × PV of a 1 Ordinary Annuity

=
annuity due Factor for (n−1 periods at i interest) + 1.000
Example: The Present Value of a 1 Ordinary Annuity factor for four years at 16% is 2.798. The present
value of a 1,000 ordinary annuity for four years with annual payments made or received at the end
of each year at an annual interest rate of 16% is:
1,000 × 2.798 = 2,798
The Present Value of a 1 Ordinary Annuity factor for three years at 16% is 2.246. The present value of
a 1,000 annuity due for four years with annual payments made or received at the beginning of each
year at an annual interest rate of 16% is:
1,000 × (2.246 + 1.000) = 3,246
Finding a Loan Payment Amount

The present value of an ordinary annuity factor table can be used to calculate loan payments when the
payments are to be made once a year at the end of the year. The annual loan payment is the annuity. The
principal balance of the loan is the present value of the annuity.
Example: The annual loan payment on a 100,000 five-year loan at an interest rate of 6% per annum
with payments due at the end (an ordinary annuity) of each of five years would be:
1) The PV of a 1 Ordinary Annuity factor for 6% for five years is 4.212.
2) Divide the loan principal, 100,000, by the factor, 4.212.
100,000
= 23,741.69
4.212
The result, 23,741.69, is the annual loan payment that will fully amortize the loan principal and the
interest over five years. The 23,741.69 is the annuity amount.
Finding a Loan’s Beginning Principal Amount

If the amount of the annual payment, the term of the loan, and the interest rate are known, the loan’s
beginning principal can be calculated. The principal amount will be the present value of the stream of
annuity payments.
Example: The annual payment amount is 23,741.69, due at the end of each year for five years. The
interest rate on the loan is 6% per annum. What is the principal amount of the loan?
23,741.69 × 4.212 = 99,999.998, or 100,000.00
How much interest will be paid over the life of the loan?
The total interest paid is the difference between the total payments paid (including principal and interest)
over the life of the loan and its original principal.
(23,741.69 × 5) − 100,000.00 = 18,708.45
The borrower will pay 18,708.45 in interest over the term of the loan.
Finding the Interest Rate on a Loan

If the amount of the annual payment, the principal amount, and the term are known, the interest rate on
the loan can be calculated.
Example: The annual loan payment on a 25,000 loan is 5,935, due at the end of each year for a term
of five years. What is the interest rate on the loan?
The present value of an ordinary annuity is the annuity amount multiplied by the appropriate Present
Value of a 1 Ordinary Annuity factor. The present value of the annuity is 25,000 and the annuity amount
is 5,935. Once the factor is known, it can be located in a Present Value of a 1 Ordinary Annuity table
and used to find the interest rate.
1) To find the factor for the loan, divide 25,000 by the loan payment, 5,935. The answer is 4.212.
2) On a PV of a 1 Ordinary Annuity table, on the five-year line find either 4.212 or the factor that is
closest to 4.212. The factor in the 6% column is exactly 4.212. Therefore, the interest rate on this
loan is exactly 6%.
If the factor for the loan falls in between two factors on the factor table, use interpolation to estimate
the interest rate. The rate will be in between the two rate columns in the table.
Finding a Single Amount That Provides for a Series of Future Withdrawals When Invested
The present value of an annuity can also be used to find a single amount that, if invested at a given
compound interest rate now, will provide for a series of a certain number of future withdrawals of a certain
amount.
Example: Samson wants to withdraw 20,000 from an account at the end of each year for five years.
The account pays 5% interest during that period, compounded annually. How much does he need to
deposit today in order to withdraw 20,000 per year and empty the account by the end of the five years?
The PV of a 1 Ordinary Annuity factor for 5% for five years is 4.329. The present value of a stream of
payments of 20,000 at the end of each year for five years is
20,000 × 4.329 = 86,580
Therefore, Samson needs to deposit 86,580 to the account today.
Derivation of the Factor for the Present Value of a 1 Ordinary Annuity

The Present Value of a 1 Ordinary Annuity can be calculated with the following formula:
(1 + i)n – 1
Present Value of a 1 Ordinary Annuity =
i (1 + i)n
Example: The present value factor for a five-year ordinary annuity of 1 discounted at 5% is calculated
as follows:
(1 + 0.05)5 – 1
Present Value of a 1 Ordinary Annuity at 5% for 5 years =
0.05 (1 + 0.05)5
1.27628 – 1
= = 4.329
0.05 × 1.27628
4.329 is the same factor that is found in a PV of a 1 Ordinary Annuity factor table for five years at 5%.
Future Value
Future value computations are used to look for an unknown future value of a known single amount of
money or stream of equal payments invested at a specific interest rate over a specific period of time. When
solving for future value, a single cash flow or a series of equal cash flows are accumulated, with interest,
to a future point. The future value will be greater than the single cash flow or the total of the series of cash
flows because of the interest added each compounding period.
Future Value of 1 (a Single Amount)

The future Value of a single amount is used to answer the question “If an amount such as 100,000 is
invested now at an annual interest rate of 6% compounded annually, how much will there be at the end of
five years”?
To calculate the future value of any single amount, use the Future Value of 1 table. Look across the column
headings to find the appropriate interest rate and then look down that column to find the number of periods.
The factor at the intersection represents the future value of 1 invested at that interest rate for that term.
To calculate the future value of an amount of X, multiply that X amount by the FV factor obtained from the
table.
Future Value = Present Value × Future Value Factor for n periods at i interest
Example:
If John invests 100,000 now for five years and does not touch it, and he receives interest on it com-
pounded annually at a rate of 6% per annum, how much will he have at the end of five years?
On a Future Value of 1 table, the factor in the 6% column on the 5-year line is 1.338. The future value
of 100,000 invested for five years at an interest rate of 6% per annum, compounded annually, is
100,000 × 1.338 = 133,800
Derivation of the Factor for the Future Value of 1

If the needed interest rate does not appear in a factor table, the formula to use to calculate the factor for
the Future Value of 1 is
Future Value of 1 = (1 + i)n
Example: Determine the factor to use to calculate the future value of 100,000 invested for five years
at an interest rate of 6% per annum, compounded annually.
Future Value of 1 at 6% for 5 years = (1 + 0.06)5 = 1.338
1.338 is the same as the factor from the Future Value of 1 factor table for 6% for five years.
Future Value of an Annuity (a Stream of Cash)

The Future Value of an Annuity is used to answer the question “If an amount such as 20,000 is invested
annually for five years at an annual interest rate of 6% compounded annually, how much will there be at
the end of five years”? A future value calculation would be used to determine the amount that needs to be
set aside from current earnings each year for a number of years in order to have a given needed amount
at the end of the period, assuming a certain interest rate to be received on the deposited funds.
The future value of an annuity is the accumulated sum of all of the equal payments made plus the accu-
mulated compound interest on the payments during the accumulation period.
The Future Value of a 1 Annuity factor can be used to calculate the future value of an annuity if and only
if all the following are true:
1) The amount to be received or paid is a constant (that is, the same) amount for each and every
payment.
2) This amount will be received or paid at the same point in every period.
3) The interest will be compounded once each period.
Ordinary Annuity Versus Annuity Due

The payments for a future value of an annuity may be made either at the beginning of each period or at
the end of each period. When the payments are made at the end of each period, the annuity is called an
ordinary annuity; when the payments are made at the beginning of each period, the annuity is called
an annuity due.
Usually, a Future Value of a 1 Annuity factor table is for an ordinary annuity, meaning that it assumes that
the first annuity payment will not be made until the end of Year 1. However, a FV of a 1 Annuity factor
table may be for an annuity due instead, meaning that it assumes the first payment is made at the begin-
ning of Year 1.
To determine whether a Future Value of a 1 Annuity factor table is for an ordinary annuity or an annuity
due:
1) If the table is a Future Value of a 1 Ordinary Annuity factor table, the factors for Period 1 for all
interest rates are 1.000 all the way across the first line of the factor table. When an annuity is an
ordinary annuity and the payments are made at the end of each period, no interest will be earned
during Period 1 because no payment will be made until the end of Period 1. Therefore, when the
first annuity payment is made at the end of Period 1, the balance in the account at the end of
Period 1 will be exactly the same as the first amount deposited, with no interest earned or com-
pounded. Thus, the factor for Period 1 is 1.000.
2) If the table is a Future Value of a 1 Annuity Due factor table, the factors for Period 1 for all
interest rates are 1 + the interest rate. When an annuity is an annuity due and the payments are
made at the beginning of each period, the first payment will be made at the beginning of Period 1.
Therefore, at the end of Period 1, interest for one period will have been earned and compounded,
or added to the principal that was on deposit for one period. A Future Value of a 1 Annuity Due
factor table may also be called a “Compound Sum of an Annuity” factor table.
Note: The Future Value of a 1 Annuity Table provided in this Appendix is for an ordinary annuity.
Calculating the Future Value of an Ordinary Annuity

To calculate the future value of an ordinary annuity (payments made at the end of each period), if a Future
Value of a 1 Ordinary Annuity factor table is available, use the ordinary annuity factor from the table
as follows:
Future value of an Periodic payment × FV of a 1 Ordinary

=
ordinary annuity Annuity factor for n periods at i interest
If the only table available is a Future Value of a 1 Annuity Due (assuming payments are made at the
beginning of each period), to calculate the future value of an ordinary annuity, use the annuity due factor
from the table for one year less and add 1.000 to it.
Future value of an Periodic payment × FV of a 1 Annuity Due

=
ordinary annuity factor for (n-1 periods at i interest) + 1.000
Example: The Future Value of a 1 Ordinary Annuity factor for three years at 5% is 3.153. The future
value of a 10,000 payment made annually at the end of each of three years (an ordinary annuity) is
10,000 × 3.153, or 31,530.
The Future Value of a 1 Annuity Due factor for two years at 5% is 2.153. The future value of a 10,000
payment made at the end of each of three years (an ordinary annuity) is 10,000 × (2.153 + 1.000), or
31,530.
Calculating the Future Value of an Annuity Due

To calculate the future value of an annuity due, when payments are made at the beginning of each period,
if an annuity due factor table is available, use the annuity due factor table as follows:
Future value of an Periodic payment × FV of a 1 Annuity Due

=
annuity due factor for n periods at i interest
However, it is more likely that an annuity due factor table will not be available. To calculate the future value
of an annuity due using a Future Value of a 1 Ordinary Annuity table, use the ordinary annuity factor from
the table for one period more and subtract 1.000 from it.
Future value of an Periodic payment × FV of a 1 Ordinary Annuity

=
annuity due factor for (n+1 periods at i interest) – 1.000
Example: The Future Value of a 1 Annuity Due factor for three years at 5% is 3.310. The future value
at the end of three years of a 10,000 payment made annually at the beginning of each of the three
years, an annuity due, is 10,000 × 3.310, or 33,100.
The Future Value of a 1 Ordinary Annuity factor for four years at 5% is 4.310. The future value at the
end of three years of a 10,000 payment made annually at the beginning of each of three years, an
annuity due, is 10,000 × (4.310 – 1.000), or 33,100.
Example: Cole’s Strip Mining Company needs to have 5,000,000 in five years in order to restore the
land on which it is currently mining coal. If Cole can earn 6% interest per year on the funds it sets aside
from earnings each year, how much does the company need to set aside from earnings at the end of
each year in order to be sure of having the needed 5,000,000 at the end of five years?
Note that this is an ordinary annuity because the payments will be made at the end of each year. The
5,000,000 needed at the end of five years is the future value. The future value, the term, and the interest
rate are all known. Solve for the periodic payment.
Future value of an ordinary annuity = Periodic Payment × Future Value of a 1 Ordinary Annuity factor
at 6% for 5 years
The Future Value of a 1 Ordinary Annuity factor for 6% for five years is 5.637.
5,000,000 = Periodic Payment × 5.637
To solve for the Periodic Payment, divide both sides of the equation by 5.637:
5,000,000
= Periodic Payment
5.637
Periodic Payment = 886,997
Derivation of the Factor for the Future Value of a 1 Ordinary Annuity

If the needed interest rate is not available in a factor table, the formula to calculate the future value of a 1
ordinary annuity is:
(1 + i)n − 1
Future Value of a 1 Ordinary Annuity =
i
The resulting factor is the factor for the future value of an ordinary annuity.
Example: The calculation of the factor for the future value of a five-year ordinary annuity of 1 at an
interest rate of 6% per annum compounded annually is
(1 + 0.06)5 – 1
Future Value of a 1 Ordinary Annuity at 6% for 5 years =
0.06
1.338225577 – 1
= = 5.637
0.06
5.637 is the same factor that appears in a Future Value of a 1 Ordinary Annuity table.
Present Value of 1 Table
Interest Rate
1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 12% 14% 16% 18% 20%
1 .990 .980 .971 .962 .952 .943 .935 .926 .917 .909 .893 .877 .862 .847 .833 1
2 .980 .961 .943 .925 .907 .890 .873 .857 .842 .826 .797 .769 .743 .718 .694 2
3 .971 .942 .915 .889 .864 .840 .816 .794 .772 .751 .712 .675 .641 .609 .579 3
4 .961 .924 .888 .855 .823 .792 .763 .735 .708 .683 .636 .592 .552 .516 .482 4
5 .951 .906 .863 .822 .784 .747 .713 .681 .650 .621 .567 .519 .476 .437 .402 5
6 .942 .888 .837 .790 .746 .705 .666 .630 .596 .564 .507 .456 .410 .370 .335 6
7 .933 .871 .813 .760 .711 .665 .623 .583 .547 .513 .452 .400 .354 .314 .279 7
Number of Periods
8 .923 .853 .789 .731 .677 .627 .582 .540 .502 .467 .404 .351 .305 .266 .233 8
9 .914 .837 .766 .703 .645 .592 .544 .500 .460 .424 .361 .308 .263 .225 .194 9
10 .905 .820 .744 .676 .614 .558 .508 .463 .422 .386 .322 .270 .227 .191 .162 10
11 .896 .804 .722 .650 .585 .527 .475 .429 .388 .350 .287 .237 .195 .162 .135 11
12 .887 .788 .701 .625 .557 .497 .444 .397 .356 .319 .257 .208 .168 .137 .112 12
13 .879 .773 .681 .601 .530 .469 .415 .368 .326 .290 .229 .182 .145 .116 .093 13
14 .870 .758 .661 .577 .505 .442 .388 .340 .299 .263 .205 .160 .125 .099 .078 14
15 .861 .743 .642 .555 .481 .417 .362 .315 .275 .239 .183 .140 .108 .084 .065 15
16 .853 .728 .623 .534 .458 .394 .339 .292 .252 .218 .163 .123 .093 .071 .054 16
18 .836 .700 .587 .494 .416 .350 .296 .250 .212 .180 .130 .095 .069 .051 .038 18
20 .820 .673 .554 .456 .377 .312 .258 .215 .178 .149 .104 .073 .051 .037 .026 20
30 .742 .552 .412 .308 .231 .174 .131 .099 .075 .057 .033 .020 .012 .007 .004 30
40 .672 .453 .307 .208 .142 .097 .067 .046 .032 .022 .011 .005 .003 .001 .001 40
375
Present Value of a 1 Annuity Table (Ordinary Annuity)
Interest Rate
1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 12% 14% 16% 18% 20%
1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 0.893 0.877 0.862 0.847 0.833 1
2 1.970 1.942 1.913 1.886 1.859 1.833 1.808 1.783 1.759 1.736 1.690 1.647 1.605 1.566 1.528 2
3 2.941 2.884 2.829 2.775 2.723 2.673 2.624 2.577 2.531 2.487 2.402 2.322 2.246 2.174 2.106 3
4 3.902 3.808 3.717 3.630 3.546 3.465 3.387 3.312 3.240 3.170 3.037 2.914 2.798 2.690 2.589 4
5 4.853 4.713 4.580 4.452 4.329 4.212 4.100 3.993 3.890 3.791 3.605 3.433 3.274 3.127 2.991 5
6 5.795 5.601 5.417 5.242 5.076 4.917 4.767 4.623 4.486 4.355 4.111 3.889 3.685 3.498 3.326 6
7 6.728 6.472 6.230 6.002 5.786 5.582 5.389 5.206 5.033 4.868 4.564 4.288 4.039 3.812 3.605 7
Number of Periods
8 7.652 7.325 7.020 6.733 6.463 6.210 5.971 5.747 5.535 5.335 4.968 4.639 4.344 4.078 3.837 8
9 8.566 8.162 7.786 7.435 7.108 6.802 6.515 6.247 5.995 5.759 5.328 4.946 4.607 4.303 4.031 9
10 9.471 8.983 8.530 8.111 7.722 7.360 7.024 6.710 6.418 6.145 5.650 5.216 4.833 4.494 4.192 10
11 10.368 9.787 9.253 8.760 8.306 7.887 7.499 7.139 6.805 6.495 5.938 5.453 5.029 4.656 4.327 11
12 11.255 10.575 9.954 9.385 8.863 8.384 7.943 7.536 7.161 6.814 6.194 5.660 5.197 4.793 4.439 12
13 12.134 11.348 10.635 9.986 9.394 8.853 8.358 7.904 7.487 7.103 6.424 5.842 5.342 4.910 4.533 13
14 13.004 12.106 11.296 10.563 9.899 9.295 8.745 8.244 7.786 7.367 6.628 6.002 5.468 5.008 4.611 14
15 13.865 12.849 11.938 11.118 10.380 9.712 9.108 8.559 8.061 7.606 6.811 6.142 5.575 5.092 4.675 15
16 14.718 13.578 12.561 11.652 10.838 10.106 9.447 8.851 8.313 7.824 6.974 6.265 5.668 5.162 4.730 16
18 16.398 14.992 13.754 12.659 11.690 10.828 10.059 9.372 8.756 8.201 7.250 6.467 5.818 5.273 4.812 18
20 18.046 16.351 14.877 13.590 12.462 11.470 10.594 9.818 9.129 8.514 7.469 6.623 5.929 5.353 4.870 20
30 25.808 22.396 19.600 17.292 15.372 13.765 12.409 11.258 10.274 9.427 8.055 7.003 6.177 5.517 4.979 30
40 32.835 27.355 23.115 19.793 17.159 15.046 13.332 11.925 10.757 9.779 8.244 7.105 6.233 5.548 4.997 40
376
Future Value of 1 Table
Interest Rate
1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% 14% 16%
1 1.010 1.020 1.030 1.040 1.050 1.060 1.070 1.080 1.090 1.100 1.110 1.120 1.140 1.160 1
2 1.020 1.040 1.061 1.082 1.103 1.124 1.145 1.166 1.188 1.210 1.232 1.254 1.300 1.346 2
3 1.030 1.061 1.093 1.125 1.158 1.191 1.225 1.260 1.295 1.331 1.368 1.405 1.482 1.561 3
4 1.041 1.082 1.126 1.170 1.216 1.262 1.311 1.360 1.412 1.464 1.518 1.574 1.689 1.811 4
5 1.051 1.104 1.159 1.217 1.276 1.338 1.403 1.469 1.539 1.611 1.685 1.762 1.925 2.100 5
6 1.062 1.126 1.194 1.265 1.340 1.419 1.501 1.587 1.677 1.772 1.870 1.974 2.195 2.436 6
Number of Periods
7 1.072 1.149 1.230 1.316 1.407 1.504 1.606 1.714 1.828 1.949 2.076 2.211 2.502 2.826 7
8 1.083 1.172 1.267 1.369 1.477 1.594 1.718 1.851 1.993 2.144 2.305 2.476 2.853 3.278 8
9 1.094 1.195 1.305 1.423 1.551 1.689 1.838 1.999 2.172 2.358 2.558 2.773 3.252 3.803 9
10 1.105 1.219 1.344 1.480 1.629 1.791 1.967 2.159 2.367 2.594 2.839 3.106 3.707 4.411 10
11 1.116 1.243 1.384 1.539 1.710 1.898 2.105 2.332 2.580 2.853 3.152 3.479 4.226 5.117 11
12 1.127 1.268 1.426 1.601 1.796 2.012 2.252 2.518 2.813 3.138 3.498 3.896 4.818 5.936 12
13 1.138 1.294 1.469 1.665 1.886 2.133 2.410 2.720 3.066 3.452 3.883 4.363 5.492 6.886 13
14 1.149 1.319 1.513 1.732 1.980 2.261 2.579 2.937 3.342 3.797 4.310 4.887 6.261 7.988 14
15 1.161 1.346 1.558 1.801 2.079 2.397 2.759 3.172 3.642 4.177 4.785 5.474 7.138 9.266 15
16 1.173 1.373 1.605 1.873 2.183 2.540 2.952 3.426 3.970 4.595 5.311 6.130 8.137 10.748 16
18 1.196 1.428 1.702 2.026 2.407 2.854 3.380 3.996 4.717 5.560 6.544 7.690 10.575 14.463 18
20 1.220 1.486 1.806 2.191 2.653 3.207 3.870 4.661 5.604 6.727 8.062 9.646 13.743 19.461 20
30 1.348 1.811 2.427 3.243 4.322 5.743 7.612 10.063 13.268 17.449 22.892 29.960 50.950 85.850 30
40 1.489 2.208 3.262 4.801 7.040 10.286 14.974 21.725 31.409 45.259 65.001 93.051 188.884 378.721 40
377
Future Value of a 1 Annuity Table (Ordinary Annuity)
Interest Rate
1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% 14% 16%
1 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1
2 2.010 2.020 2.030 2.040 2.050 2.060 2.070 2.080 2.090 2.100 2.110 2.120 2.140 2.160 2
3 3.030 3.060 3.091 3.122 3.153 3.184 3.215 3.246 3.278 3.310 3.342 3.374 3.440 3.506 3
4 4.060 4.122 4.184 4.246 4.310 4.375 4.440 4.506 4.573 4.641 4.710 4.779 4.921 5.066 4
5 5.101 5.204 5.309 5.416 5.526 5.637 5.751 5.867 5.985 6.105 6.228 6.353 6.610 6.877 5
6 6.152 6.308 6.468 6.633 6.802 6.975 7.153 7.336 7.523 7.716 7.913 8.115 8.536 8.977 6
7 7.214 7.434 7.662 7.898 8.142 8.394 8.654 8.923 9.200 9.487 9.783 10.089 10.730 11.414 7
Number of Periods
8 8.286 8.583 8.892 9.214 9.549 9.897 10.260 10.637 11.028 11.436 11.859 12.300 13.233 14.240 8
9 9.369 9.755 10.159 10.583 11.027 11.491 11.978 12.488 13.021 13.579 14.164 14.776 16.085 17.519 9
10 10.462 10.950 11.464 12.006 12.578 13.181 13.816 14.487 15.193 15.937 16.722 17.549 19.337 21.321 10
11 11.567 12.169 12.808 13.486 14.207 14.972 15.784 16.645 17.560 18.531 19.561 20.655 23.045 25.733 11
12 12.683 13.412 14.192 15.026 15.917 16.870 17.888 18.977 20.141 21.384 22.713 24.133 27.271 30.850 12
13 13.809 14.680 15.618 16.627 17.713 18.882 20.141 21.495 22.953 24.523 26.212 28.029 32.089 36.786 13
14 14.947 15.974 17.086 18.292 19.599 21.015 22.550 24.215 26.019 27.975 30.095 32.393 37.581 43.672 14
15 16.097 17.293 18.599 20.024 21.579 23.276 25.129 27.152 29.361 31.772 34.405 37.280 43.842 51.660 15
16 17.258 18.639 20.157 21.825 23.657 25.673 27.888 30.324 33.003 35.950 39.190 42.753 50.980 60.925 16
18 19.615 21.412 23.414 25.645 28.132 30.906 33.999 37.450 41.301 45.599 50.396 55.750 68.394 84.141 18
20 22.019 24.297 26.870 29.778 33.066 36.786 40.995 45.762 51.160 57.275 64.203 72.052 91.025 115.380 20
30 34.785 40.568 47.575 56.085 66.439 79.058 94.461 113.283 136.308 164.494 199.021 241.333 356.787 530.312 30
40 48.886 60.402 75.401 95.026 120.800 154.762 199.635 259.057 337.882 442.593 581.826 767.091 1,342.025 2,360.757 40
378

CIA Part 3 Textbook

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CIA Part 3

Hard copy books purchased from HOCK international or from an authorized

Brian Hock, CIA, CMA

(866) 807-HOCK or (866) 807-4625

Published June 2020

Acknowledgement is due to the Institute of Internal Auditors for permission to use

© 2020 HOCK international, LLC

Throughout these materials, we have chosen particular language, spellings, structures

This material is designed exclusively to assist people in their exam preparation. No

Brian Hock, CIA, CMA

Exam Introduction ............................................................................................................. 1

System and Program Change Controls 105

Appendix A – Time Value of Money Concepts (Present/Future Value) ..................... 362

The Part 3 exam has four sections:

• Section I: Business Acumen (35%)

• Section II: Information Security (25%)

• Section III: Information Technology (20%)

• Section IV: Financial Management (20%)

Section I – Business Acumen

Planning in Order to Achieve Superior Performance

The Strategic Planning Process

2) Analyzing the organization’s external competitive environment in order to identify opportunities

5) Developing and implementing the chosen strategies.

Developing the Mission Statement

The mission statement includes four components:

The characteristics of well-constructed goals are:

a. They are precise and measurable.

b. They should be crucial and address important issues.

Analyzing the External Environment

• Defining the competitors and analyzing their strengths and weaknesses.

• Studying impediments to the company’s entering new markets.

Analyzing the Internal Environment

• Superior customer responsiveness. Superior customer responsiveness occurs when a company

Formulating Strategies (SWOT Analysis)

• Corporate-level strategy, considering what business or businesses the company should be in so

Developing and Implementing the Chosen Strategies

1) Its organizational structure

2) Its control systems

3) Its organizational culture

Characteristics of Successful Strategic Plans

• A successful strategic plan is integrated throughout the organization. Strategies should be

1 B. Common Performance Measures

Strategic Issues in Performance Measurement

Performance Measures Should be Related to Cost and Revenue Drivers

Financial Performance Measurement

Return on Investment (ROI)

Income of Business Unit

North division’s ROI is: 1,000

West division’s ROI is: 7,500

The Required Rate of Return

The Weighted Average Cost of Capital (WACC)

(Interest Paid on Debt – Effect of Taxes) + Dividends Paid on Shares

Disadvantages of Using ROI for Performance Measurement

Benefits of Return on Investment as a Performance Measure

Limitations of Return on Investment as a Performance Measure

• ROI measures return as a percentage rather than as a monetary amount.

Residual Income (RI)

The formula for RI is:

Operating income of business unit

The target return = 4,000,000 × 0.10 = 400,000

Benefits of Residual Income as a Performance Measure

Limitations of Residual Income as a Performance Measure

Using ROI and RI

• ROI is focused on the rate of the return, whereas