UNIT 1: INTRODUCTION TO

FINANCIAL ENVIRONMENT
 
WELCOME TO FINANCE FOR MANAGERS!
It's not just accountants who deal with the financial side of a business. It's highly likely that, as a
Board member, Director, line manager or department head, you're going to have to analyse
financial reports at some point. It is also not necessary for you to be an expert accountant in
order to analyse the financial reports. However, it is of fundamental importance that you are able
to read, understand and interpret accounting and financial information in order to make value-
added decisions for the benefit of the organisation
Financial management is a crucial aspect of any thriving business. Profit maximization, or
stockholder wealth maximization, are two real concerns for any organization and they depend on
solid financial decisions. To make good decisions, management needs good information. And
that information comes from the accounting system.
The financial information from the accounting system comes in the form of financial statements.
These statements contain important information about the organization's operating results. This
information is important for effective management, and financial control. As a manager, or any
other person with financial responsibility, you have to be able to interpret this information
yourself.
The relationship between certain items of financial data can be used to identify areas where your
firm excels and, more importantly, where there are opportunities for improvement. Using,
understanding, and interpreting these statements will help you make much better business
decisions.
By the end of the course, students should be able to:

 Explain the theoretical assumptions behind various accounting techniques.

 Interpret the financial information and explain their relevance of financial information.
 Explain the limitations of accounting and how financial techniques may need to be
supplemented with other approaches;
 Apply various accounting and finance techniques.

 
COURSE CONTENT:

1. Introduction to Financial Environment

2. Sources of Financial Information
3. Performance Measurement and Financial Analysis
4. Reporting and Communication
5. Budgeting Decisions
6. Cost of Capital and Investment Appraisal
7. Dividend Policy
8. Risk Management
9. Current development & Emerging Issues

 
ASSESSMENT:

 Continuous Assessment                                40%

       E-Learning                                          10%

       Assignment(s)                                     10%
       One Test                                              20%
 

 Final Examination                                          60%

 
PRESCRIBED READING:
Atrill, P, McLaney, E. J. (2013) Accounting and Finance for Non-Specialists
RECOMMENDED READING:
Collier, Paul M (2009) Accounting for Managers: Interpreting Accounting Information for
Decision-making
Dyson, J.R. (2007) Accounting for Non-Accounting Students. Harlow: Prentice Hall
Holmes, Geoffrey Andrew, Sugden, Alan, Gee, Paul (2008) Interpreting Company Reports and
Accounts
JOURNALS:
Farrant, K. Inkinen, M., Rutkowska, M. and Theodoridis, K. (2013) What can company data tell
us about financing and investment decisions? Quarterly Bulletin 2013(Q4), pp. 361-370
[Online]. Available at: http://www.bankofengland.co.uk/publications/Pages/quarterlybulletin/
capital.aspx (Links to an external site.)
Cornell, B. and Shapiro, C. (1987) Corporate stakeholders and corporate finance, Financial
Management, Vol. 16(1), pp.5-14.
Mason, C. and Stark, M. (2004) What do investors look for in a business plan?
A comparison of investment criteria of bankers, venture capitalists and business
angels, International Small Business Journal, 22(3), pp. 227-248.
E-Conomic (2015) Income statement - What is an income statement? [Online]. Available
at: https://www.economic.co.uk/accountingsystem/glossary/income-statement (Links to an
external site.)
Beaver, W. H. (1967) Financial ratios as predictors of failure, Journal of Accounting Research,
4 (Supplement), pp. 71-111.
 

1.1 Accounting
Accounting is concerned with collecting, analysing and communicating financial information.
This information is useful for those who need to make decisions and plans about businesses, and
for those who need to control those businesses. For example, the managers of businesses may
need accounting information to decide whether to:
 develop new products or services (such as a computer manufacturer developing a new range of
computers);
 increase or decrease the price or quantity of existing products or services (such as a
telecommunications business changing its mobile phone call and text charges);
 borrow money to help finance the business (such as a supermarket wishing to increase the
number of stores it owns);
 increase or decrease the operating capacity of the business (such as a beef farming business
reviewing the size of its herd);
 change the methods of purchasing, production or distribution (such as a clothes retailer
switching from UK to overseas suppliers).
The information provided should help in identifying and assessing the financial consequences of
such decisions.Managers needs to be expert users of financial information derived from
accounting statements
Shareholders and other individuals or firms (external to the company), such as creditors and
investors also need some reliable information with regards to the company’s financial
performance.
 Based on this information they will be able to draw conclusions such as if the company is
achieving its financial targets and if it is well managed.
 Based on this information investors may decide to invest (or not) in the company while
creditors may decide if there is scope to extend their credit to the company (or not) while
shareholders may also decide if they want to still maintain (or increase/decrease) their shares in
the company under consideration.

 
ACCOUNTING CYCLE: STEPS
1. Identifying and Analyzing Business Transactions (Financial data)
Business transactions (should be an accounting event) start the process. An accounting event is a
transaction that has an impact on the account balance.Transactions can include the sale or return
of a product, the purchase of supplies for business activities, or any other financial activity that
involves the exchange of the company’s assets, the establishment or payoff of a debt, or the
deposit from or payout of money to the company’s owners. A source document such as an
invoice is used to record a business transaction.
2. Recording in the Journals (books of original entry)
The transaction is listed in the appropriate journal, maintaining the journal’s chronological order
of transactions. The journal is also known as the “book of original entry” and is the first place a
transaction is listed.e.g Sales/returns day book, Purchases/returns day book, Cash book and
General Journal
3. Posting to the Ledger (Books of final entry)
The transactions are posted to the account that it impacts. An account records changes to a
specific item.These accounts are part of the General Ledger, where you can find a summary of
all the business’s accounts.
Types of accounts.jpg

Personal accounts: Accounts for persons (businesses). Its include sales ledger (credit
customers) and purchases ledger( credit suppliers)
Impersonal accounts: Divided into real accounts and nominal accounts. Real accounts records
assets and nominal records liabilities,expenses, revenue, capital and drawings.
4. Unadjusted Trial Balance
At the end of the accounting period (which may be a month, quarter, or year depending on a
business’s practices), you calculate a trial balance. A trial balance is a listing of debit and credit
balances.
5. Adjusting Entries e.g. accruals
You may pass adjustments to the trial balance through journal entries if there are any corrections
to be made.
6. Financial Statements
You prepare the balance sheet and income statement using the corrected account balances
(adjusted trial balance).
7. Interpretation of Financial Statements
 You analyze the performance of the company based on the requirements of a particular user of
the financial information.

1.2 The concept of financial reporting

and regulation
Besides the managers, there are those outside the business who may need information to decide
whether to:
 invest or disinvest in the ownership of the business;
 lend money to the business;
 offer credit facilities;
 enter into contracts for the purchase of products or services.
Financial reporting provide information that is useful to these stakeholders in making rational
investment and similar decisions. Usually these stakeholders are not directly involved in the
running of the company. Therefore, they can only rely on financial information provided so as to
monitor the financial performance of the company and help them to understand whether the
company is appropriately managed.
It’s against this background that the need for regulation around financial reporting is important
because:
i) If the form and content of the financial statements was not regulated, then the information
which would be provided to shareholders and the other users could give misleading impression
around a company’s financial position.
ii) If there was no regulation the financial statements of different companies could never be
comparable.
iii) To ensure that the financial information provided to external users is accurate.

The components of Regulation

The rules and regulations that are relevant to the financial reporting are applicable to any
business entity and its components are: the legislation, the accounting standards and the stock
exchange regulations.
Legislation
Most countries have in place legislation which governs financial reporting. Naturally this
legislation differs from country to country. Broadly speaking this legislation covers issues such
as:
 The accounting records that a company must keep and when should they be reported
 The requirement that these accounting records should be accurate and true
 Potential requirement that these accounts must be kept in line with national or international
accounting standards
Accounting Standards
Legislation provides the broad framework with which companies must comply but it is the
accounting standards that detail the rules of recording financial transactions.
National Accounting Bodies:
Zambia- Zambia Institute of Chartered Accountants (ZICA)
UK- Accounting Standards Board (ASB)
USA- Financial Accounting Standards Board (FASB)
In recent years, due to the international nature of business in the corporate world, there has been
a movement towards an international set of accounting rules which is applied globally in order to
improve the consistency of financial reporting.
This set of rules has been developed from the International Accounting Standards Board (IASB)
and are currently known as the International Financial Reporting Standards (IFRS, previously
known as International Accounting Standards- IAS).
The IFRSs are now the basis for the financial reporting of most listed companies worldwide.
Furthermore, the IASB has developed a new set of IFRSs to be used by small and medium-sized
entities (SMEs). The IASB works closely with national accounting standards setters
The conceptual framework of the IFRSs describes the main concepts related to preparing and
presenting of the financial statements, namely, the Statement of Comprehensive Income,
Statement of Financial Position, Statement of Cash Flows and Statement of Changes in Equity
(we will see the first three in the next chapters). This framework is considered to be a guidance
to be used by the IASB to develop the IFRSs as well as practitioners, researchers and other users
to resolve accounting issues that are not addressed directly in IFRSs.

1.3 Fundamental Accounting

Principles
Nature of accounting principles
Principles of accounting are generally referred to as a set of Rules and convention used in
accounting or that should be followed in preparation of all accounts and financial statements.
Characteristics of accounting principles
• They originate from a combination of traditions, experience of accountants in their respective
organisations and official decree by the accounting bodies or government.
• They require authoritative support and some means of enforcement.
• They may change over time as shortcomings in the rules existing come to light.
• The rules must be clearly understood by those who use them
• The general acceptance of an accounting principle usually depends on how well it meets the
three criteria of relevance, objectivity and feasibility.
Sources of Accounting Principles
 Generally Accepted Accounting Principles (GAAP) established by FASB in the USA. FASB
produces a publication of the statement of financial accounting concept, which provides the
conceptual criteria to help resolve future accounting issues.
 International Accounting Standards Board (IASB): It sets up the international accounting
standards and ensures that they are accepted worldwide. Accounting regulatory bodies in
different countries comply with IASC’s recommendations
 National Accounting Regulatory Bodies such Zambia Institute of Chartered Accountants
(ZICA): They have authority to establish an accounting standard.
Financial Statements and Accounting Principles
There are four reports that are produced at the end of an accounting process:
i) Balance sheet or statement of financial position: Indicate financial position and net worth of
the business at a certain point in time.
ii) Income statement or statement of comprehensive income: Shows the profitability of business
over a given period.
iii) Statement of Cash flow : Indicates the liquidity position of the business
iv) Statement of changes in equity: shows the movement in shareholders’ funds.

1.4 Statement of Financial Position

and Accounting Principles
The business entity concept (Entity Principle):
A business entity is an economic unit that engages in identifiable business activities separate
from its owner (provider of capital). Accounts are prepared for the business and owners interest
recorded in the owners’ equity.

Going concern concept

Going concern is one of the fundamental assumptions in accounting on the basis of which
financial statements are prepared. Financial statements are prepared assuming that a business
entity will continue to operate in the foreseeable future after the balance sheet date without the
need or intention on the part of management to liquidate the entity or to significantly curtail its
operational activities. Therefore, it is assumed that the entity will realize its assets and settle its
obligations in the normal course of the business. Because of the concept, the accounts do not
change the recorded values of assets to correspond with changing market prices for these assets.

Money measurement concept

The accounting process records only activities that can be expressed in monetary terms. The
advantage of the money measurement concept is that money provides a common denominator by
means of which all aspects of the entity can be expressed and compared. The use of money
measurement helps us achieve objectivity in the valuation and accounting of any entity’s assets
because money measurement provides a finite and factual basis for valuation and can be verified.

Historical cost concept

The asset value shown in the balance sheet should be the actual cost paid, and not the asset's
value. The accounting measurement of the value of an asset therefore does not reflect what the
assets are worth except at the time they are acquired.

Dual aspect concept (Duality concept)

In the balance sheet all economic resources (or assets) of an entity are claimed either by
shareholders or by creditors. Since all claims cannot exceed the amounts to be claimed, it follows
that every business transaction has a duality. The duality convention is fundamental to
accounting and it underlines the accounting equation that states that debits are equal to credits in
any set of prepared accounts.

1.5 Income Statement and Accounting

Principles
Accounting period concept (Time period principle)
Financial records pertaining only to a specific period are to be considered in preparing accounts
for that period. The length of the accounting period depends on how frequently the managers and
other stakeholders require information about the entity’s performance.

1. Management needs information more than once (frequently) to assist in decision making i.e monthly,
quarterly e.t.c
2. Businesses are required by law to prepare accounts annually for either tax purposes or accountability.

Prudence concept (conservatism concept)

Revenue and profits are included in the balance sheet only when they are realized (or there is
reasonable 'certainty' of realizing them) but liabilities are included when there is reasonable
'possibility' of incurring them. The concept helps when dealing with measurement of
uncertainties.
Realisation concept
Any change in the market value of an asset or liability is not recognized as a profit or loss until
the asset is sold or the liability is paid off. The realisation concept refers to the inflows of cash or
claims to cash that arise from the sale of goods and allow you to take into account only those
revenue flows you are certain will be received or will be paid.
Matching concept (Accrual)
Operating expenses for each period are matched with the revenues they relate to for that
accounting period. Then expenses incurred whether actually paid or outstanding and the
revenues for the respective period are matched in the income statement to determine the
profitability or lack of it.

Consistency concept
Once an accounting method has been chosen, that method should be used unless there is a sound
reason to do otherwise. It should use the same method for all subsequent events of the same
character.

Materiality concept
Minor events may be ignored, but the major ones should be fully disclosed. This means that no
attempt should be made to record events so insignificant that the work of recording them is not
justified by the usefulness of the results. There must however be full disclosure of all-important
information.

1.6 Stock exchange regulations

A company whose stocks are listed in a stock exchange should comply with the regulations of
this stock exchange some of which are usually related to the financial statements. Some stock
exchanges may require more frequent (interim) financial statements than local or international
accounting standards or legislation require. Similarly, disclosure of additional information on
specific items relevant to the company may be required as well

1.7 Users of Accounting Information

 
a) Investors are the providers of risk capital
(i) Information is required to help make a decision about buying or selling shares, taking up a
rights issue and voting.
(ii) Investors must have information about the level of dividend, past, present and future and any
changes in share price.
(iii) Investors will also need to know whether the management has been running the company
efficiently.
(iv)  As well as the position indicated by the statement of profit or loss and other comprehensive
income, statement of financial position and earnings per share (EPS), investors will want to
know about the liquidity position of the company, the company's future prospects, and how the
company's shares compare with those of its competitors.
(b) Employees need information about the security of employment and future prospects for jobs
in the company, and to help with collective pay bargaining.
(c) Lenders need information to help them decide whether to lend to a company. They will also
need to check that the value of any security remains adequate, that the interest repayments are
secure, that the cash is available for redemption at the appropriate time and that any financial
restrictions (such as maximum debt/equity ratios) have not been breached.
(d) Suppliers need to know whether the company will be a good customer and pay its debts.
(e) Customers need to know whether the company will be able to continue producing and
supplying goods.
(f) Government's interest in a company may be one of creditor or customer, as well as being
specifically concerned with compliance with tax and company law, ability to pay tax and the
general contribution of the company to the economy.
(g) The public at large would wish to have information for all the reasons mentioned above, but
it could be suggested that it would be impossible to provide general purpose accounting
information which was specifically designed for the needs of the public.
 
Financial statements cannot meet all these users' needs, but financial statements which
meet the needs of investors (providers of risk capital) will meet most of the needs of other
users.

Characteristics of Information from Financial Reporting

 Understandability. The information must be readily understandable to users of the financial
statements. This means that information must be clearly presented, with additional information
supplied in the supporting footnotes as needed to assist in clarification.
 Relevance. The financial information must be relevant to the decision making needs of the
users, which is the case when the information influences the economic decisions of users.
 Faithful representation. The information must be free of material error and bias, and not
misleading.
 Comparability. The information must be comparable to the financial information presented for
other accounting periods, so that users can identify trends in the performance and financial
position of the reporting entity.
 Materiality requires accountants and auditors to focus on financial information which is
expected to affect the decisions of the users.
 Verifiability requires the information to communicate the underlying economics of the
company's business.
 Timeliness requires disclosure of financial information not to be excessively delayed.
However, there is another stream of financial information which is for internal users and it is
called management accounting (and the associated management reports). Management
accounting and its reports are aiming to inform not external stakeholders but internal decision
makers (managers, directors etc) so as to enable them to make the most informed decisions when
running the business.

1.8 Branches of Accounting

Financial accounting: Preparation and publication of highly summarised financial information
of an entity.
 Presented for owners of business but management use it for planning & control
 Information is also of interest to others: employees, creditors e.t.c
 Use historical data and is constrained by accounting standards
 Auditing: Checking of accounts to ensure they do not present a distorted picture. Auditors are trained
accountants specialised in checking that accounts are prepared in line the standards. In limited
liability company auditor (referred to as external auditors) are appointed by shareholders to protect
their interests. Internal auditors are employees of company who perform routine audit tasks.
 Tax accounting: preparation of accounts for tax purposes. Tax accountants compute tax payable by
both individuals and businesses e.g income tax returns, VAT returns.

1. Financial management: Concerned with the management of the finances of an organisation in order to
achieve the financial objectives of the organisation.

 Financial managers are more involved in the management of an entity than financial accountant &
Management accountants
 Extensively use non-financial data than financial accountant

1. Management accounting: Concerned with the presentation of accounting information in the form
most helpful to management decision making.

 Incorporate all types of financial and non-financial information from a wide range of sources e.g
political & environmental considerations, product quality
 Provides information intended specifically to aid management in running the business.

 
Difference between Financial and Management accounting
The differences between the two types of accounting reflect the different user groups that they
address. Briefly, the major differences are as follows:

 Nature of the reports produced. Financial accounting reports tend to be general purpose. That is, they
contain financial information that will be useful for a broad range of users and decisions rather than
being specifically designed for the needs of a particular group or set of decisions. Management
accounting reports, on the other hand, are often for a specific purpose. They are designed either with
a particular decision in mind or for a particular manager.
 Level of detail. Financial accounting reports provide users with a broad overview of the performance
and position of the business for a period. As a result, information is aggregated and detail is often
lost. Management accounting reports, however, often provide managers with considerable detail to
help them with a particular operational decision.
 Regulations. Financial reports, for many businesses, are subject to accounting regulations that try to
ensure they are produced with standard content and in a standard format. Law and accounting rule
setters impose these regulations. Since management accounting reports are for internal use only, there
are no regulations from external sources concerning the form and content of the reports. They can be
designed to meet the needs of particular managers.

 Reporting interval. For most businesses, financial accounting reports are produced on an annual
basis, though many large businesses produce half-yearly reports and a few produce quarterly ones.
Management accounting reports may be produced as frequently as required by managers. In many
businesses, managers are provided with certain reports on a monthly, weekly or even daily basis,
 which allows them to check progress frequently. In addition, special-purpose reports will be prepared
when required (for example, to evaluate a proposal to purchase a piece of machinery).

 Time horizon. Financial accounting reports reflect the performance and position of the business for
the past period. In essence, they are backward looking. Management accounting reports, on the other
hand, often provide information concerning future performance as well as past performance. It is an
oversimplification, however, to suggest that financial accounting reports never incorporate
expectations concerning the future. Occasionally, businesses will release projected information to
other users in an attempt to raise capital or to fight off unwanted takeover bids.

 Range and quality of information. Financial accounting reports concentrate on information that can
be quantified in monetary terms. Management accounting also produces such reports, but is also more
likely to produce reports that contain information of a non-financial nature such as measures of
physical quantities of inventories (stocks) and output. Financial accounting places greater emphasis
on the use of objective, verifiable evidence when preparing reports. Management accounting reports
may use information that is less objective and verifiable, but they provide managers with the
information they need.

 
We can see from this that management accounting is less constrained than financial accounting.
It may draw on a variety of sources and use information that has varying degrees of reliability.
The only real test to be applied when assessing the value of the information produced for
managers is whether or not it improves the quality of the decisions made

1.9 Financial Markets and Institutions

 

 
 
 

 On one side of a financial system, lenders/Savers that have surplus funds are trying to invest.
 They must consider the risk and the return. The financial system provides them with different
investment choices according to the preferences and the objectives that they have.
 On the opposite side of the financial system, there are borrowers/spenders whose financial needs
exceed their available funds so they have to raise funds. The financial system should provide them
with alternative financial instruments in order to obtain funds.
 Therefore, the key activity of a financial system is to bring together the units which have surplus with
the units which have deficits.
 Apart from the companies, the intermediaries, the capital and the financial markets are fundamental
aspects of a financial system.
 Companies as well as investors tend to exchange financial instruments in financial markets. This is
because (for example) companies can effectively raise money from these markets by issuing stocks.
 Financial markets provide price discovery, liquidity and reduced transaction costs.
 Price discovery means that the interactions between buyers and sellers in a financial market,
determines actually the price of the traded asset.
 Liquidity means that there are sellers and buyers willing to trade so as to exchange financial assets.
This is a crucial characteristic as it is not constant and differs between financial markets.
 Reduced transaction costs exist because the existence of financial markets reduces search costs (to
find a buyer /seller for an asset).

One could classify the financial markets in two categories: Primary and secondary.
 
Primary Markets
The part of the  market which deals with the issuance of new securities (for example a
company’s stocks) is the primary market. Organizations who wish to issue a new security are
doing so from the primary market and similarly investors who would like to invest in these new
securities are able to do it through the primary market.
 
Secondary Markets
The part of the capital market in which previously issued securities are traded is the secondary
market. Some well-known examples include the Lusaka Stock Exchange (LuSE), London Stock
exchange (LSE) the New York Stock Exchange (NYSE) and others.
Capital Markets and stock exchange

 A Capital market is where long term capital is raised.

 A stock exchange is a market where the securities of companies and other instruments are bought and
sold.
 Securities are instruments for raising finance by the shareholders of a company. They come in two
types i.e equity(shares) and debt.
 Equity gives one part-ownership of a company and therefore entitlement to a dividend..
 Debt securities represents debt by a company. Debt securities usually also carry an interest charge
which is paid to their holders at specified periods during the debt security’s term.

UNIT 2: SOURCES OF FINANCIAL

INFORMATION
By the end of this Unit, students should demonstrate understanding of:
i. explain the nature and purpose of the three major financial statements;
ii. prepare a simple balance sheet and interpret the information that it contains;
iii. discuss the limitations of the balance sheet in portraying the financial position of a business
iv. prepare an income statement from relevant financial information;
v. explain how the income statement and balance sheet of a limited company differ in detail from
that of a sole proprietorship or a partnership business.
vi. discuss the crucial importance of cash to a business;
vii. explain the nature of the cash flow statement and discuss how it can be helpful in identifying
cash flow problems;
viii. prepare a cash flow statement;
ix. interpret a cash flow statement
 Financial Statements
The objective of the major financial accounting statements is to provide a picture of the overall
financial position and performance of the business. To achieve this objective, the business’s
accounting system will normally produce three particular statements on a regular, recurring
basis. These include the statement of financial position, statement of comprehensive income and
statement of cash flow. These were introduced in unit one. They are concerned with answering
the following questions:
1) What cash movements (that is, cash in and cash out) took place over a particular period?
2) How much wealth (that is, profit) was generated, or lost, by the business over that period?
3) What is the accumulated wealth of the business at the end of that period?
Financial statements play an important role in the decision making process. Information from
financial statements is used both internally in the business and by parties outside the business to
evaluate the current position as well as the past trading results of the business, and to project the
future position. The purpose of these statements, therefore, is to covey useful information
regarding the financial health of the business.

Statement of Financial Position

The balance sheet (or statement of financial position) lists the firm’s assets and liabilities,
providing a snapshot of the firm’s financial position at a given point in time. It is important to
note that, (no matter its visual structure) the balance sheet is divided into two parts, the assets
and the liabilities plus the shareholders’ equity.
The assets list the company’s cash, inventory, property, plant and equipment as well as any other
investments that it may have. In other words, an asset is something that the company has. The
liabilities side, shows the company’s obligations to creditors (these may be long-term or short-
term in nature). In other words, liability is something that the company owes to someone else.
Shareholders’ equity is the difference between the company’s assets and liabilities and it is an
accounting measure of the company’s net worth.
The assets’ side of the balance sheet show how the company uses its capital while the liabilities
and shareholders’ equity side shows how the company raises the money it needs.
 
The balance sheet equation MUST always be:
Assets = Liabilities + Shareholders Equity
This is known as the accounting equation!
RECOGNITION OF ASSET
As indicated above,an asset is essentially a resource held by the business. For a particular item to
be treated as an asset for accounting purposes it should have the following characteristics:
n A probable future benefit must exist. This simply means that the item must be expected to have
some future monetary value. This value can arise through its use within the business or through
its hire or sale. Thus, an obsolete piece of equipment that could be sold for scrap would still be
considered an asset, whereas an obsolete piece of equipment that could not be sold for scrap
would not be regarded as one.
n The business must have an exclusive right to control the benefit. Unless the business has
exclusive rights over the resource it cannot be regarded as an asset. Thus, for a business offering
holidays on barges, the canal system may be a very valuable resource, but as the business will
not be able to control the access of others to the canals, it cannot be regarded as an asset of the
business. (However, the barges owned by the business would be regarded as assets.)
n The benefit must arise from some past transaction or event. This means that the transaction (or
other event) giving rise to the business’s right to the benefit must have already occurred, and will
not arise at some future date. Thus an agreement by a business to purchase a piece of machinery
at some future date would not mean the item is currently an asset of the business.
n The asset must be capable of measurement in monetary terms. Unless the item can be
measured in monetary terms, with a reasonable degree of reliability, it will not be regarded as an
asset for inclusion on the balance sheet. Thus, the title of a magazine (for
example Hello! or Vogue) that was created by its publisher may be extremely valuable to the
business, but this value is usually impossible to quantify. It will not, therefore, be treated as an
asset.
Note that all four of these conditions must apply. If one of them is missing, the item will not be
treated as an asset, for accounting purposes, and will not appear on the balance sheet.
 
CLASSIFICATION OF ASSETS

1. CURRENT ASSETS

Current assets are basically assets that are held for the short term. To be more precise, they are
assets that meet any one of four criteria. These are:

 they are held for sale or consumption in the normal course of a business’s operating cycle;
 they are for the short term (that is, to be sold within the next year);
 they are held primarily for trading;
 they are cash, or near cash such as easily marketable, short-term investments.
The most common current assets are inventories (or stock), customers who owe money for goods
or services supplied on credit (known as trade receivables or debtors), and cash.
 

2. NON-CURRENT ASSETS

Non-current assets (also called fixed assets) are assets other than current assets. They are held for
the long-term operations of the business. Essentially, they are the ‘tools’ of the business and are
held with the objective of generating wealth.

Claims
A claim is an obligation on the part of the business to provide cash, or some other form of
benefit, to an outside party. A claim will normally arise as a result of the outside party providing
funds in the form of assets for use by the business. There are essentially two types of claim
against a business:
 

 Capital. This represents the claim of the owner(s) against the business. This claim is sometimes
referred to as the owner’s equity. Some find it hard to understand how the owner can have a claim
against the business, particularly when we consider the example of a sole-proprietor-type business
where the owner is, in effect, the business.

However, for accounting purposes, a clear distinction is made between the business (whatever its
size) and the owner(s). This is in line with the business entity concept explained in unit one.
Consider a big company like Zambeef Plc ,it is seen as a separate entity with its own separate
existence and when financial statements are prepared, they are prepared for the business rather
than for the owner(s). This means that the balance sheet should reflect the financial position of
the business as a separate entity.

 Liabilities. This represent the claims of all other individuals and organizations, apart from the
owner(s). Liabilities must have arisen from past transactions or events such as supplying goods or
lending money to the business.

 
Once a claim has been incurred by a business, it will remain as an obligation until it is settled.
Now that the meaning of the terms assets and claims has been established, we can go on and
discuss the relationship between the two. This relationship is quite simple and straightforward. If
a business wishes to acquire assets, it will have to raise the necessary funds from somewhere. It
may raise the funds from the owner(s) or from other outside parties or from both.

CLASSIFICATION OF LIABILITIES
Liabilities can be classified into two groups:

1. CURRENT LIABILITIES

Current liabilities are basically amounts due for settlement in the short term. To be more precise,
they are liabilities that meet any one of four criteria:

 they expect to be settled within the normal course of the business’s operating cycle;
 they are due to be settled within 12 months of the balance sheet date;
 they are held primarily for trading purposes;
 the business does not have the right to defer settlement beyond 12 months after the balance sheet
date.

2. NON-CURRENT LIABILITIES

Non-current liabilities represent those amounts due to outside parties that are not current
liabilities.

 
FORMAT OF STATEMENT OF FINANCIAL POSITION

Statement of financial position for KaKa Ltd as at 31 December XXXX

                                                                                             k'm                              k'm
Non current Assets:
Intangible e.g goodwill,patents                                               X
Tangible assets:
Property, plant and equipment                                               X
Investments                                                                            X
                                                                                              ——
                                                                                                                                   X
Current assets:
Inventories                                                                              X
Trade and other receivables                                                   X
Prepayments                                                                           X
Cash and cash equivalent                                                       X
                                                                                                 ——
                                                                                                                                  X
                                                                                                                                 ——
Total assets                                                                                                               XX
                                                                                                                                  ——
Equity and liabilities:
 
Capital and reserves:
 
Ordinary share capital                                                            X
Preference share capital                                                         X
Share premium account                                                         X
Revaluation Reserves                                                            X
Retained earnings                                                                   X
                                                                                             ——
                                                                                                                                    X
Non current liabilities:
Loan notes,Debentures,Bank loans                                                                            X
 
Current liabilities:                                                                 
Trade and other payables                                                       X
Overdrafts                                                                               X
Tax payable                                                                            X
                                                                                              ——
                                                                                                                               X
                                                                                                                               ——
Total equity and liabilities                                                                                        X___
 
The top half of the statement of financial position shows the assets of the business.
The bottom half of the statement of financial position shows the capital and liabilities of the
business.
 
The Income Statement
The income statement or statement of (comprehensive) income lists the company’s revenues and
expenses over a period of time. The income statement is important because it shows
the profitability of a company during the time interval specified in its heading. The period of
time that the statement covers is chosen by the business and will vary. People pay attention to the
profitability of a company for many reasons. For example, if a company made a net loss lenders
may be hesitant to extend additional credit to the company. On the other hand, if a company that
has made a net income, it shows the ability to use borrowed and invested funds in a successful
manner. For this reason, a company's ability to operate profitably is important to current lenders
and investors, potential lenders and investors, company management and others. The income
statement is sometimes called profit and loss account (or "P & L” account) and the net income is
also referred to as the company’s earnings.
The measurement of profit requires that the total revenue and expenses of the business, generated
during a particular period, be identified.
 
Revenue is simply a measure of the inflow of economic benefits arising from the ordinary
activities of a business. These benefits, which accrue to the owners, will result in either an
increase in assets (such as cash or amounts owed to the business by its customers) or a decrease
in liabilities. Different forms of business enterprise will generate different forms of revenue.
Some examples of the different forms that revenue can take are as follows:

 sales of goods (for example, of a manufacturer);

 fees for services (for example, of a solicitor);
 subscriptions (for example, of a club);
 interest received (for example, of an investment fund).

 
Expense is really the opposite of revenue. It represents the outflow of economic benefits arising
from the ordinary activities of a business. This loss of benefits will result in either a decrease in
assets or an increase in liabilities. Expenses are incurred in the process of generating revenue, or
attempting to generate it. The nature of the business will again determine the type of expenses
that will be incurred. Examples of some of the more common types of expenses are:

 the cost of buying goods that are subsequently sold – known as cost of sales or cost of goods sold;
 salaries and wages;
 rent and rates;
 motor vehicle running expenses;
 insurances;
 printing and stationery;
 heat and light;
 telephone and postage, and so on.

 
The difference between the total revenue and total expenses will represent either profit (if
revenue exceeds expenses) or loss (if expenses exceed revenue). Thus, we have:
Profit (loss) for the period = Total revenue for the period less Total expenses incurred in
generating the revenue
 
THE RELATIONSHIP BETWEEN INCOME STATEMENT AND STATEMENT OF
FINANCIAL POSITION
A balance sheet will also be prepared to reveal the new financial position at the end of the period
covered by the income statement. This balance sheet will incorporate the changes in wealth that
have occurred since the previous balance sheet was drawn up.
The effect on the balance sheet of making a profit (loss) means that the equation can be extended
as follows:
Assets = Capital + Profit (or − Loss) + Liabilities
The amount of profit or loss for the period affects the balance sheet as an adjustment to capital.
The above equation can be extended to:
Assets = Capital + (Sales revenue − Expenses) + Liabilities
In theory, it would be possible to calculate profit and loss for the period by making all
adjustments for revenue and expenses through the capital section of the balance sheet.
However, this would be rather cumbersome. A better solution is to have an ‘appendix’ to capital,
in the form of an income statement. By deducting expenses from revenue for the period, the
income statement derives the profit (loss) for adjustment in the capital item in the balance sheet.
This figure represents the net effect of trading for the period. Providing this ‘appendix’ means
that a detailed and more informative view of performance is presented to users.
 
FORMAT OF AN INCOME STATEMENT
Statement of comprehensive income for KaKa Ltd for the year ended
31 December XXXX
                                                                                                        K’m
Revenue                                                                                              X
Cost of sales                                                                                       (X)
                                                                                                           ___
Gross profit                                                                                        X
Other operating income                                                                     X
Distribution costs                                                                               (X)
Administrative expenses                                                                    (X)
                                                                                                         ___
Profits from operations                                                                      X
Net interest costs (interest paid less interest received)                     X
                                                                                                         ___
Profits before tax                                                                                X        
Income tax expense                                                                          (X)
                                                                                                         ___
Net profits for the period                                                                   X
                                                                                                        ___
Other comprehensive income
Gain on property revaluation                                                            X
Total comprehensive income for the year                                         X
 
The Statement of Cash flow
The primary purpose of the statement of cash flows is to provide information
about cash receipts, cash payments, and the net change in cash resulting from the operating,
investing, and financing activities of a company during the period. The net change from these
three classifications should equal the change in a company's cash and cash equivalents during
the reporting period. For instance, the cash flow statement for the calendar year 2015 will report
the causes of the change in a company's cash and cash equivalents between its statement of
financial position (balance sheets) of December 31, 2014 and December 31, 2015. This is
valuable information from the investors perspective because they will be able  to understand how
a company's operations are running, where its money is coming from, and how it is being spent.

In addition to the cash amounts being reported as operating, investing, and financing activities,
the cash flow statement must disclose other information, including the amount of interest paid,
the amount of income taxes paid, and any significant investing and financing activities which did
not require the use of cash.
The statement of cash flows utilises the information from the income statement and the balance
sheet s as to determine how much cash the company has generated and how this cash has been
allocated during a period. From an investor’s perspective the statement of cash flows provides
extremely valuable information. As you have seen, the statement of cash flows is divided in three
sections:
Operating activities: Shows the cash inflows and outflows caused by core business operations,
the operations component of cash flow reflects how much cash is generated from a company's
products or services.
Investment activities: Shows the cash used for investments and cash generated from investments.
Financing activities: Shows the flow of cash between the firm and its investors
There are two methods used to prepare the statement of cash flow namely, Indirect method and
direct method.
 
Proforma statement of cash flows (Indirect Method)
 

1. a) Cash flows from operating activities:

                                                                                                K’m                             K’m

Net profits before tax                                                                X
Adjustments for:
Depreciation                                                                           X
Profit/ (Loss) on sale of noncurrent assets                            (X) X
(Increase)/Decrease provisions                                              (X) X
Interest expense                                                                      X
Investment income                                                                 (X)
                                                                                              ––––
Operating profit before working capital changes                    X
(Increase)/decrease in inventories                                         (X)/X
(Increase)/decrease in trade receivables                                (X)/X
Increase/ (decrease) in trade payables                                   X/(X)
                                                                                               ––––
Cash generated from operations                                            X
Interest paid                                                                            (X)
Income taxes paid                                                                   (X)
                                                                                               ––––
Net cash from operating activities                                                                             X
 

1. b) Cash flows from investing activities:

Purchases of property, plant and equipment                        (X)

Proceeds of sale of property, plant and equipment               X
Interests received                                                                   X
Dividends received                                                                 X
                                                                                             ––––
Net cash used in investing activities                                                                         (X)
 

1. c) Cash flows from financing activities:

Proceeds from issue of shares                                             X

Proceeds from long-term borrowings                                    X
Payment of finance lease liabilities                                       (X)
Dividends paid                                                                       (X)
                                                                                             ––––
Net cash used in financing activities                                                                                     (X)
Net increase in cash and cash equivalents                                                                           X
Cash and cash equivalents at beginning of the period                                                          X
                                                                                                                                             ––––
Cash and cash equivalents at end of the period                                                                   X
                                                                                                                                             ––––
 
Proforma statement of cash flows (Direct Method)
                         

1. a) Cash flows from operating activities:

                                                                                                K’m                             K’m

Cash receipts from customers                                                X
Cash paid to suppliers                                                            X                    
Cash generated from operations                                            X
Interest paid                                                                            (X)
Income taxes paid                                                                   (X)
                                                                                                ––––
Net cash from operating activities                                                                             X
 

1. b) Cash flows from investing activities:

Purchases of property, plant and equipment                        (X)

Proceeds of sale of property, plant and equipment               X
Interests received                                                                   X
Dividends received                                                                 X
                                                                                             ––––
Net cash used in investing activities                                                                         (X)
 

1. c) Cash flows from financing activities:

Proceeds from issue of shares                                              X

Proceeds from long-term borrowings                                    X
Payment of finance lease liabilities                                       (X)
Dividends paid                                                                       (X)
                                                                                             ––––
Net cash used in financing activities                                                                          (X)
Net increase/(decrease) in cash and cash equivalents                                               X
Cash and cash equivalents at beginning of the period                                               X
                                                                                                                                  ––––
Cash and cash equivalents at end of the period                                                         X
                                                                                                                                  ––––
Note:
Cash: cash on hand (including overdrafts) and on demand deposits.
Cash equivalents: short-term, highly liquid investments that are readily convertible into known
amounts of cash and are subject to an insignificant risk of changes in value.
 
In essence, preparing a statement of cash flows is very straightforward. You should therefore
simply learn the formats above and apply the steps. Note that the following items are treated in a
way that might seem confusing, but the treatment is logical if you think in terms of cash.
(a) Increase in inventory is treated as negative (in brackets). This is because it represents a
cash outflow; cash is being spent on inventory.
(b) An increase in receivables would be treated as negative for the same reasons; more
receivables mean less cash.
(c) By contrast an increase in payables is positive because cash is being retained and not used
to settle accounts payable. There is therefore more of it.
(d) Depreciation is not a cash expense, but is deducted in arriving at profit. It makes sense,
therefore, to eliminate it by adding it back.
(e) By the same logic, a loss on a disposal of a non-current asset (arising through under provision
of depreciation) needs to be added back and a profit deducted
 
International Standards
As mentioned in unit 1, there has been an increasing need to adopt some accounting and
reporting standards that would be similar around the world so as to enable decision makers to
compare financial statements from companies around the globe. In 2005 a great number of
companies around the globe had (in EU it was compulsory in other countries it was expected
from companies to do so) to prepare their financial reports in line with the International Financial
Reporting Standards (IFRS). Many business entities which were not publicly held (and therefore
not required to adopt IFRS) were also planning to adopt them in some cases.
International reporting standards currently govern the structure of the key financial reports that
this unit presented. Although this module will not analyse the accounting standards into detail it
is worth listing those which are to some extend associated with this module’s content:
IAS 1: Presentation of Financial Statements
IAS 7: Statement of cash flows
IAS 8: Accounting policies, changes in accounting estimates and errors
IAS 32: Financial Instruments: Presentation
IAS 39: Financial Instruments: Recognition and measurement
IFRS 1: First time adoption of IFRS.
 
 
 

2.1 Statement of Financial Position

The balance sheet (or statement of financial position) lists the firm’s assets and liabilities,
providing a snapshot of the firm’s financial position at a given point in time. It is important to
note that, (no matter its visual structure) the balance sheet is divided into two parts, the assets
and the liabilities plus the shareholders’ equity.
The assets list the company’s cash, inventory, property, plant and equipment as well as any other
investments that it may have. In other words, an asset is something that the company has. The
liabilities side, shows the company’s obligations to creditors (these may be long-term or short-
term in nature). In other words, liability is something that the company owes to someone else.
Shareholders’ equity is the difference between the company’s assets and liabilities and it is an
accounting measure of the company’s net worth.
The assets’ side of the balance sheet show how the company uses its capital while the liabilities
and shareholders’ equity side shows how the company raises the money it needs.
                                           
The balance sheet equation MUST always be:
Assets = Liabilities + Shareholders Equity
This is known as the accounting equation!

RECOGNITION OF ASSET
As indicated above,an asset is essentially a resource held by the business. For a particular item to
be treated as an asset for accounting purposes it should have the following characteristics:

 A probable future benefit must exist. This simply means that the item must be expected to have some
future monetary value. This value can arise through its use within the business or through its hire or
sale. Thus, an obsolete piece of equipment that could be sold for scrap would still be considered an
 asset, whereas an obsolete piece of equipment that could not be sold for scrap would not be regarded
as one.

 The business must have an exclusive right to control the benefit. Unless the business has exclusive
rights over the resource it cannot be regarded as an asset. Thus, for a business offering holidays on
barges, the canal system may be a very valuable resource, but as the business will not be able to
control the access of others to the canals, it cannot be regarded as an asset of the business. (However,
the barges owned by the business would be regarded as assets.)

 The benefit must arise from some past transaction or event. This means that the transaction (or other
event) giving rise to the business’s right to the benefit must have already occurred, and will not arise
at some future date. Thus an agreement by a business to purchase a piece of machinery at some future
date would not mean the item is currently an asset of the business.

 The asset must be capable of measurement in monetary terms. Unless the item can be measured in
monetary terms, with a reasonable degree of reliability, it will not be regarded as an asset for
inclusion on the balance sheet. Thus, the title of a magazine (for example Hello! or Vogue) that was
created by its publisher may be extremely valuable to the business, but this value is usually
impossible to quantify. It will not, therefore, be treated as an asset.

 
Note that all four of these conditions must apply. If one of them is missing, the item will not be
treated as an asset, for accounting purposes, and will not appear on the balance sheet.
 
CLASSIFICATION OF ASSETS

1. CURRENT ASSETS

Current assets are basically assets that are held for the short term. To be more precise, they are
assets that meet any one of four criteria. These are:

 they are held for sale or consumption in the normal course of a business’s operating cycle;
 they are for the short term (that is, to be sold within the next year);
 they are held primarily for trading;
 they are cash, or near cash such as easily marketable, short-term investments.

The most common current assets are inventories (or stock), customers who owe money for goods
or services supplied on credit (known as trade receivables or debtors), and cash.
 

2. NON-CURRENT ASSETS

Non-current assets (also called fixed assets) are assets other than current assets. They are held for
the long-term operations of the business. Essentially, they are the ‘tools’ of the business and are
held with the objective of generating wealth.
Note that an asset does not have to be a physical item – it may also be a nonphysical right to
certain benefits. Assets that have a physical substance and can be touched are referred to as
tangible assets. Assets that have no physical substance but which, nevertheless, provide expected
future benefits (such as patents) are referred to as intangible assets.
               
Claims
A claim is an obligation on the part of the business to provide cash, or some other form of
benefit, to an outside party. A claim will normally arise as a result of the outside party providing
funds in the form of assets for use by the business. There are essentially two types of claim
against a business:

 Capital. This represents the claim of the owner(s) against the business. This claim is sometimes
referred to as the owner’s equity. Some find it hard to understand how the owner can have a claim
against the business, particularly when we consider the example of a sole-proprietor-type business
where the owner is, in effect, the business.

However, for accounting purposes, a clear distinction is made between the business (whatever its
size) and the owner(s). This is in line with the business entity concept explained in unit one.
Consider a big company like Zambeef Plc ,it is seen as a separate entity with its own separate
existence and when financial statements are prepared, they are prepared for the business rather
than for the owner(s). This means that the balance sheet should reflect the financial position of
the business as a separate entity.

 Liabilities. This represent the claims of all other individuals and organizations, apart from the
owner(s). Liabilities must have arisen from past transactions or events such as supplying goods or
lending money to the business.

 
Once a claim has been incurred by a business, it will remain as an obligation until it is settled.
Now that the meaning of the terms assets and claims has been established, we can go on and
discuss the relationship between the two. This relationship is quite simple and straightforward. If
a business wishes to acquire assets, it will have to raise the necessary funds from somewhere. It
may raise the funds from the owner(s) or from other outside parties or from both.

CLASSIFICATION OF LIABILITIES
Liabilities can be classified into two groups:

1. CURRENT LIABILITIES

Current liabilities are basically amounts due for settlement in the short term. To be more precise,
they are liabilities that meet any one of four criteria:
 they expect to be settled within the normal course of the business’s operating cycle;
 they are due to be settled within 12 months of the balance sheet date;
 they are held primarily for trading purposes;
 the business does not have the right to defer settlement beyond 12 months after the balance sheet
date.

2. NON-CURRENT LIABILITIES

Non-current liabilities represent those amounts due to outside parties that are not current
liabilities.
 

FORMAT OF STATEMENT OF FINANCIAL POSITION

 
Statement of financial position for KaKa Ltd as at 31 December
XXXX
                                                                                K’                                       K’
Fixed Assets:
Intangible                                                                                                           X
Noncurrent assets:
Property, plant and equipment                                                                           X
Investments                                                                                                        X
                                                                                                                        ——
                                                                                                                          X
Current assets:
Inventories                                                               X
Trade and other receivables                                    X
Prepayments                                                            X
Cash and cash equivalent                                        X
                                                                                ——                                          X
 
                                                                                                                                 ——
Total assets                                                                                                               XX
                                                                                                                                 ——
Equity and liabilities:
 
Capital and reserves:
 
Ordinary share capital                                                                                                 X
Preference share capital                                                                                             X
Share premium account                                                                                              X
Revaluation Reserves                                                                                                 X
Retained earnings                                                                                                       X
                                                                                                                                 ——
                                                                                                                                    X
Noncurrent liabilities:
Loan notes                                                                                                                  X
 
Current liabilities:                                                                  
Trade and other payables                                                    X
Overdrafts                                                                             X
Tax payable                                                                           X
                                                                                             ——
                                                                                                                                  X
                                                                                                                                  ——
Total equity and liabilities                                                                                         X___
 
The top half of the statement of financial position shows the assets of the business.
The bottom half of the statement of financial position shows the capital and liabilities of the
business.
2.2 Statement of profit or loss and
other comprehensive Income
The income statement or statement of (comprehensive) income lists the company’s revenues and
expenses over a period of time. The income statement is important because it shows
the profitability of a company during the time interval specified in its heading. The period of
time that the statement covers is chosen by the business and will vary. People pay attention to the
profitability of a company for many reasons. For example, if a company made a net loss lenders
may be hesitant to extend additional credit to the company. On the other hand, if a company that
has made a net income, it shows the ability to use borrowed and invested funds in a successful
manner. For this reason, a company's ability to operate profitably is important to current lenders
and investors, potential lenders and investors, company management and others. The income
statement is sometimes called profit and loss account (or "P & L” account) and the net income is
also referred to as the company’s earnings.
The measurement of profit requires that the total revenue and expenses of the business, generated
during a particular period, be identified.
 Revenue is simply a measure of the inflow of economic benefits arising from the ordinary
activities of a business. These benefits, which accrue to the owners, will result in either an
increase in assets (such as cash or amounts owed to the business by its customers) or a decrease
in liabilities. Different forms of business enterprise will generate different forms of revenue.
Some examples of the different forms that revenue can take are as follows:

 sales of goods (for example, of a manufacturer);

 fees for services (for example, of a solicitor);
 subscriptions (for example, of a club);
 interest received (for example, of an investment fund).

 Expense is really the opposite of revenue. It represents the outflow of economic benefits arising
from the ordinary activities of a business. This loss of benefits will result in either a decrease in
assets or an increase in liabilities. Expenses are incurred in the process of generating revenue, or
attempting to generate it. The nature of the business will again determine the type of expenses
that will be incurred. Examples of some of the more common types of expenses are:

 the cost of buying goods that are subsequently sold – known as cost of sales or cost of goods sold;
 salaries and wages;
 rent and rates;
 motor vehicle running expenses;
 insurances;
 printing and stationery;
 heat and light;
 telephone and postage, and so on.
 ‘
‘The difference between the total revenue and total expenses will represent either profit (if
revenue exceeds expenses) or loss (if expenses exceed revenue). Thus, we have:
Profit (loss) for the period = Total revenue for the period less Total expenses incurred in
generating the revenue
 THE RELATIONSHIP BETWEEN INCOME STATEMENT AND STATEMENT OF
FINANCIAL POSITION
 A balance sheet will also be prepared to reveal the new financial position at the end of the
period covered by the income statement. This balance sheet will incorporate the changes in
wealth that have occurred since the previous balance sheet was drawn up.
The effect on the balance sheet of making a profit (loss) means that the equation can be extended
as follows:
Assets = Capital + Profit (or − Loss) + Liabilities
The amount of profit or loss for the period affects the balance sheet as an adjustment to capital.
The above equation can be extended to:
Assets = Capital + (Sales revenue − Expenses) + Liabilities
In theory, it would be possible to calculate profit and loss for the period by making all
adjustments for revenue and expenses through the capital section of the balance sheet.
However, this would be rather cumbersome. A better solution is to have an ‘appendix’ to capital,
in the form of an income statement. By deducting expenses from revenue for the period, the
income statement derives the profit (loss) for adjustment in the capital item in the balance sheet.
This figure represents the net effect of trading for the period. Providing this ‘appendix’ means
that a detailed and more informative view of performance is presented to users.
 FORMAT OF AN INCOME STATEMENT
 Statement of comprehensive income for KaKa Ltd for the year ended
31 December XXXX
                                                                                                         K’m
Revenue                                                                                            X
Cost of sales                                                                                     (X)
                                                                                                          ___
Gross profit                                                                                        X
Other operating income                                                                     X
Distribution costs                                                                               (X)
Administrative expenses                                                                    (X)
                                                                                                          ___
Profits from operations                                                                       X
Net interest costs (interest paid less interest received)                     X
                                                                                                         ___
Profits before tax                                                                               X        
Income tax expense                                                                          (X)
                                                                                                         ___
Net profits for the period                                                                   X
                                                                                                         ___
Other comprehensive income
Gain on property revaluation                                                           X
Total comprehensive income for the year                                        X

2.3 Statement of Cash flows

The statement of cash flows utilises the information from the income statement and the balance
sheet s as to determine how much cash the company has generated and how this cash has been
allocated during a period. From an investor’s perspective the statement of cash flows provides
extremely valuable information. The statement of cash flows is divided in three sections:
Operating activities: Starts with the net income from the income statement. It then adjusts this
item by adding back all non-cash entries related to the company’s operating activities.
Investment activities: Lists the cash used for investments
Financing activities: Shoes the flow of cash between the firm and its investors

Proforma statement of cash flows (Indirect Method)

a) Cash flows from operating activities:
                                                                                                                          
K’m                                K’m
Net profits before tax                                                                                            X
Adjustments for:
Depreciation                                                                                                         X
Profit/ (Loss) on sale of non-current assets                                                        (X) X
(Increase)/Decrease provisions                                                                          (X) X
Interest expense                                                                                                   X
Investment income                                                                                               (X)
                                                                                                                          ––––
Operating profit before working capital changes                                                  X
(Increase)/decrease in inventories                                                                      (X)/X
(Increase)/decrease in trade receivables                                                            (X)/X
Increase/ (decrease) in trade payables                                                                X/(X)
                                                                                                                           ––––
Cash generated from operations                                                                         X
Interest paid                                                                                                        (X)
Income taxes paid                                                                                               (X)
                                                                                                                           ––––
Net cash from operating
activities                                                                                                             X
b) Cash flows from investing activities:
Purchases of property, plant and equipment                                                      (X)
Proceeds of sale of property, plant and equipment                                              X
Interests received                                                                                                 X
Dividends received                                                                                               X
                                                                                                                           ––––
Net cash used in investing
activities                                                                                                          (X)
c) Cash flows from financing activities:
Proceeds from issue of shares                                                                             X
Proceeds from long-term borrowings                                                                    X
Payment of finance lease liabilities                                                                      (X)
Dividends paid                                                                                                     (X)
                                                                                                                           ––––
Net cash used in financing
activities                                                                                                         (X)
Net increase in cash and cash
equivalents                                                                                                X
Cash and cash equivalents at beginning of the
period                                                                               X
                                                                                                                                                             
    ––––
Cash and cash equivalents at end of the
period                                                                                        X
                                                                                                                                                             
    ––––
 
 
Proforma statement of cash flows (Direct Method)
a) Cash flows from operating activities:
                                                                                                                     
K’m                                  K’m
Cash receipts from customers                                                                        X
Cash paid to suppliers                                                                                    X
Cash generated from operations                                                                    X
Interest paid                                                                                                   (X)
Income taxes paid                                                                                          (X)
                                                                                                                      ––––
Net cash from operating
activities                                                                                                          X
b) Cash flows from investing activities:
Purchases of property, plant and equipment                                                  (X)
Proceeds of sale of property, plant and equipment                                          X
Interests received                                                                                             X
Dividends received                                                                                           X
                                                                                                                      ––––
Net cash used in investing
activities                                                                                                     (X)
c) Cash flows from financing activities:
Proceeds from issue of shares                                                                       X
Proceeds from long-term borrowings                                                              X
Payment of finance lease liabilities                                                                (X)
Dividends paid                                                                                               (X)
                                                                                                                     ––––
Net cash used in financing
activities                                                                                                    (X)
Net increase/(decrease) in cash and cash equivalents                                                                       
X
Cash and cash equivalents at beginning of the
period                                                                         X
                                                                                                                                                           
––––
Cash and cash equivalents at end of the
period                                                                                   X
                                                                                                                                                            
––––
Note:
Cash: cash on hand (including overdrafts) and on demand deposits.
Cash equivalents: short-term, highly liquid investments that are readily convertible into known
amounts of cash and are subject to an insignificant risk of changes in value.
In essence, preparing a statement of cash flows is very straightforward. You should therefore
simply learn the formats above and apply the steps. Note that the following items are treated in a
way that might seem confusing, but the treatment is logical if you think in terms of cash.
(a) Increase in inventory is treated as negative (in brackets). This is because it represents a cash
outflow; cash is being spent on inventory.
(b) An increase in receivables would be treated as negative for the same reasons; more
receivables mean less cash.
(c) By contrast an increase in payables is positive because cash is being retained and not used to
settle accounts payable. There is therefore more of it.
(d) Depreciation is not a cash expense, but is deducted in arriving at profit. It makes sense,
therefore, to eliminate it by adding it back.
(e) By the same logic, a loss on a disposal of a non-current asset (arising through under provision
of depreciation) needs to be added back and a profit deducted
International Standards
As mentioned in unit 1, there has been an increasing need to adopt some accounting and
reporting standards that would be similar around the world so as to enable decision makers to
compare financial statements from companies around the globe. In 2005 a great number of
companies around the globe had (in EU it was compulsory in other countries it was expected
from companies to do so) to prepare their financial reports in line with the International Financial
Reporting Standards (IFRS). Many business entities which were not publicly held (and therefore
not required to adopt IFRS) were also planning to adopt them in some cases.
International reporting standards currently govern the structure of the key financial reports that
this unit presented. Although this module will not analyse the accounting standards into detail it
is worth listing those which are to some extend associated with this module’s content:
IAS 1: Presentation of Financial Statements
IAS 7: Statement of cash flows
IAS 8: Accounting policies, changes in accounting estimates and errors
IAS 32: Financial Instruments: Presentation
IAS 39: Financial Instruments: Recognition and measurement
IFRS 1: First time adoption of IFRS.

UNIT 3: PERFORMANCE
MEASUREMENT AND FINANCIAL
ANALYSIS
By the end of this unit, students should be able to:

1. explain the objective of financial statements analysis

2. identify the major categories of ratios that can be used for analysis purposes;
3. calculate important ratios for assessing the financial performance and position of a business;
4. explain the significance of the ratios calculated;
5. discuss the limitations of ratios as a tool of financial analysis.
 

3.1 The objective of Financial

Statements Analysis
The objective of financial statements analysis
Published financial information is very extensive and frequently does not present those aspects
of business value and performance, which users are particularly interested in. For example, of
itself, the monetary profit disclosed does not identify the profitability or return achieved by an
organisation. It is only when this value is expressed as some measure of "profitability” or "return
on capital”, that users, especially shareholders, can begin to assess whether to withdraw or
expand their investment.
Financial techniques in this area seek to "reduce data”, generate useful measures of performance
and enable comparison over time. Reducing data provides a summarised view but clearly at the
expense of detail.
Performance measures provide the scope to chart company performance over time and against
"benchmark” measures. A review over time can be useful in decision making, but only where the
choice of period is relevant to the decision. Analysis, which seeks to establish competitive
performance, typically utilises a comparison approach with perhaps, the comparator sector or
peer group. Again, the analysis will only be valuable if relevant comparison data is used.
The techniques utilise published financial statements as their base data. Published statements
need not present all of the data required, nor all valuations appropriate to decision making. It is
important to note the limitations of any financial analysis in this context, in particular: the
financial statements used to provide the raw data should be drawn up using the same accounting
practice. Where differences in approach exist, and this is common between different countries,
any comparative analysis will be distorted by differences in the accounting approach to e.g. the
calculation of profit. a single measure derived from analysis, such as a financial ratio, will not
provide enough information to properly inform decision making.
Despite these caveats, a number of analysis tools can be effectively employed to measure and
review financial performance, position and capability.
 
Basic Performance Measurement
The basic approach to analysis involves the generation of a performance measure. As a basic
example consider a company’s profit and sales:
 

  Profit margin of 5%  
 Profit of
  Sales of K200m
K10m

 
 
By summarising profit and sales (turnover), the 5% figure has reduced the amount of data that
managers need to consider. Importantly, it provides a "performance measure” - profitability. This
approach is the basis of financial ratios. Used in isolation, the measure is of limited value; its
value increases if it is viewed over a time period. A useful way of assessing performance,
therefore, is through time series analysis.
Assume that the organisation has achieved the following profitability over the last four years:

Year 1 2 3 4

Profit margin 20% 15% `12% 5%

The 5 per cent can now be viewed in the context of a four year period. In this case, the 5per cent
in year 4 provides better information for decision making. It is the worst performance in the
period and continues a declining pattern of performance. It can be useful to express this
information in graphical form, further reducing it, and making it easier for management review.
Comparing the company with either an average performance for the sector in which it operates
or a peer group of competitors can yet further increase the value of the measure. Such
comparison is often referred to as financial "benchmarking”. Indeed financial statement analysis
must always be putted into a context (mainly sector/industry) as it is meaningless to compare for
example the performance of a hotel business with a manufacturer of IT equipment.
Analysis Techniques
Techniques can be applied to companies of differing size, thus enabling a more meaningful
comparison than can be achieved by using the raw financial data.
"Common size "techniques typically involve expressing the elements of a financial statement as
component percentages. Techniques include:

 Trend Analysis - considers changes over time, using a "base” year comparator.
 Horizontal Analysis - considers changes over time, comparing year to year changes.
 Vertical Analysis - considers changes over time, comparing component elements.

3.2 Ratio analysis

There are many financial ratios that can be used in order to analyse balance sheets. Financial
ratios generally provide an efficient way of analysing balance sheet information and they are
very helpful when comparing the financial health of two (or more) businesses. By calculating
few financial ratios it is often possible to draw an accurate picture of a firm’s financial
performance and to uncover issues that did not look obvious in the first instance. However, while
very helpful, one should be aware of the disadvantages that financial ratios have when they are
used in isolation.
Financial ratios may show a firm’s financial strengths and weaknesses but they do not uncover
the reasons behind these strengths and weaknesses. Therefore a detailed a further in depth
investigation is required. Furthermore they should always be considered in context and if two
businesses are compared, then the businesses should be relatively similar (at least in industry) as
the financial structure of firms that belong to different sectors may be significantly different.
While there is no definite and specific list of financial ratios that can be used, there are some
particularly important categories of ratios (explained below) and within these categories some
ratios are given.
 Profitability. Businesses generally exist with the primary purpose of creating wealth for their
owners. Profitability ratios provide an insight to the degree of success in achieving this purpose.
They express the profits made (or figures bearing on profit, such as overheads) in relation to
other key figures in the financial statements or to some business resource.
Efficiency. Ratios may be used to measure the efficiency with which particular resources have
been used within the business. These ratios are also referred to as activity ratios.
Liquidity. It is vital to the survival of a business for there to be sufficient liquid resources
available to meet maturing obligations (that is, debts that must be paid in the relatively near
future). Some liquidity ratios examine the relationship between liquid resources held and payable
(creditors) due for payment in the near future.
Financial gearing. This is the relationship between the contribution to financing the business
made by the owners of the business and the amount contributed by others, in the form of loans.
The level of gearing has an important effect on the degree of risk associated with a business, as
we shall see. Gearing is, therefore, something that managers must consider when making
financing decisions. Gearing ratios tend to highlight the extent to which the business uses loan
finance.
Investment. Certain ratios are concerned with assessing the returns and performance of shares
held in a particular business from the perspective of shareholders who are not involved with the
management of the business.
The analyst must be clear who  the target users are and why they need the information.
Different users of financial information are likely to have different information needs, which will
in turn determine the ratios that they find useful. For example, shareholders are likely to be
interested in their returns in relation to the level of risk associated with their investment. Thus
profitability, investment and gearing ratios will be of particular interest. Long-term lenders are
concerned with the long-term viability of the business and to help them to assess this, the
profitability and gearing ratios of the business are also likely to be of particular interest. Short-
term lenders, such as suppliers of goods and services on credit, may be interested in the ability of
the business to repay the amounts owing in the short term. As a result, the liquidity ratios should
be of interest
 
PROFITABILITY RATIO
Profitability ratios help users of financial statements to know how much profit a Business has
made and then to compare it with the previous periods or with other businesses. You wish to
know that profitability is the end product of the policies and decisions made by any business and
therefore, it’s the most important barometer of success (measure of performance). We are going
to cover four main profitability ratios in this course namely return on capital employed (ROCE),
return on equity, gross profit margin and profit margin.

Return on capital employed ratio

Return on capital employed ratio measures how efficiently a company can generate profits from
its capital employed by comparing net operating profit to capital employed. In other words,
return on capital employed shows investors how much profit each kwacha (money) of capital
employed generates.
ROCE is a long-term profitability ratio because it shows how effectively assets are performing
while taking into consideration long-term financing. This is why ROCE is a more useful ratio
than return on equity (Links to an external site.) (explained below) to evaluate the longevity of a
company.
This ratio is based on two important calculations: operating profit and capital employed. Net
operating profit is often called PBIT or profit before interest and taxes which is generated from
operations. PBIT can be calculated by adding interest and taxes back into net income if need be.
You must be aware that capital employed is a fairly complicated term because it can be used to
refer to many different financial ratios. However, most often capital employed refers to the total
assets of a company less all current liabilities or shareholders' fund plus long-term liabilities.
Therefore a return of 1 means that every kwacha (money) of Capital employed generates 1
kwacha of net income. This is an important measurement for potential investors because they
want to see how efficiently a company will use their money to generate net income.
Its formula is given as follows:
ROCE = Net operating profit
               Capital employed
 Return on equity
Just like ROCE, the return on equity ratio measures the ability of a firm to generate profits from
its shareholders investments in the company. In other words, the return on equity ratio shows
how much profit each kwacha (money) of ordinary shareholders' equity generates.
ROE is an important indicator for investors because it shows how effective management is using
equity financing to fund operations and grow the company.
Its formula is given below:
 ROE = Net profit
             Shareholders' equity
 
Return of Assets (Total assets)
The return on assets ratio (ROA) measures the net income produced by total assets during a
period by comparing net income to the average total assets. In other words, ROA measures how
efficiently a company can manage its assets to produce profits during a period (It shows how
profitable a company's assets are).
Its formula is given below:
ROA = Net profit
           Total assets
Gross profit margin ratio
Gross profit margin ratio measures how profit a company makes from selling its stock or
merchandise. This is the pure profit from the sale of stock that can go to paying operating
expenses.
Gross margin ratio is often confused with the profit margin ratio (explained below), but the two
ratios are completely different. Gross margin ratio only considers the cost of goods sold in its
calculation because it measures the profitability of selling inventory. Profit margin ratio on the
other hand considers other expenses.
Its profit is given as follows;
Gross profit margin = Gross profit
                                  Sales
 
Profit margin ratio
The profit margin ratio, also called the return on sales ratio measures the amount of net income
earned with each kwacha (money) of sales generated by comparing the net income and net sales
of a company. In other words, the profit margin ratio shows what percentage of sales are left
over after all expenses are paid by the business.
As you may be aware investors want to know whether profits are high enough to distribute to
dividends. An extremely low profit margin formula would indicate the expenses are too high and
the management needs to budget and cut expenses.
Its formula is given below:
 Profit margin = Net profit
                         Sales
LIQUIDITY RATIO
If you are extending credit to a customer or making a short-term bank loan, you are interested in
more than the company’s leverage. You want to know whether it will be able to lay its hands on
the cash to repay you. That is why credit analysts and bankers look at several measures
of liquidity. Liquid assets can be converted into cash quickly and cheaply. There are basically
two liquidity ratios namely the current asset and the quick asset ratios.
Current assets ratio or working capital ratio
This ratio is given by the formula:
Current assets
Current liabilities
 
It’s usually expressed as a ratio e.g 4:1. As you observe from the formula, it indicates the number
of times the current liabilities are covered by current assets. As a rule of thumb, a ratio of 2:1 is
generally considered satisfactory i.e. Current assets covering liabilities twice as much. Therefore,
if all our current liabilities fall due at same time, we would be able to settle without financial
challenges. However, a ratio of less than 2:1 is usually an indication of serious financial
problems, especially if the current assets consist of a very high proportion of stock.
 
Quick Assets ratio or Acid test
This is gauges the business’s ability to meet its current liabilities should they demand payments
simultaneously from its liquid assets. Its given by the formula:
 
Current assets – Stock
Current liabilities
The stock figure is subtracted from current assets because it may not be easy to dispose of stocks
in the short term especially in times of crisis. In other words, stock cannot always be readily
turned into cash in the short term. As a rule of thumb, a ratio of 1:1 is generally considered
satisfactory i.e. current assets covering liabilities.
As you learnt from above, the two ratios are a good indicator of the company’s liquidity position.
However, for a company selling slow moving stocks, the quick asset ratio provides a more
realistic measure of liquidity.
Efficiency Ratios
These ratios are used measure the efficiency of the business and include the following:

Stock turnover ratio

Stock turnover ratio shows how many times a company's stock is sold and replaced over a
period. You can also calculate the number of days it takes to sell the inventory on hand i.e. the
stock days.
Generally it is calculated as:
Stock Turnover =        Sales
                           Closing stock or Average stock
However, it may also be calculated as:
Stock Turnover = Cost of Goods Sold
                             Closing stock or Average stock
Note that this is expressed as X times
 
Stock days = Closing stock or average stock   X 365 days
                       Sales or Cost of goods sold
Fixed assets turnover ratio
This ratio indicates the number of times that fixed assets are covered by the sales revenue. The
more times that fixed assets are covered by the sales, the greater the recovery of the investment
in fixed assets.
 It’s given by the formula
 Fixed assets turnover ratio= Total sales revenue
                                           Fixed assets at net book value   
 Trade debtors’ collection period
 This measures the period that its takes for trade debtors to settle their accounts or credit period
given to customers. The less the number of debtor collection days (normally measured in days or
months) the more efficient the debt collection is.
 It’s given by the formula
Debtor (receivables) days= Average trade debtors or closing debtors X 365 days
                                          Total credit sales
 Trade creditor payment period
Like the trade debtors period, it measures the period that it takes for the Business to pay its trade
creditors. If it takes your company longer to pay its creditors or payables, it means you are
stretching them as well using their money to finance the company’s operations. This might even
negatively the relationship between you and your suppliers.
It’s given by the formula
 Creditors (payables) days = Average trade creditors or closing creditors X 365 days
                                           Total credit sales
 GEARING/LEVERAGE RATIOS
 Leverage ratios are concerned with how much financial leverage the company has taken on. You
may wish to know that when a company borrows money, it promises to make a series of interest
payments and also repay the amount it borrowed. These payments will be made from the profits
generated by the company. A company that is heavily in debt (and seems to be getting more
debt) and not making enough profit might face the following situations:

1. Banks and other would be lenders will most likely refuse further borrowing and the company will be
trouble
2. There will be very little profit left over (if any) for shareholders after the interest have been paid.
3. The company will then become bankrupt and shareholders lose their entire investment

 Debt Ratio. Financial leverage is usually measured by the ratio of long-term debt to total long-
term capital. Here “long-term debt” should include not just bonds or other borrowing, but also
the value of long-term leases. Total long-term capital, sometimes called total capitalization,  is
the sum of long-term debt and shareholders’ equity.
Long-term debt ratio =          long-term debt
                                      Long-term debt + equity
Another way to express leverage is in terms of the company’s debt-equity ratio:
 
Debt-equity ratio        =          long-term debt
                                              Equity
Interest Cover Ratio. Another measure of financial leverage is the extent to which interest is
covered by earnings. Banks prefer to lend to firms whose earnings are far in excess of interest
payments. Therefore, analysts often calculate the ratio of earnings before interest and taxes
(EBIT) to interest payments.
 
Interest cover ratio     =         EBIT
                                  Interest payments
INVESTORS’ RATIO
These ratios are generally more important to shareholders, prospective investors and financial
managers who are interested in the performance of shares on the stock exchange market. The
ratios include, Price earnings ratio (P/E), Earnings per share (EPS), Dividend yield and Dividend
pay-out ratio
 Price earnings (P/E) ratio
The P/E ratio is a market prospect ratio that calculates the market value of a stock relative to its
earnings by comparing the market price per share by the earnings per share. In other words, the
price earnings ratio shows what the market is willing to pay for a stock based on its current
earnings.
Investors often use this ratio to evaluate what a stock's fair market value should be by predicting
future earnings per share. Companies with higher future earnings are usually expected to issue
higher dividends or have appreciating stock in the future.
Its formula is given below:
  P/E ratio = Market price per share
                  Earnings per share
 Earnings per share (EPS) ratio
EPS is a market prospect ratio that measures the amount of net income earned per share of stock
outstanding. In other words, this is the amount of money each share of stock would receive if all
of the profits were distributed to the outstanding shares at the end of the year.
Earnings per share or basic earnings per share is calculated by subtracting preferred dividends
from net income (net profit) and dividing by the weighted average common shares outstanding.
Its formula is given below:
EPS = Net profit - preference dividend 
           Number of outstanding shares
Dividend Yield Ratio
The dividend yield is a financial ratio that measures the amount of cash dividends distributed to
ordinary shareholders relative to the market value per share. The dividend yield is used by
investors to show how their investment in stock is generating either cash flows in the form of
dividends or increases in asset value by stock appreciation.
Its formula is given below:
Dividend yield ratio = Dividend per share
                                  Market price per share
Dividend Payout Ratio
The dividend payout ratio measures the percentage of net income that is distributed to
shareholders in the form of dividends during the year. In other words, this ratio shows the portion
of profits the company decides to keep in order to fund operations and the portion of profits that
is given to its shareholders. Investors are particularly interested in the dividend payout ratio
because they want to know if companies are paying out a reasonable portion of net income to
investors.
Its formula is given below:
Dividend payout ratio = Dividend per share
                                      Earnings per share
Limitation of ratio analysis

 Manipulation of financial statements: You may be aware that any ratio including profit may be
distorted by the choice of accounting policies. Sometimes, the management of a company may be
involved in creative accounting (deliberate presentation of incorrect financial picture about the
company)
 Ratios are not definitive: You may wish to know that ideal levels vary from industry to industry and
are not definitive. You may discover that some companies may be able to exist without any difficulty
with ratios that are far below the industrial average.  
 Availability of comparative information: When making comparisons with other companies in the
industry, you may discover that industry averages may hide wide variations in figures. Figures for
similar companies may provide a better guide, but its difficult to indentify companies that are similar
and obtaining enough detailed information about them.
 Use of historical (out-of-date) information: You are aware that the past does not always reflect the
future; therefore comparison of previous history of a business may be of limited use. For example, a
company that has recently undergone substantial change may have a better or worse future compared
to the past.
 Other information: You will realise that ratio analysis on its own is not sufficient for interpreting
company accounts and there other financial and non financial information that should be considered.
 Need for careful interpretation: You may compare two businesses and discover that one has a higher
liquidity level (better position). However, further investigation might reveal poor working capital
management.

UNIT 4: REPORTING AND

COMMUNICATION
 
On the completion of the unit students should be able to understand the following:
1.The distinction between financial information for internal and external use
2.The role of management accounting in decision making
3.distinguish between fixed costs and variable costs and use this distinction to explain the
relationship between costs, volume and profit;
4.prepare a break-even chart and deduce the break-even point for some activity
5.discuss the weaknesses of break-even analysis;
6.demonstrate the way in which marginal analysis can be used when making short-term decisions
 

4.1 Distinction Between Financial

Information for External and Internal
Use
 In the previous units we saw the financial reports that are sourced from financial accounting. We also
discussed that the users of these financial reports (see figure 4.0) are external to the firm individuals
(or entities).
 In this unit we will draw the line between external and internal users of financial information and we
will also introduce the concept of management accounting.

Figure 4.0 Users of financial of financial information

FINANCIAL & MANAGEMENT ACCOUNTING
The financial reports that we analyzed in the previous units were directed towards the external
users of accounting information. As you may recall, these financial reports were based on
financial accounting. However, there is another stream of financial information which is for
internal users and it is called management accounting (and the associated management reports).
Management accounting and its reports are aiming to inform not external stakeholders but
internal decision makers (managers, directors e.t.c) so as to enable them to make the most
informed decisions when running the business.
DIFFERENCES BETWEEN FINANCIAL ACCOUNTING & MANAGEMENT
ACCOUNTING

1. Financial Accounting is the branch of accounting which keeps track of all the financial information of
the entity. Management Accounting is that branch of accounting which records and reports both the
financial and non-financial information of an entity.
2. Users of financial accounting are both the internal management of the company and the external
parties while the users of the management accounting are only the internal management.
3. Financial accounting is to be publicly reported whereas the Management Accounting is for the use of
the organisation and hence it is very confidential.
4. Only monetary information is contained in financial accounting. As against this, management
accounting contains both monetary and non-monetary information such as the number of workers, the
quantity of raw material used and sold, etc.
5. Financial Accounting is done in the prescribed format, whereas there is no prescribed format for the
Management Accounting.
6. Financial Accounting focuses on providing information about the functioning of the entity’s business
to its users, whereas Management Accounting focuses on providing information to help them in
evaluating the performance and devising plans for the future.
7. The Financial Accounting is mainly done for a specific period, which is usually one year. On the
other hand, the management accounting is done as per the needs of the management say quarterly,
half yearly, etc.
8. Financial accounting information is required to be published and audited by statutory auditors.
Unlike, management accounting, which does not require information to be published and audited, as
they are for internal use only.

4.2 The role of Management

Accounting Information in Business
Decision Making
Management accounting involves the use of accounting and other relevant information in the
planning and control of the activities of an enterprise by its management. Management have to
plan for both the short term and the long term. For example management may need to build a
new processing plant to meet future anticipated increase in demand for a product. Therefore this
long term objective can be converted into a succession of short-term plans of action in the form
of annual budgets.
MANAGEMENT ACCOUNTING

 Control enables management to see whether the organisation’s long-term objectives are achievable.
This is done by comparing actual performance with the short-term plans so that deviations from these
short-term plans can be identified and corrective action taken to ensure that the long-term objectives
are possible. During the process of planning and controlling, management will be required to make
decisions.
 Because this group of (internal) users is so broad and the potential amount of information that they
collectively need is vast, there is a special branch of accounting (called management accounting) that
deals with the particular needs of management
 Activity

 Firm’s XYZ net profits dropped from £300m to £50m in the year to December 2013
depressed by massive increase in production costs due to sharply increasing costs of raw
materials and overspending in (unsuccessful) advertising campaigns. The managing director
of the company explained his plans to improve profit margins to a level comparable to the
 main competitors and also promised more effective management of assets, in a statement to
the company’s shareholders.
What observations can you make from the scenario above?

 Observation
 This can be achieved through:

1.Controlling costs or improving sales or from combination of both

2.Using assets more effectively to generate or higher sales
3.Need broad range of managerial skills-sales, production & asset management
Therefore, there is need for management accounting in order to identify relevant costs &
revenues, measure the achievement of targets & communicate the outcome

 In conclusion, each company has different needs & therefore the management accounting information
has to serve those needs.
 COMMUNICATION

o Communication is not a management accounting function. However, effective communication is
a crucial element in every organization and it is a particularly complicated one in large
organizations where a vast amount of financial information is exchanged across different
managerial levels and perhaps different functions.
o It is worth always remembering that management accounting information considers only internal
users of information and therefore the communication channels should be related with the
organizational structure of the company.
 Managing director wants the company to focus on improving profit margins.

4.3 Costs
TYPES OF COSTS

 Costs represent the resources that have to be sacrificed to achieve a business objective.
 In financial accounting- concerned with the nature of the expenses e.g wages, lighting and heating
etc.
 In cost accounting- concerned with the purpose of the expense such as whether the wages are in
respect say manufacturing or distribution (direct or indirect)
 All expenditure can be classified into three main groups- Labour, Materials and expenses. The costs
incurred under these headings can be further subdivided into two important ways:
 Direct and Indirect costs: Items which can or cannot be directly applicable to a product or service and
 Fixed and Variable costs: according to whether or not the level of costs varies with the level of
output.
 DIRECT & INDIRECT COSTS
Direct costs cover any expenses that can be wholly associated with a particular product or
service. The total of such direct costs, direct materials and direct expenses is known as prime
costs.
The total of indirect materials, indirect labour and indirect expenses is called overheads.
DIRECT LABOUR COST

 The cost of remuneration for employees’ effort and skills applied directly to a product or saleable
service and which can be identified separately in product costs.

ACTIVITY
Company XYZ manufactures a wide range of different products using specialized machines. It
has employed machine operators, mechanic engineers and factory manager.
 
Discuss how the labour costs of these employees would be classified.
How would you classify the idle time?
DIRECT MATERIALS
These are materials entering into and becoming constituent elements of a product or saleable
service and which can be identified separately in product cost.

 The following materials fall within this definition.

I.All materials specially purchased for a particular job, order or process

II.All materials requisitioned from the stores for particular orders
III.Components or parts produced or purchased and requisitioned from the finished goods store.
IV.Materials passed from one operation to another
ACTIVITY
Toyota Zambia manufactures motor vehicles and service parts.

 Discuss how you classify the oil used to lubricate the production machinery.
 How would you classify the carriage in wards?

DIRECT EXPENSES

 These are costs other than materials or labour, which are incurred for a specific product or saleable
service. Direct expenses are not as common as direct materials and labour
 ACTIVITY
 Company XYZ manufactures two products using two specialize equipment.
 Discuss how you would classify the electricity that the two machines use.

COST BEHAVIOUR
FIXED & VARIABLE COSTS

 The amount of fixed costs stays the same (10,000) irrespective of the volume of units produced.
 As indicated above, at zero volume of activity the variable cost is zero. The cost increases in a
straight line as activity increases.

STEPPED FIXED COSTS

 Suppose an organisation rents a factory. The yearly rent is the same no matter what the output of the
factory is. If business expands sufficiently, however, it may be that a second factory is required and a
large increase in rent will follow. This can be illustrated in graph above with a step indicating an
increase in rent.

SEMI_VARIABLE COSTS
 An example of semi variable costs could be telephone charge because it include a fixed rental charge
and then cost per unit consumed
 Fixed costs and variable costs can be separated using the High-Low method if two levels of output
are given. For example:
 At output 2000 units, costs of K12,000
 At output 3000 units, costs of K17,000
 For an extra 1000 units of output, an extra K5000 has been generated. The variable cost component is
K5 per unit. Therefore, at the level of 2000 units the total variable cost is K10,000 and fixed costs
K2,000.

4.4 Cost Volume Profit Analysis

COST VOLUME PROFIT

 Cost-volume-profit (CVP) analysis is used to determine how changes in costs and volume affect a
company's operating income and net income. In performing this analysis, there are several
assumptions made, including:
 Sales price per unit is constant.
 Variable costs per unit are constant.
 Total fixed costs are constant.
 Everything produced is sold.
 Costs are only affected because activity changes.
 If a company sells more than one product, they are sold in the same mix.

 CVP analysis requires that all the company's costs, including manufacturing, selling, and
administrative costs, be identified as variable or fixed.
 Key calculations when using CVP analysis are the contribution margin and the contribution
margin ratio. The contribution margin represents the amount of income or profit the company made
before deducting its fixed costs. Said another way, it is the amount of sales kwacha available to cover
 (or contribute to) fixed costs. When calculated as a ratio, it is the percent of sales kwacha available to
cover fixed costs. Once fixed costs are covered, the next kwacha of sales results in the company
having income.


 BREAKEVEN ANALYSIS

o The break-even point (BEP) is the level of activity (in units of output or sales revenue) at which
total costs (fixed + variable) = total sales revenue.
o Calculation of BEP is as follows:
o BEP (in units of output) =Fixed costs for the period

       Contribution per unit

o Contribution per unit = sales revenue per unit less variable cost per unit.
o Margin of safety = excess of planned volume of activity over BEP

       = Sales-BEP/Sales x 100%

o Profit–volume (PV) chart is an alternative approach to the BEP chart.

o MARGIN OF SAFETY
 o PROFIT VOLUME ANALYSIS

o EXAMPLE
o The fixed costs are $1,000 per year
o Product X has variable costs of $2 per unit, and selling price of $6 per unit.

(a) If budgeted sales and production are 300 units, what is the budgeted profit (or loss) for the
year?
(b) What is the breakeven point (in units)?
(c) What is the breakeven revenue?
(d) How many units need to be sold to achieve a target profit of $300 per year?
(e) What is the margin of safety?

4.5 Pricing Decisions

An important decision for a profit making organization is that of fixing a selling price.
Pricing is very important because:
 It makes a pivotal contribution to profit maximization – the overriding aim of most businesses.
 Businesses make profits by selling goods and services at a price higher than their cost.
 The amount that they are able to sell will often be determined by the price charged for the goods and
services.

Pricing is one of the four components of the marketing mix, the others being Product, Promotion
and Place.
Decisions in relation to all four components should be made within the context of the overall
marketing strategy.
 
Factors influencing selling price
Below are the three important factors that influence the pricing of a product or service:

 costs
 customers
 competition

 
Cost based pricing: the accountant’s approach
'Cost plus' pricing is a much favoured traditional approach to establishing the selling price by:

 calculating the unit cost

 adding a markup or margin to provide profit.

 
The unit cost may reflect:

 full cost
 manufacturing cost
 variable cost.

 
The markup is equally subjective and often reflects:

 the risk involved in the product

 competitors’ markups
 desired profit and/or ROCE (return on capital employed)
 type of cost used
 type of product, etc.

 
It is important to understand the difference between:
 Profit markup: the profit is quoted as a percentage of the cost.
 Profit margin: the profit is quoted as a percentage of the selling price

 
Example
If the full cost of an item is K540, calculate the selling price using a 25% mark up and a 25%
profit margin:
Solution

 A 25% markup would produce a selling price of K675 (K540 × 1.25).

 A 25% profit margin would produce a selling price of $720 [K540 × (100/75)].

 
Customer based pricing – the marketer’s approach
Customer based pricing reflects customers’ perceptions of the benefits they will enjoy (e.g.
convenience, status, etc.).
But this approach:

 Has regard to costs i.e customer based pricing must ensure that financial objectives are met.
 Exploits the willingness of customers to pay a multiple of the cost price if they perceive the benefits
to be substantial.
 Has as its first step the production of a profile of the target customer.
 Reflects a belief that the greater the understanding of the wants, needs and values of your customer
the better placed you are to price the

Example
On a remote beach in a hot country, the offer of food and drink to tourists on the beach will be
perceived by them as being of significant benefit and they are likely to be prepared to pay a
significant amount in excess of cost.
 
Competition based pricing
Competition based pricing means setting a price based upon the prices of competing products.
Competing products can be classified as:

1. The same type of product – easily distinguished from one’s own products; price changes by
competitors will not have a material impact.
2. The same type of product – not easily distinguished from one’s own products; price changes by
competitors will have a material impact.
3. Substitute products that may be bought instead of your type of product (e.g. buy ice cream instead of
soft drinks on a hot day). The impact of price changes will depend on relative price/performance of
substitute.
Example
Made to measure shoes and mass manufactured shoes are examples of products that can be easily
distinguished and where the price of one has little impact upon the price of the other.
If, however, one is a mass manufacturer of shoes it is very difficult to distinguish one’s product
from that of other mass manufacturers. The prices of competitors will have a material bearing on
one’s own prices.

4.6 Marginal Analysis

When we are trying to decide between two or more possible courses of action, and where
economic costs and benefits are the decision-making criteria, only costs that vary with the
decision should be included in the decision analysis.
In marginal analysis we concern ourselves just with costs and revenues that vary with the
decision and so this usually means that fixed costs are ignored
Marginal analysis tends to assume that the variable cost per unit will be equal to the marginal
cost, which is the additional cost of producing one more unit of output.
In marginal analysis fixed costs are irrelevant to the decision. This is because either:
1) fixed costs tend to be impossible to alter in the short term; or
2) managers are reluctant to alter them in the short term.
Example 1
Man Muzo plc owns the premises that it uses to provide a service. There is a downturn in
demand for the service, and it would be possible for Man Muzo plc to carry on the business from
smaller, cheaper premises.
Can you think of any reasons why the business might not immediately move to smaller, cheaper
premises?
Suggestion
1) It is not usually possible to find a buyer for premises at very short notice.
2) It may be difficult to move premises quickly where there is, say, delicate equipment to be
moved.
3) Management may feel that the downturn might not be permanent, and would thus be reluctant
to take such a dramatic step and deny itself the opportunity to benefit from a possible revival of
trade.
The case for Man Muzo ltd in the example may provide an example of one of the more inflexible
types of cost, but most fixed costs tend to be broadly similar in this context.
Example 2
A householder wants a house decorated. Two decorators have been asked to price the job.
Decorator A will do the work for K2,500, the other decorator B wants K3,000, in both cases on
the basis that the householder will supply the materials. It is believed that the two decorators will
do an equally good job. The materials will cost K2,000 irrespective of which decorator does the
work. Assuming that the householder wants the house decorated at the lower cost, which
decorator should be asked to do the work? Is the cost of the materials relevant to the decision?
Clearly decorator A should be selected. The cost of the materials is irrelevant because it will be
the same in each case. It is only possible to distinguish rationally between courses of action on
the basis of differences between them.
In this example, a distinction is made between relevant and irrelevant costs. For many decisions
that involve relatively small variations from existing practice and/or relatively limited periods of
time, all fixed costs are irrelevant to the decision, because they will be the same irrespective of
the decision made.
USE OF MARGINAL ANALYSIS
Marginal analysis may be used in four key areas of decision making:
1) accepting/rejecting special contracts;
2) determining the most efficient use of scarce resources;
3) make-or-buy decisions;
4) closing or continuation decisions.
 
A) Accepting/rejecting special contracts
To help you understand. We will use the following example:
Example
Assuming Dumbwiza Industries has spare capacity in that its basket makers have some spare
time. An overseas retail chain has offered the business an order for 400 baskets at a price of
K165 each. Without considering any wider issues, should the business accept the order?(Assume
that the business does not rent the machine.)
Solution
Since the fixed costs will be incurred in any case, they are not relevant to this decision. All we
need to do is see whether the price offered will yield a contribution. If it will, the business will be
better off by accepting the contract than by refusing it.
                                                                            K
  Additional revenue per unit                             165
  Less  Marginal (variable) cost per unit             160
  Additional contribution per unit                         5__
For 400 units, the additional contribution will be K2,000 (that is, 400 × K5). Since no fixed cost
increase is involved, irrespective of what else is happening to the business, it will be K2,000
better off by taking this contract than by refusing it.
Other factors to consider before the decision is made may include:
1) The possibility that spare capacity will have been ‘sold off’ cheaply when there might be
another potential customer who will offer a higher price, but, by which time, the capacity will be
fully committed.
2)Selling the same product, but at different prices, could lead to a loss of customer goodwill
3) If the business is going to suffer continually from being unable to sell its full production
potential at the ‘regular’ price, it might be better, in the long run, to reduce capacity and make
fixed cost savings.
4) On a more positive note, the business may see this as a way of breaking into the overseas
market. This is something that might be impossible to achieve if the business charges its regular
price.
 
B) Determining the most efficient use of scarce resources
Generally the size of the market will limit the output. This is to say that the ability of a business
to sell will limit production, rather than the ability to produce will limit sales. In some cases,
however, it is a limit on what can be produced that limits sales. Limited production might stem
from a shortage of any factor of production – labour, raw materials, space, machinery and so on.
Such scarce factors are often known as key or limiting factors. The most profitable combination
of products will occur where the contribution per unit of the scarce factor is maximised.
Example 1
A business provides three different services, the details of which are as follows:
Service (code name)                            X            Y               Z
                                                              K            K              K
Selling price per unit                             55            40          60
Variable cost per unit                            (30)          (20)       (32)
Labour time per unit                                5hrs        3hrs      6hrs
Fixed cost is K17,000
The market will take as many units of each service as can be provided, but the ability to provide
the service is limited by the availability of labour, all of which needs to be skilled.
Which service should be given priority?
Solution
Service (code name)                                  x                    y                  z
                                                                   K                K                K

 Selling price per unit                           55               40              60

 Variable cost per unit                         (30)             (20)            (32)
 Contribution per unit                           25                20              28
 Labour time per unit                            5 hours         3 hours     6 hours

Within reason, the market will take as many units of each service as can be provided, but the
ability to provide the service is limited by the availability of labour, all of which needs to be
skilled. Fixed costs are not affected by the choice of service provided because all three services
use the same facilities. The most profitable service is Y because it generates a contribution of
K6.67 (K20/3) an hour. Followed by X which generate only K5 per hour (K25/5 and Lastly Z
with K4.7 per hour (K28/6). So, to maximize profit, priority should be given to the production
that maximises the contribution per unit of limiting factor.
Example 2
A business makes three different products, the details of which are as follows:
Product (code name)                                    B14         B17            B22
Selling price per unit (K)                           25            20               23
Variable cost per unit (K)                          10              8               12
Weekly demand (units)                             25            20               30
Machine time per unit (hours)                   4               3                 4
Fixed costs are not affected by the choice of product because all three products use the same
machine. Machine time is limited to 148 hours a week.
Which combination of products should be manufactured if the business is to produce the highest
profit?
Solution
Product (code name)                               B14                   B17                    B22
                                                             K                     K                       K
Selling price per unit                            25                    20                     23
Variable cost per unit                           (10)                  (8)                   (12)
Contribution per unit                             15                     12                    11
Machine time per unit                             4 hours           3 hours            4 hours
Contribution per machine hour               K3.75              K4.00               K2.75
Order of priority                                        2nd                 1st                     3rd
Therefore:
Produce 20 units (maximum demand) of product B17 using                60 hours
               22 units of product B14 using (remaining machine hours)      88 hours
                                                                                                             148 hours
This leaves unsatisfied the market demand for a further three units of product B14 and 30 units
of product B22.
Other to consider before making the decision may include:

 Consider obtaining additional machine time. This could mean buying or hiring a new machine,
subcontracting the machining to another business, or perhaps squeezing a few more hours a week out
of the business’s existing machine. Perhaps a combination of two or more of these is a possibility.
 Redesign the products in a way that requires less time per unit on the machine.
 Increase the price per unit of the three products. This might well have the effect of dampening
demand, but the existing demand cannot be met at present, and it may be more profitable in the long
run to make a greater contribution on each unit sold than to take one of the other courses of action to
overcome the problem.

C) Make or buy decision

Businesses are frequently confronted by the need to decide whether to produce the product or
service that they sell themselves, or to buy it in from some other business. For example, the
producer may have a component for the appliance made by another manufacturer. Obtaining
services or products from a subcontractor is often called outsourcing.
Example 1
Man Muzo Ltd needs a component for one of its products. It can subcontract production of the
component to a subcontractor who will provide the components for K200 each. The business can
produce the components internally for total variable costs of K150 per component. Man Muzo
Ltd has spare capacity.
Should the component be subcontracted or produced internally?
The answer is that Man Muzo Ltd should produce the component internally, since the variable
cost of subcontracting is greater by K50 than the variable cost of internal manufacture.
Example 2
Now assume that Man Muzo Ltd (Example above) has no spare capacity, so it can only produce
the component internally by reducing its output of another of its products. While it is making
each component, it will lose contributions of K70 from the other product.
Should the component be subcontracted or produced internally?
Example 3
The answer is to subcontract.
The relevant cost of internal production of each component is:
                                                                                                     K
Variable cost of production of the component                            150
Opportunity cost of lost production of the other product               70
                                                                                                    220
Producing internally (K220) is obviously more costly than the K200 per component that will
have to be paid to the subcontractor.
Other factors to consider before making the decision may include:
1) The general problems of subcontracting:

 (a) loss of control of quality;

 (b) potential unreliability of supply.


2 Expertise and specialisation.

It is possible for most businesses, with sufficient determination, to do virtually everything in-
house. This may, however, require a level of skill and facilities that most businesses neither have
nor feel inclined to acquire. For example, though it is true that most businesses could generate
their own electricity, their managements tend to take the view that this is better done by a
specialist generator business. Specialists can often do things more cheaply, with less risk of
things going wrong.
 
D) Closing or continuation decision
It is quite common for businesses to produce separate financial statements for each department or
section, to try to assess the relative effectiveness of each one. Normally a decision will have to
be made on whether to close or continue with a  department that is not performing well.
Example
Good sports Ltd is a retail shop that operates through three departments, all in then same
premises. The three departments occupy roughly equal-sized areas of the premises. The trading
results for the year just finished showed the following:
                                    Total                 SE              SC               GC
                             K000             K000         K000          K000
Sales                    534                254           183             97
Costs                  (482)               (213)         (163)         (106)
Profit/(loss)          52                    41              20            ( 9)
Units(‘000)           135                 60              45             30
VC per unit                                2.78            2.6              2
Assuming last year’s performance to be a reasonable indication of future performance, which
department would you advise to be closed off? 
 
It would appear that if the GC department were to close, the business would be more profitable,
by K9,000 a year, assuming last year’s performance to be a reasonable indication of future
performance. When the costs are analyzed between those that are variable and those that are
fixed, however, the contribution of each department can be deduced and the following results
obtained:
                                                                                     Total                   SE                
SC                       GC
                                                                         K000               K000            K000           K000
Sales                                                                  534                  254              183               97
Variable costs                                                   (344)               (167)             (117)            (60)
Contribution                                                      190                   87                 66                37
Fixed costs (rent, and so on)                            (138)               (46)               (46)               (46)
Profit/(loss)                                                          52                   41                20                ( 9)
Now it is obvious that closing the general clothes department, without any other developments,
would make the business worse off by K37,000 (the department’s contribution). The department
should not be closed, because it makes a positive contribution. The fixed costs would continue
whether the department were closed or not. As can be seen from the above analysis,
distinguishing between variable and fixed costs, and deducing the contribution, can make the
picture a great deal clearer.
Other factors to be considered before making the decision may include:
1) Expansion of the other departments or replacing the general clothes department with a
completely new activity
2) Subletting the space occupied by the general clothes department.
3) Keeping the department open, even if it generated no contribution whatsoever (assuming that
there is no other use for the space), may still be beneficial
 
 

UNIT 5: BUDGETING DECISIONS

 By the end of this unit, student should be able to:

I.define a budget and show how budgets, corporate objectives and long-term plans are related;
II.explain the interlinking of the various budgets within the business;
III.indicate the uses of budgeting, and construct various budgets, including the cash budget, from
relevant data;
IV.use a budget to provide a means of exercising control over the business.
V. Perform basic variance analysis.
 

5.1 Budgeting
A Budget is a short-term business plan, mainly expressed in financial terms.
Budgets are the short-term means of working towards the business’s objectives.
Usually for 12 months with sub periods of a month.
Uses of a budget are to:
1 promote forward thinking;
2 help co-ordinate the various aspects;
3 motivate performance;
4 provide the basis of a system of control;
5 provide a system for authorization.
PRINCIPAL BUDGET FACTOR

 The principal budget factor is the factor that limits the activity for the budget period. Normally this is
the level of sales and therefore the sales budget is usually the first budget to be prepared and this
leads to the others.
 However, it could be (for example) a limit on the availability of raw materials that limits activity. In
this case Raw Materials would be the principal budget factor, and this would the first budget to be
prepared.

5.2 Types of Budgets

TYPES OF BUDGETS
There several types of budgets but for this course we will concentrate on the ones below:

 FIXED BUDGET

Fixed budget is the original budget designed to forecast future performance

and challenges faced by the business.

 FLEXED BUDGET

Flexed budget is used for performance measurement purpose. Variables like activity level (sales
volume) are changed to facilitate comparison with actual or competitors results.

 ROLLING BUDGET

Rolling budget is not a one time activity, it is a process which continues throughout the life of
the business. Initially first budget is prepared on quarterly or yearly basis. Afterwards, when each
month passes, new month is added to the budget at it end
EXAMPLE
A company has prepared the following fixed budget for the coming year.
  Sales 10,000 units
  Production 10,000 units
                                                                     $

 Direct materials                     50,000

 Direct labour                          25,000
 Variable overheads               12,500
 Fixed overheads                    10,000

  Total                                            97,500

 Budgeted selling price $10 per unit.

 At the end of the year, the following costs had been incurred for the actual production of 12,000
units.

                            $

 Direct materials                    60,000

 Direct labour                         28,500
 Variable overheads               15,000
 Fixed overheads                   11,000

                                                    114,500

 The actual sales were 12,000 units for $122,000

 (a) Prepare a flexed budget for the actual activity for the year
 (b) Calculate the variances between actual and flexed budget(Use a marginal costing approach)
 (C) Prepare a statement that reconcile the budgeted profit and actual.

Solution
 
 
Unit
Details Fixed Budget Flexed Budget Actual Variance
cost

Units 10,000 12,000 12,000

Sales 100,000 10 120,000 122,000 2,000

Direct materials 50,000 5 60,000 60,000 -

Direct Labour 25,000 2.5 30,000 28,500 1,500

Variable overhead 12,500 1.25 15,000 15,000 -

Contribution 12,500 15,000 18,500

Fixed cost 10,000 10,000 11,000 (1,000)

Budgeted Profit 2,500 5,000 7,500 2,500

 
c)
Original budgeted profit                                                  12,500
Sales volume variance (2000 x 1.25)                               2,500 F
                                                                                         15,000
Sales price variance                                                           2,000 F
Labour variance                                                                 1,500 F
Actual contribution                                                              18,500
Fixed costs:
Budgeted                                                       10,000
Variance                                                         1000 F          11,000
Actual profit                                                                         7,500
 
METHOD OF BUDGETING
Incremental budgeting

 This approach is to take the previous years results and then to adjust them by an amount to cover
inflation and any other known changes.
 It is the most common approach, is a reasonably quick approach, and for stable companies it tends to
be fairly accurate.
 However, one large potential problem is that it can encourage the continuation of previous problems
and inefficiencies.

Zero-based budgeting

 With zero-based budgeting we do not consider the previous period. Instead, we consider each activity
on its own merits and draw up the costs and benefits of the different ways of performing it (and
indeed whether or not the activity should continue).


Activity based budgeting:

 Activity based budgeting is the approach based on data available for activity based costing. This
approach is different from all above approaches in the way it is the budgeting based on activities.
Other budgets concentrate on cost and revenue while ABB is focused on the activities of the business
operations.

 
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5.3 Cash Budget

The cash budget represents a detailed plan of future cash flows and is composed of four
elements: cash receipts, cash payments, net change in cash for the period, and new financing
needed.
It is helpful for us to know how to prepare the cash budget because:

 it is a key budget; most economic aspects of a business are reflected in cash sooner or later, so that
for a typical business the cash budget reflects the whole business more than any other single budget;
 Very small, unsophisticated businesses (for example, a corner shop) may feel that full scale budgeting
is not appropriate to their needs, but almost certainly they should prepare a cash budget as a
minimum.

Since budgets are documents that are to be used only internally by a business, their style is a
question of management choice and will vary from one business to the next.
However, since managers, irrespective of the business, are likely to be using budgets for similar
purposes, some consistency of approach tends to be found. In most businesses the cash budget
will probably possess the following features:

1. the budget period would be broken down into sub-periods, typically months;
2. the budget would be in columnar form, with one column for each month;
3. receipts of cash would be identified under various headings and a total for each month’s receipts
shown;
4. payments of cash would be identified under various headings and a total for each month’s payments
shown;
5. the surplus of total cash receipts over payments, or of payments over receipts, for each month would
be identified;
6. the running cash balance would be identified. This would be achieved by taking the balance at the
end of the previous month and adjusting it for the surplus or deficit of receipts over payments for the
current month.

Typically, all of the pieces of information in points 3) to 6) in the above list would be useful to
management for one reason or another.
 
You may go through the following example in order to help you understand this topic.
 
Example
Bwalya Ltd is a wholesale business. The budgeted income statements for each of the next six
months are as follows:
                                             Jan                    Feb                    Mar                  Apr
May                  Jun
                                    K000               K000               K000               K000               K000            
K000
Sales revenue             52                    55                    55                    60                    55               53
Cost of goods sold      30                    31                    31                    35                    31               32
Salaries & wages        10                    10                    10                    10                    10               10
Electricity                     5                      5                      4                      3                      3                 3
Depreciation                3                      3                      3                      3                      3                 3
Other overheads         2                      2                      2                      2                      2                  2
Total expenses            50                    51                    50                    53                    49                50
Net profit                      2                      4                      5                      7                      6                  3
The business allows all of its customers one month’s credit (this means, for example, that cash
from January sales will be received in February). Sales revenue during December totalled
K60,000.The business plans to maintain inventories at their existing level until sometime in
March, when they are to be reduced by K5,000. Inventories will remain at this lower level
indefinitely. Inventories purchases are made on one month’s credit. December purchases totalled
K30,000. Salaries, wages and ‘other overheads’ are paid in the month concerned. Electricity is
paid quarterly in arrears in March and June. The business plans to buy and pay for a new
delivery van in March. This will cost a total of K15,000, but an existing van will be traded in for
K4,000 as part of the deal. The business expects to have K12,000 in cash at the beginning of
January.
 
Solution
The cash budget for the six months ending in June will look as follows:
                                                        Jan            Feb               Mar             Apr          
May       June
                                             K000         K000          K000           K000          K000      K000
Cash Receipts
Receivables (Note 1)             60             52               55                 55              60          55
Cash Payments
Payables (Note 2)                   30            30               31                 26               35        31
Salaries and wages                 10            10              10                 10               10        10
Electricity                                  –              –               14                   –                 –          9
Other overheads                     2                2                 2                   2                 2          2
Van purchase                          –                –                11                  –                 –          –
Total payments                     42               42              68                 38               47        52
Cash surplus                           18              10              (13)               17                13        3
Opening balance
(Note 3)                                   12               30               40                27                44        57
Closing balance                      30               40               27                44                57        60
Notes:

1. The cash receipts from trade receivables lag a month behind sales because customers are given a
month in which to pay for their purchases. So, December sales will be paid for in January and so on.
2. In most months, the purchases of inventories will equal the cost of goods sold. This is because the
business maintains a constant level of inventories. For inventories to remain constant at the end of
each month, the business must replace exactly the amount that has been used. During March,
however, the business plans to reduce its inventories by K5,000.This means that inventories
purchases will be lower than inventories usage in that month. The payments for inventories purchases
lag a month behind purchases because the business expects to be allowed a month to pay for what it
buys.
3. Each month’s cash balance is the previous month’s figure plus the cash surplus (or minus the cash
deficit) for the current month. The balance at the start of January is K12,000 according to the
information provided earlier.
4. Depreciation does not give rise to a cash payment. In the context of profit measurement (in the
income statement), depreciation is a very important aspect. Here, however, we are interested only in
cash.

5.4 Standard Costing and Variance

analysis
STANDARD COSTING AND VARIANCE ANALYSIS

 In the previous chapter we stated that one important use that is made of budgets is that of controlling.
As the company progresses through the year, the budget gives us something to which we can
compare the actual results in order to help identify any problems. Having identified problems we can
then investigate as to whether or not these problems can be controlled in the future.
 In this chapter we will look at the setting of standard costs for these purposes and also look at the
calculations of variances (or differences) between actual and budgeted results

STANDARD COST

 Standard costing is a system of accounting based on pre-determined costs and revenue per unit which
are used as a benchmark to assess actual performance and therefore provide useful feedback
information to management

STANDARD COST CARD

 Standard cost card for Product X

                                                                              $ per unit
Sales price                                                   100

 Materials   (2 kg @ $20/kg )                  40

 Labour (1.5 hrs @ $2/hr )                       3
 Variable o/h (1.5 hrs @ $6/hr)                 9
 Fixed o/h (1.5 hrs @ $10/hr)                 15

Standard cost of production                         67

Standard profit per unit                                33
VARIANCE ANALYSIS
The actual results achieved by an organisation will, more than likely, be different from the
expected results (the expected results being the standard costs and revenues). These differences
are called variances (which is the difference between an actual result and an expected result).
The process by which the total difference between standard and actual results is analysed is
referred to as variance analysis.
For this course, we are going to cover the following variance:

 sales volume variance = difference between budgeted and actual volume (in units) multiplied by the
contribution per unit;
 sales price variance = difference between actual sales revenue and actual volume at the budgeted
sales price per unit;
 direct materials usage variance = difference between actual usage and budgeted usage, for the
actual volume of output, multiplied by the budgeted material cost per unit of material;

 direct material price variance = difference between the actual material cost and the actual usage
multiplied by the budgeted cost per unit of material;

 direct labour efficiency variance = difference between actual labour time and budgeted time, for the
actual volume of output, multiplied by the budgeted labour rate;
 direct labour rate variance = difference between the actual labour cost and the actual labour time
multiplied by the budgeted labour rate;
 fixed overhead spending variance = difference between the actual and budgeted spending on fixed
overheads.

 
Possible reasons for variances                                                        
Material price    
Favorable:

 Unforeseen discounts received

 Greater care in purchasing
 Change in material standard

Adverse:

 Price increase
 Careless purchasing
 Change in material standard

Material usage variance

Favorable:
 Material used of higher quality than standard
 More effective use made of material

Adverse:

 Errors in allocating material to jobs

 Defective material
 Excessive waste
 Theft
 Stricter quality control
 Errors in allocating material to jobs

Labour rate variance

Favorable

 Use of workers at a rate of pay lower than standard

 Wage rate increase

Adverse

 Idle time Possible if idle time has been built into the budget
 Machine breakdown
 Non-availability of material
 Illness or injury to worker

Labour efficiency variance

Favorable:

 Output produced more quickly than expected, because of work motivation, better quality of
equipment or materials, better learning rate
 Errors in allocating time to jobs
 Adverse:
o Lost time in excess of standard allowed
o Output lower than standard set because of lack of training, sub-standard material etc
o Errors in allocating time to jobs

                                                                                                                                                    
Overhead expenditure variance
Favorable:

 Savings in costs incurred

 More economical use of services

Adverse:

 Increase in cost of services

 Excessive use of services
 Change in type of services used

 
Overhead volume variance
Favorable:

 Production or level of activity greater than budgeted.

Adverse:

 Production or level of activity less than budgeted

 
Fixed overhead capacity
Favorable:

 Production or level of activity greater than budgeted

Adverse

 Production or level of activity less than budgeted

 
Selling price variance
Favorable:

 Unplanned price increase

Adverse:

 Unplanned price reduction

Sales volume variance

Favorable:

 Additional demand

Adverse:

 Unexpected fall in demand

 Production difficulties
Click here for additional reading

UNIT 6: COST OF CAPITAL AND

INVESTMENT APPRAISAL
By the end of this unit, student should be able to:

1. explain the nature and importance of investment decision making;

2. identify the four main investment appraisal methods used in practice;
3. use each method to reach a decision on a particular practical investment opportunity;

1. discuss the attributes of each of the methods;

2. Discuss the various sources of finance

6.1 Sources of Finance

You may be aware that source of short term finance refers to money that is needed for financial
activities carried out for less than one year. These funds are usually used for day to day
operations such as payment of wages, inventory ordering, advertisement expenses and so on.
SHORT-TERM SOURCES OF FINANCE

1) Bank Overdraft
As you know, an overdraft is a temporary source of funds that can be provided by your bank
(through your bank account). Overdraft is a facility which allows your business to withdraw
from the current account exceeding the available cash balance. Your company will be charged
interest based on amount overdrawn and the length of time overdrawn. When your company
customer has an overdraft facility, and the account is always in overdraft, then it has a solid core
overdraft. A commitment fee will be charged for using the overdraft facility. There are some
advantages and disadvantages of bank overdraft.
Advantage

 Flexibility is the main advantage of this source. Banks have flexibility to adjust the level of overdraft
facility. This means that it allows the business to arrange special payments.
 Overdrafts can be arranged relatively quickly and interest is only paid when the account is
overdrawn.

 
 
Disadvantages

 In the short time, overdraft’s interest can be fairly high rates especially for small companies. If the
money cannot be paid back on time, business faces large charges because of high interest rates.
 In addition, most times, overdrafts need to be secured on business assets and this put the assets at
risk, in case business cannot meet repayments.
 Overdrafts are normally repayable on demand.

2) Short term Bank loans

A term loan is a loan for a fixed amount for a specified period (normally less than one year). You
will find that it is drawn in full at the beginning of the loan period and repaid at a specified time
or in defined instalments. Bank loans are very flexible. They can vary in the length of time that
the loan has to be repaid. You will find that term loans are offered with a variety of repayment
schedules. Often, the interest and capital repayments are predetermined.
 
Calculation of repayments on a loan
We can use the annuity table to calculate the repayments on a loan.
For example, a K30, 000 loan is taken out by a business at a rate of 12% over 5 years. What will
be the annual payment?
The annuity factor for 12% over 5 years is 3.605. Therefore K30,000 = 3.605 x annual payment.
 
Annual payment = K30, 000 ÷ 3.605
 = K8, 321.78
Example
A loan of K100, 000 is to be repaid to the bank in equal annual year-end instalments made up of
capital repayments and interest at 9% pa.
 
The annual payment   = K100, 000 ÷ 3.890
=K25, 707
Each payment can then be split between the repayment of capital and interest.
 
Year    Balance b/f      Interest @ 9%                          Annual payment           Balance c/f
K                     K                                 K                                 K
1          100,000                        9,000                           (25,707)                      83,293
2          83,293                         7,496                           (25,707)                      65,082
3          65,082                         5,857                           (25,707)                      45,232
4          45,232                         4,071                           (25,707)                      23,596
5          23,596                         2,111*                           (25,707)                      -
 
* Rounding difference
Disadvantage

 As with any other form of loan there are interest payments to be made and this can be expensive and
also can vary.

Advantages

 For the bank, It makes monitoring and control of the advance much easier i.e the bank can see
immediately when the customer is falling behind with his repayments or struggling to make the
payments.
 The customer knows what he will be expected to payback at regular intervals and the bank can
forecast its future income with more certainty (depending on whether the interest rate is fixed or
floating)
 The customer does not have to worry about the bank deciding to reduce or withdraw an overdraft
facility before he is in a position to repay what is owed.

 
3) Trade credit
This is a period of time that may be given to your company to pay for goods that you have
received. It is often 30 to 90 days but some companies might not pay for 6 months and on some
occasions even a year after they have received goods. It’s an interest free short term loan.
However it is important to take into account the loss of discounts your suppliers may offer for
early payments. Unacceptable delays in payment will worsen a company’s credit rating and
additional credit may become difficult to obtain.
 
4) Leasing Finance

As you may recall from the previous unit, leasing is a kind of hiring agreement between lessor
and your company (lease) for items that you may not afford (e.g. vehicles, machinery) in one go.
You company pays the leasing company each month a specified amount, although the company
doesn’t actually own an item. Length of a lease contract time depends on details of product, such
as cost and usable life.
Lease agreements can be of benefit to the firm for the following reasons:

 It can be cheaper to arrange a lease rather than having to buy equipment outright
 Leases can be very flexible - equipment might only be needed for a short time or for a particular
project and so does not warrant being bought outright.
 The company that owns the equipment, machinery or vehicles is responsible for the maintenance and
this can help reduce costs for the business.
 The payments made are generally fixed and will not therefore change as interest rates change. This
helps business plan more effectively.

 
5) Sale and Lease back
As you are already aware from the previous unit, sale and lease back is a form of finance. This
will depend on the value of the assets, but you may either be able to sell surplus assets (if they
have any) or perhaps sell existing assets that you use to a specialist leasing company and then
lease them back. The main advantage is that this will give you access to some capital while you
continue using the asset. However, you are then burdened with annual leasing costs. Other
drawbacks include:

 Your company will lose ownership of a valuable asset.

 The future borrowing capacity of your company will be reduced.
 Your company will also be contractually committed to occupying the property for many years.
 The real cost is likely to be high.

 
LONG-TERM SOURCES OF FINANCE
1) Equity finance
You may be aware that equity is the capital raised through the sale of shares in a company to
investors via new issue or a rights issue (sale to the existing shareholders).In other words Equity
financing essentially involves you selling an ownership interest to raise funds for your company
purposes.
There are mainly two types of shares (ownership) that you need to be aware of in this course
namely ordinary shares (or stock) and preference shares (or stock). An ordinary share represents
equity ownership in a company and entitles the owner to a vote in matters put before
shareholders in proportion to their percentage ownership in the company. Preference shares
represent ownership in a company but normally does not entitle the owner to a voting right. As a
preference shareholder you will be entitled to receive dividend before ordinary shareholders.

If you are an ordinary shareholder you will be entitled to receive dividends if any are available
after dividends on preferred shares are paid. You are also entitled to the share of the residual
economic value of the company should your company unwind. However, you are last in line
after bondholders and preferred shareholders for receiving business proceeds. As such, ordinary
shareholders are considered unsecured creditors.
Stock market listing
If you are a private company you may decide to go public and issue shares. To do so, you must
be able meet that exchange's listing requirements and pay both the exchange's entry and yearly
listing fees. Listing requirements vary by exchange and include minimum stockholder's equity, a
minimum share price and a minimum number of shareholders. Exchanges like Lusaka stock
exchange have listing requirements to ensure that only high quality securities are traded on them
and to uphold the exchange's reputation among investors.
 
  Why seek a stock market listing?
The following are reasons why your company may seek a stock market listing:
 1. a) Access to a wider pool of finance
A stock market listing widens the number of potential investors. It may also improve your
company's credit rating, making debt finance easier and cheaper to obtain.

1. b) Improved marketability of shares

Shares that are traded on the stock market can be bought and sold in relatively small quantities at
any time. Existing investors can easily realise a part of their holding.

1. c) Transfer of capital to other uses

As a Founder owner you may wish to liquidate the major part of your holding either for personal
reasons or for investment in other new business opportunities.

1. d) Enhancement of company image

Quoted companies are commonly believed to be more financially stable. A stock exchange
listing may improve the image of your company with its customers and suppliers, allowing it to
gain additional business and to improve its buying power.

1. e) Facilitation of growth by acquisition

A listed company is in a better position to make a paper offer for a target company than an
unlisted one. However, the owners of a private company which becomes a listed plc (public
company) must accept that the change is likely to involve a significant loss of control to a wider
circle of investors. The risk of the company being taken over will also increase following listing.
 
2) Venture capital funds
You may wish to know that some organisations are engaged in the creation of venture capital
funds. What happens is that these organisations raises venture capital funds from investors and
invests in management buyouts or expanding companies.
The venture capital fund managers usually reward themselves by taking a percentage of the
portfolio of the fund’s investments. Venture capital trusts are a special type of fund giving
investors tax reliefs.
 
When you decide to look for venture capital, the venture capitalist will require:

1. an equity stake in the company.

2. a convincing business plan that can be successful

 a representation on the company’s board, to look after its interests.

 
3) Debt finance
As you be aware debt instrument is a paper or electronic obligation that enables the issuing party
to raise funds by promising to repay a lender in accordance with terms of a contract. You may
also be aware of the types of debt instruments which include loan notes, bonds, certificates,
mortgages, leases or other agreements between a lender and a borrower.
Bills - debt securities maturing in less than one year.         
Notes - debt securities maturing in one to 10 years.            
Bonds - debt securities maturing in more than 10 years.
 
Type of debt instruments
a) Debenture
A debenture is a type of debt instrument that is not secured by physical assets or collateral. You
need to be aware that debentures are backed only by the general creditworthiness and reputation
of the issuer. Both corporations and governments frequently issue this type of bond in order to
secure capital. Like other types of bonds, debentures are documented in an indenture.
 
b) Bonds
A bond is a debt investment in which an investor loans money to an entity (corporate or
governmental) that borrows the funds for a defined period of time at a fixed interest rate. You
may wish to know that bonds are used by companies or governments to finance a variety of
projects and activities. Bonds are commonly referred to as fixed-income securities and Interest
on bonds is usually paid every six months (semi-annually).
c) Deep discount bonds

A bond that sells at a significant discount from par value. A bond that is selling at a discount
from par value and has a coupon rate significantly less than the prevailing rates of fixed-income
 securities with a similar risk profile.

d) Zero-Coupon Bonds  
This is a type of bond that makes no coupon payments but instead it is issued at a considerable
discount to par value. For example, let's say a zero-coupon bond with a K1,000 par value and 10
years to maturity is trading at K700; you'd be paying K700 today for a bond that will be worth
K1,000 in 10 years’ time. As a borrower you can raise cash immediately and there is no cash
repayment until redemption date.
c) Convertible bonds
This is a hybrid source of finance because it gives the holder a right to convert into equity.
Companies sometimes issue bonds or preferred stock that gives holders the option (rights and not
obligation) of converting them into common stock (ordinary shares) or of purchasing stock at
favourable prices. If you buy convertible bonds, you will have an option (rights) of converting
them into common stock at a specified price during a particular period or specific date. Existing
shares are used to carry out the conversion.

6.2 Overview of time value and cost

of capital
OVERVIEW OF TIME VALUE AND COST OF CAPITAL
The essential feature of investment decisions is time. Investment involves making an outlay of
something of economic value, usually cash, at one point in time, which is expected to yield
economic benefits to the investor at some other point in time. Usually, the outlay precedes the
benefits. Also, the outlay is typically one large amount and the benefits arrive as a series of
smaller amounts over a fairly protracted period.
 
Consider the following choice:
I offer to give you K100 now or K100 in two years’ time.
Which would you choose?
We suppose you would choose K100 now than in two years’ time.
 
Why would you see K100 to be received in two year’s time as unequal in value to K100 to
be paid immediately? (There are basically three reasons.)
 
The reasons are:

 Opportunity cost (interest lost);

 risk;
 effects of inflation

 
OPPORTUNITY COST (INTEREST LOST)
If we are to be deprived of the opportunity to spend our money for a year or two, we could
equally well be deprived of its use by placing it on deposit in a bank or building society. In this
case, at the end of the year we could have our money back and have interest as well. Thus, unless
the opportunity to invest will offer similar returns, we shall be incurring an opportunity cost. An
opportunity cost occurs where one course of action, for example making an investment deprives
us of the opportunity to derive some benefit from an alternative action, for example putting the
money in the bank.
From this we can see that any investment opportunity must, if it is to make us wealthiest, do
better than the returns that are available from the next best opportunity.
Thus, if you see that putting the money in the bank on deposit as the alternative to investment in
the machine, the return from investing in the machine must be better than that from investing in
the bank. If the bank offered a better return, the business would become wealthier by putting the
money on deposit.
 
RISK
Buying a machine to manufacture a product, or to provide a service, to be sold in the market, on
the strength of various estimates made in advance of buying the machine, exposes the business to
risk. There is uncertainty as to whether things will turn out as expected. For instance:

 The machine might not work as well as expected; it might break down, leading to loss of the service.
 Sales of the service may not be as buoyant as expected.
 Labour costs may prove to be higher than was expected.
 The sale proceeds of the machine could prove to be less than was estimated.

 
It is important to remember that the decision as to whether or not to invest in the machine must
be taken before any of these things are known. It is only after the machine has been purchased
that we could discover that the level of sales, which had been estimated before the event, is not
going to be achieved. It is not possible to wait until we know for certain whether the market will
behave as we expected before we buy the machine.
‘
Normally, people expect to receive greater returns where they perceive risk to be a factor. One
such example is that banks tend to charge higher rates of interest to borrowers whom the bank
perceives as more risky. Those who can offer good security for a loan, and who can point to a
regular source of income, tend to be charged fairly low rates of interest.
 
In practice, investors tend to expect a higher rate of return from investment projects where the
risk is perceived as being higher. How risky a particular project is, and therefore how large this
risk premium should be, are matters that are difficult to handle. It is usually necessary to make
some judgments on these questions.
 
Inflation
If we are to be deprived of K100 for a year, when we come to spend that money it will not buy as
many goods and services as it would have done a year earlier. Generally, we shall not be able to
buy as many loaves of bread as we could have done a year earlier. This is because of the loss in
the purchasing power of money, or inflation, which occurs over time. Clearly, the investor needs
this loss of purchasing power to be compensated for if the investment is to be made. This is on
top of a return that takes account of what could have been gained from an alternative investment
of similar risk.
In practice, interest rates observable in the market tend to take inflation into account. Rates that
are offered to potential building society and bank depositors include an allowance for the rate of
inflation that is expected in the future.
 
COST OF CAPITAL
A rational investor, who is seeking to increase his or her wealth, will only be prepared to make
investments that will compensate for the loss of interest and purchasing power of the money
invested and for the fact that the returns expected may not materialise (risk). This is usually
assessed by seeing whether the proposed investment will yield a return that is greater than the
basic rate of interest (which would include an allowance for inflation) plus a risk premium.
Naturally, investors need at least the minimum returns before they are prepared to invest. This
minimum expected return is normally referred to as cost of capital or cost of finance.
 The minimum return or opportunity cost of finance is influenced by the interest forgone,
inflation and risk premium as earlier discussed. This is, in effect, the cost to the business of the
finance that it will use to fund the investment, should it go ahead. This will normally be the cost
of the mixture of funds (shareholders’ funds and borrowings) used by the business and its
referred to as weighted average cost of capital (WACC). Every company has to decide its game
plan for financing the business at an early stage. The cost of capital thus becomes a critical factor
in deciding which financing track to follow. Companies are either financed by debt, equity or a
combination of the two. Companies at early-stage seldom have sizable assets to pledge as
collateral for debt financing, therefore equity financing becomes the default mode of funding for
most of them. Hence, the weighted average cost of capital is made up of cost of equity and costs
of debt.
The cost of debt is merely the interest rate paid by the company on such debt. However, since
interest expense is tax-deductible, the after-tax cost of debt is calculated as: cost of debt x (1 - T)
where T is the company’s marginal tax rate.
The cost of equity is more complicated, since the rate of return demanded by equity investors is
not as clearly defined as it is by lenders. Theoretically, the cost of equity is approximated by the
Capital Asset Pricing Model (CAPM = Risk-free rate + (Company’s Beta x Risk Premium). It
can also be approximated using the dividend growth model as given by the formula below:
Cost of equity (Ke) = D1 + g
                                  P0
Where D1= dividend per share
            P0 = Share price
            g = dividend growth
 
The cost of capital is very important as it is used as a discount rate when discounting cash flow
(see below).This is because it represents a hurdle rate that a company must overcome before it
can generate value. It is extensively used in the capital budgeting process to determine whether
the company should proceed with a project as we learn later in this unit).
 
FUTURE VALUES
 
Now, consider an investor (an owner of, or shareholder in, a company) who is evaluating an
investment opportunity requiring an immediate outlay of K10,000 and which will generate
income in subsequent years. The investor will be concerned with how much income will be
generated in the future. How much future income is required to make the investment attractive to
the investor?
 
If a decision maker is to be able to make a choice about whether to go ahead with an investment
or is to be able to rank investment opportunities where there is more than one alternative, then a
way must be found to allow money to be received at different points of time to be compared.
One way of making the comparison is to work out what the value of money to be received now
(FV0) will be at the point in the future when other money will be realised.
The formula to calculate the future value (FVt) of any sum of money at any point in the future is
given below.
 
Future value in year t = FVt = FV0 x (1+r)t
 
Where FV0 is the value now or present value (discussed below) and FVt is the future value at
time t.
 
Example
Given the cost of capital of 10%, what is the future value of K1000 after?

1. One year
2. Two years

 Four years

 
Answer
FVt = FV0 x (1+r)t
 
Year 1: FV0 = 1000 x (1+0.1)1 = 1,100
Year 2: FV0 = 1000 x (1+0.1)2 = 1,210
Year 3: FV0 = 1000 x (1+0.1)3 = 1,610
 
PRESENT VALUE
Future values are a useful concept and help to capture the principle which underlies the time
value of money. However, when considering investments or dividend decisions the decision
maker is typically faced with a stream of cash inflows and outflows, rather than just comparing
cash flows now with a single sum of money to be received or paid at some point in the future.
Therefore it is better to convert all cash flows received at different points of time to a common
reference point to allow direct comparison.
 
This simply requires a reversal of the way in which future values were calculated. We saw earlier
that K1000 now has a future value in one years’ time of K1, 100 when the cost of capital is 10%.
It, therefore, follows that K1, 100 to be received in one years’ time, when the cost of capital is
10% has a value now, or a present value, of K1000.
Similarly, K1,610 to be received in three years when the cost of capital is 10% has a present
value of K1000. The present value of a sum of money to be received in the future is calculated
by dividing them future sum by (1+r) t as follows:

Example 1
Assume you need K5, 000 next year to buy a printer. The interest rate is 10% per year. How
much money should you set aside now in order to pay for the printer?
Solution
PV = FV after t  periods
(1 + r)  t
PV = K5, 000 = K4, 545.45
                   (1+0.1)
Therefore, if you invest K4, 545.45 for a year at 10%, you will earn K5000 to buy the printer.
To prove this:
FV= 4,545.45 (1+0.1) = K5, 000
Example 2
Assume you need the printer after two years.
PV = K5, 000 = K4, 132.23
                   (1+0.1)^2
You have noticed that the longer the time before you must make a payment, the less amount you
need to invest today.
Thus you need to invest K4,545.45 today to provide K5, 000 in one year but only K4,132.23 to
provide the same K5,000 in two years
 
Taking a future sum of money and calculating its present value in this way is known
as discounting. The formula above can be used to discount any future sum to its present value. It
allows sums of money to be received at different points in time to be expressed in terms of a
common reference point.
 
It is essential to take account of the time value of money and to discount future sums to their
present value before making a financial decision. It is through the concept of present values that
decision makers can make the trade-off between money to be received at different points of time.
Crucially, failure to take account of the time value of money may well lead decision makers to
make incorrect judgements about the desirability or otherwise of financial alternatives.
To calculate the present value of an amount of money, PV, to be received t years in the future
when the discount (or cost of capital) rate is r all that is required is to divide V by (1+r)t .
 

6.3 Investment appraisal

INVESTMENT APPRAISAL
Capital Investment
We will categorise investment expenditure as capital expenditure and revenue expenditure. You
may wish to know that capital expenditure results in acquisition of non-current assets or
improvement in their earning capacity. Revenue expenditure is incurred for the purpose of
business trade and to maintain the existing earning capacity of non- current assets. In other words
investment can be in non-current assets or working capital. Investment in non-current assets
involves significant amount of time between commitment & recovery. Investment in working
capital is for a shorter period of time. We will at working capital later. Most of the forms of
investments you learn about in this course are commercial. Commercial sector investment is
generally based on financial consideration while non-profit making organisation differs.
Purpose for Capital Investment
All businesses require capital equipment (fixed assets) such as machinery, premises and vehicles.
The purchase of such assets is known as capital investment and is undertaken for the following
reasons:

 To replace existing equipment which is out-of-date or obsolete

 To expand the productive capacity of the business
 To reduce the production costs per unit (i.e. to achieve economies of scale)
 To produce new products and, therefore, break into new markets

 
 
 
The investment decision making process

1. Project Generation:

Investment proposals of various types may originate at different levels within a firm. As
discussed above the investment proposals may fall into one of the following categories:

1. (a) Proposals to add new product to the product line.

(b) Proposals to expand capacity in existing product lines.

2. Proposals designed to reduce costs in the output of existing products without altering the scale of
operation.

You will find that the investment proposals of any type can originate at any level from top
management level to the worker’s level. The proposal may originate systematically or
haphazardly. In view of the fact that enough investment proposals should be generated to employ
the firm’s funds fully well and efficiently, a systematic procedure for generating proposals must
be evolved. Mostly you will find that the healthy firm is the one in which there is a continuous
flow of profitable investment proposals.

1. Project Evaluation:

Project evaluation involves two steps:

(a) Estimation of benefits and costs. The benefits and costs must be measured in terms of cash
flows, and
(b) Selection of an appropriate criterion to judge the desirability of the projects.
The evaluation of products should be performed by a group of experts. All care must be taken in
selecting a criterion to judge the desirability of the projects. The various desirability criteria
include the:

1. traditional methods (pay back method and accounting rate of return method)
2. discount cash flow criteria (net present value method ,internal rate of return method and probability
index method)

As far as possible the criterion selected must be consistent with the firm’s objective of
maximising its market value.

 Project Selection:

You will find that there are no standard administrative procedures that can be laid down for
approving the investment proposal. The screening and selection procedures would differ from
firm to firm. However, projects are screened at multiple levels within an organisation. You will
select the project based the criterion set in (ii) above.

1. Project Execution:

Finally you will need to appropriate funds for capital expenditure after the final selection of
investment proposal. The formal plan for the appropriation of funds is called the capital budget.
You also need systematic procedures that should be developed to review the performance of
projects during their life and after completion. The follow up comparison of actual performance
with original estimates not only ensures better forecasting but also helps to sharpen the
techniques for improving future forecasts.
IMPORTANCE OF INVESTMENT DECISIONS
 
Investment decisions tend to be of crucial importance to the business because:
 
Large amounts of resources are often involved. Many investments made by businesses involve
laying out a significant proportion of their total resources. If mistakes are made with the
decision, the effects on the businesses could be significant, if not catastrophic.
 
It is often difficult and/or expensive to ‘bail out’ of an investment once it has been undertaken.
 
It is often the case that investments made by a business are specific to its needs. For example, a
hotel business may invest in a new, purposely-designed hotel complex. The specialist nature of
this complex will probably lead to it having a rather limited second-hand value to another
potential user with different needs. If the business found, after having made the investment, that
room occupancy rates were not as buoyant as was planned, the only possible course of action
might be to close down and sell the complex. This would probably mean that much less could be
recouped from the investment than it had originally cost, particularly if the costs of design are
included as part of the cost, as they logically should be.
 

6.4 Investment Appraisal Techniques

METHOD OF INVESTMENT APPRAISAL

PAYBACK PERIOD
The pay back technique measures the length of time the project takes to pay back the initial cost
for the project. The period is counted as 1 full year where the entire cash flow is used to pay back
towards the capital, while in the year a portion is required to complete the full payment , this
fraction is multiplied with 12months.
                  
Acceptance/Rejection Rule:
Projects with shorter payback periods are accepted over those with longer payback periods.
 
Example
Kaka Ltd is evaluating two new project A and B. The company has determined that the after-tax
cash flows for:

 project A will be 400; 400; 400; 400 respectively, for each of the Years 1 through to year 4. The
initial cash outlay will be K1,000
 project B will be 600; 400; 200; nil respectively, for each of the Years 1 through to year 4. The initial
cash outlay will be K1,000

Find the Payback period for Project A and B?

 
Solution
Year               Project A        Balance         Project B                   Balance
 
0                      (1000)            (1000)                        (1000)             (1000)            
1                      400                  (600)                           600                  (400)
2                      400                  (200)                           400                  0
3                      400                  200                              200
4                      400                                                      nil
 
Payback          2.5 years                                             2 years
 
2.5 years is worked as follows 400+400=800 so we need only 200 out of 400 from year 3 to
make or pay back K1000. Therefore 200/400=0.5
2+ 0.5=2.5 years. Or you can say 0.5*12 months, which is 2 years, 6 months.
Note: In a discounted payback model the cash flows will first be discounted to take into
account the time value of money this is more superior to the non discounted method.
 
Payback could may occur during a year and you can take account of this by reducing the cash
inflows from the investment to days, weeks or years
            Days/Weeks/Months x Initial Investment
   Payback = ------------------------------------------
                              Total Cash Received
Example
A company procures a machine at a cost of K600, 000. It produces items that generate a profit of
K4.25 per unit on a production run of 60,000 units per year for three years.
Payback = 36 x 600,000/765,000
= 28.23 months
(2 years, 6¾ months)
 
Advantages:

1. Payback period is simple and easy to understand as well as to compute.

2. Payback period is universally used and easy to understand.
3. Payback period gives more importance on liquidity for making decision about the investment
proposals.
4. Payback period deals with risk. The project with a shortest PBP has less risk than with the project
with longest PBP.
5. Payback period is used as a screening tool in capital expenditure which is an added advantage.

Disadvantages:

1. In the calculation of payback period, time value of money is not recognized.

2. Payback period gives high emphasis on liquidity and ignores profitability.
3. Only cash flow before the payback period is considered. Cash flow that occur after the PBP is not
considered.
4. Payback period ignores the size of the project and timing of cash flows
5. The Cutoff period is subjective

 
ACCOUNTING RATE OF RETURN (ARR)
 
ARR= (Sum of profits & (losses))/project life
                         (Initial cost + salvage value)/2

 ARR is the average accounting profits & losses divided by its Average investment. An alternative

is to use the initial cost of investment.
 Accept/ Rejection Rule
 If the company target rate is less than the computed accounting rate we accept the project,
otherwise reject the project.

 
 
 
Example
A company has the following profits from a project over a five year period; K2000, K1500,
K2200, K1200 and K4000. The initial investment is K20, 000.The Company’s target accounting
rate is 19%.Find the ARR.
 
ARR = Average account profits /average investment
Average account profits = (2000+1500+2200+1200+4000)/5 = K2180
 Average investment = initial cost +salvage value
                                      = (20,000+0)/2 = K10000
ARR = K2180/K10,000 *100% = 21.8%
Can this project be Accepted or Rejected?
The project is  acceptable  since its ARR is    
    above the company’s target of 19%.
 
Advantages of ARR

1. Like payback period, this method of investment appraisal is easy to calculate.

2. With ARR the Needed information will usually be available
3. It recognizes the profitability factor of investment.

Disadvantages of ARR

1. It ignores time value of money. Suppose, if we use ARR to compare two projects having equal initial
investments. The project which has higher annual income in the latter years of its useful life may rank
higher than the one having higher annual income in the beginning years, even if the present value of
the income generated by the latter project is higher.
2. It can be calculated in different ways as indicated above. Thus there is problem of consistency.
3. It uses accounting profit rather than cash flow information. Thus it is not suitable for projects which
have high maintenance costs because their viability also depends upon timely cash inflows.

 
NET PRESENT VALUE (NPV)
Net present value of a project is the potential change in an investor's wealth caused by that
project while time value of money is being accounted for. The NPV method compares the
present value of future cash flows from a given project with the initial cost of the project. The
future cash flows are discounted first at the firms cost of capital or required rate of return, so that
they are compared at their present value taking into consideration the time factor. The difference
between the cost and the present value of the future cash flows is the NPV. It can be positive or
negative.
The rule is that we accept projects with positive NPVs and reject those with negative NPVs.
With mutually exclusive projects, select project with highest NPV.
Advantages:

 Takes account of time value of money.

 Uses cash flow rather that accounting profit which is subjective.
 Takes account of all relevant cash flows over life of project.
 Can take account of conventional and non-conventional cash flows, as well as changes in discount
rate during project
 Gives absolute measure of project value.

 
DISADVANTAGES

 Project cash flows may be difficult to estimate (but applies to all methods).
 Accepting all projects with positive NPV only possible in a perfect capital market.
 Cost of capital may be difficult to find.
 Cost of capital may change over project life,rather than being constant.

 
Example
A firm expects the following stream of cash flows from its project of K500, 000 per annum for 5
years. The projects’ initial costs are K1.0 million and company’s cost of capital is 10%.
Determine whether the company should take this project or not using NPV?
Solution
 
Year   Cash flow(K) DCF 10%                  Present Value
0          (1000, 000)         1.0000                    (1,000,000)
1          500,000                       0.9091                  454,550                 
2          500,000                       0.8264                   413,200
3          500,000                       0.7513                  375,650
4          500,000                       0.6830                  341,500
5          500,000                       0.6209                  310,450
                                                              +NPV   895,350
 
The project yields a positive NPV hence the company should accept this project.
Note: when cash flows form an annuity you can use the present of annuity to discount the five
year cash flows. The result should be the same.
 
Year   Cash flow (K)   DCF 10%        Present Value
0               (1000, 000) 1.0000                   (1,000,000)
1-5       500,000           3.7908                    1,895,400
                                                                     ----------
                                      +NPV                   895,400
 
PROFITABILITY INDEX
 
Example
Musonda is evaluating a new project for his firm, MJ Inc. A firm expects the following stream of
cash flows from its project of K500,000 per annum for 5 years. The projects’ initial costs are
$1.5 million. Find the PI When evaluating the discount rate is 10%?
 
Solution
Year           Cash flow($)         DCF 10%   Present Value
0              (1,500, 000)          1.0000                     (1,500,000)      
1-5              500,000              3.7908                         1,895,400
                                                                       
The PI for this project is 1,895,400/ 1,500, 000
PI = 1.2636
 
Yes The PI is More than 1.00. This means that the project is profitable. [Accept as PI >1.00]
 
Advantages of profitability index:

1. Just like NPV, PI considers the time value of money.

2. Just like NPV, PI considers analysis of all cash flows of the project entire life.
3. PI considers the size of the project
4. PI ascertains the exact rate of return of the project because it uses cash flows.
5. PI is easy to understand and communicate to non-financial managers

Disadvantages  of Profitability Index (PI)

1.
Just like the NPV, It is difficult to estimate the discount rate.

2. It is difficult to calculate profitability index if two projects having different useful life. Therefore, it
may not give a correct decision when used to compare mutually exclusive projects.

 
 
INTERNAL RATE OF RETURN
 
IRR is the discount rate that equates the present value of the future net cash flows from an
investment project with the project’s initial cash outflow (ICO). In short its rate at which the
NPV is zero.
 
ICO =      CF1     +   CF2          +…      CFt 
         1+ IRR)1     (1 + IRR)2           (1 + IRR)t
 
This means that to get an NPV of Zero the initial cost should exactly equal to the present value
of the future cash flows. In other words the project breaks even. The IRR represent the minimum
rate of return that a project would yield.
Accept /rejection Rule:
A firm should accept all projects that have an IRR which is greater than the company’s cost of
capital and reject those that have an IRR which is less than the company’s cost of capital or
required rate of return
To illustrate the idea behind the IRR,
Example 1
Consider a project that costs K100 today and pays K110 in one year. Suppose you were asked,
‘What is the IRR on this investment?
Solution

NPV= 0
0= K-100 + 110/1+IRR
K100 = 110/1+IRR
IRR = 10%
The fact that IRR is simply the discount rate that makes the NPV equal to Zero is important
because it tells us how to calculate returns on more complicated investments. As we have seen
finding IRR turns out to be relatively easy for a single period investment. However, suppose you
were looking at an investment with more than one cash flow. How would you find the IRR?
Example
Suppose an investment costs K100 and has cash flows K60 per year for two years. Find the IRR?
However based on what we know we can set the NPV equal to Zero and solve for the discount
rate

• NPV = 0 = -K100 + [60/(1+IRR)] + [60/(1+IRR)2]

You will find that to solve for IRR might be complicated and therefore we use the formula given
below:
Example
Musonda is evaluating a new project for his firm, MJ Inc. A firm expects the following stream of
cash flows from its project of K500,000 per annum for 5 years. The projects’ initial costs are
K1.5 million.
When evaluating the NPV at the rate of 10% and 32 % they found the following values:
Year       Cash flow(K)        DCF 10%           Present Value
0           (1,500, 000)         1.0000                (1,500,000)
1- 5           500,000           3.7908                 1,895,400
                                                                      ----------
                                        +NPV                    395,400
Year       Cash flow (K)    DCF 32%           Present Value
0           (1500, 000)        1.0000               (1,500,000)
1-5          500,000            2.3452                1,172,600
                                                                     ----------
                                       -NPV                    (327,400)
Evaluate the Internal Rate of return (IRR)?
Solution

IRR = 10% +    395,400                 x (32% -10%)

                       (395,400 +327,400)

       = 22.03%
Advantages:
1. It is closely related to NPV and results in the same decision.
2. It is easy to understand and communicate even to non-financial managers
3. It takes into accounts the time value of money
4. It uses cash flows rather than accounting profits and therefore provides a correct return.
Disadvantages:
.
1. Difficulties with project rankings and Multiple IRRs -A problem if applying IRR to projects
with non-conventional cash flows is that multiple IRRs may be found: NPV will give you correct
selection advice.
2. NPV can accommodate changes in discount rate during project, but IRR ignores them.
3. NPV method assumes that cash flows can be reinvested at a rate equal to the cost of capital:
IRR method assumes that cash flows can be reinvested at rate equal to IRR which is practically
not possible.
4. In the case of capital rationing, it may not give you value-maximizing selection decision
5. It may not give you value-maximizing decision when compare two mutually exclusive
projects.
 
NPV & IRR COMPARED
• The main advantage of IRR method is that the information it provides is more easily
understood by Managers especially non-financial managers. However, managers may confuse
IRR and accounting return on capital employed (ROCE)
• IRR can produce multiple IRRs if non-conventional cash flows are present and could lead to
serious errors in the decision of whether to accept or reject a project. This is not the case with
NPV.
• When you are faced with mutually exclusive projects, IRR and NPV may give conflicting
rankings as to which projects should be given priority. The NPV method should be preferable.
However, this would be irrelevant for independent projects since both methods can give the same
decision
• Assumption underlying the NPV method is that any net cash inflows generated during the life
of the project will be reinvested at the cost of capital while IRR assumes that cash flows will be
reinvested to earn a return equal to the IRR of the original project. The assumption behind NPV
is more realistic. The reinvestment assumption underlying the IRR method cannot be
substantiated
You may need to know the following Project Relationships:
• Dependent – A project whose acceptance depends on the acceptance of one or more other
projects.
• Independent – A project whose acceptance (or rejection) does not prevent the acceptance of
other projects under consideration.
• Mutually Exclusive – A project whose acceptance precludes (prevents) the acceptance of one or
more alternative projects.
 
STANDARD FORMAT FOR NPV
Year Year Year Year Year
                                                                   0                  1               2              3                      4
Sales receipts                                                                 X              X              X                      X
Costs                                                                             (X)             (X)           (X)                    (X)
Sales less Costs                                                             X               X              X                      X
Taxation                                                                         (X)            (X)            (X)                   (X)
Capital expenditure                                    (X)
Scrap value                                                                                                                             X
Working capital                                          (X)                                                                         X
Tax benefit of
tax depreciation                                        ___              _ X__        _ X__        _ X__            _ X__
Net cash flow                                            (X)                  X               X               X                  X
Discount factors
(Post-tax cost of capital)                                              _X__            _X__        _ X__         _ X__
Present value                                           (X)               X____           X___        X____          X
NPV is the sum of present values
 
Click here for additional reading
 
 

UNIT 7: DIVIDEND POLICY

By the end of this unit, students should be able to:
i. Explain the basic concept of dividend policy
ii. Explain the factors that affect dividend policy decisions
iii. Explain the types of dividend policy

7.1 Basic concept of dividend policy

The primary objective of business is to maximise shareholders wealth. Since, in theory, the value
of shares is heavily dependent on future expected dividends, it is important to consider the
dividend policy of the company and the effect this may have on shareholders expectations.
Dividend irrelevance theory
Modigliani and Miller argued that the level of dividend is irrelevant and that is simply the level
of profits that matters. In an efficient market, dividend irrelevancy theory suggests that, provided
all retained earnings are invested in positive NPV projects, existing shareholders will be
indifferent about the pattern of dividend payouts.
Their logic was that it is the level of earnings that determines the dividends that the company is
able to pay, but that the company has the choice as to how much to distribute as dividend and
how much to retain for expansion of the company.
A large dividend will result in little future growth whereas a smaller dividend (and therefore
more retention) will result in more growth in future dividend. It is expected future dividends that
determine the share price and therefore the shareholders should be indifferent between the
alternatives outlined above. As a result, the company should focus on improving earnings rather
than worry about the level of dividends to be paid.
3 Practical influences on dividend policy
However, practical influences, including market imperfections, mean that changes in dividend
policy, particularly reductions in dividends paid, can have an adverse effect on shareholder
wealth:
(a) the signalling effect
If a company reduces a dividend then there is a danger that it will worry the shareholders, even if
it results from increased retention and not from a fall in earnings. The danger is that whatever
information is given to shareholders about the reasons, their immediate reaction might be to
assume that the company is performing badly. If this is their reaction then they will reduce their
future expectations with an adverse effect on the share price. Similarly an increase in the
dividend payment may serve to increase their future expectations even if it results simply from a
reduction in retention rather than an increase in earning.
(b) Liquidity preference
Some shareholders invest for income and others for capital growth. If they require income then
they will choose to invest in companies that have a record of high dividend payments whereas if
they prefer growth then they will choose companies that have a record of lower dividends but
more retention and expansion.
If, for example, an investor requires income and has therefore chosen a company paying high
dividends, they are going to be unhappy if the company changes its policy and starts to retain a
higher proportion of earnings.
Modigliani and Miller counter this by saying that since the expansion should increase the share
price then shareholders needing cash can always sell some of the shares to recoup the fall in
dividends. This is fine in theory, but ignores transaction costs and also the fact that shareholders
can argue that their company should pay them their cash directly and not ‘force’ them to start
selling shares.
(c) taxation
As stated already, the basic choice is between high dividends with low capital growth, or low
dividends with high capital growth. Dividend income is taxed differently from capital gains and
therefore the tax position of the investors can influence their preference.

7.2 Factors affecting dividend policy

decisions
Legal position
Many countries will place legal restrictions on the amount of dividend that can be paid out
relative to a company's earnings.
In addition, governments have operated policies of dividend restraint over various periods.
Profitability
Profit is obviously an essential requirement for dividends. All other things being equal, the more
stable the profit the greater the proportion that can be safely paid out as dividends. If profits are
volatile it is unwise to commit the firm to a higher dividend payout ratio.
Inflation
In periods of inflation, paying out dividends based on historic cost profits can lead to erosion of
the operating capacity of the business. For example, insufficient funds may be retained for future
asset replacement. Current cost accounting recalculates profit taking into consideration inflation,
asset values and capital maintenance. Firms would then ensure that the dividend is limited to the
CCA profit.
Growth
Rapidly growing companies commonly pay very low dividends, the bulk of earnings being
retained to finance expansion.
Control
The use of internally generated funds does not alter ownership or control. This can be
advantageous particularly in family owned firms.
Liquidity
Sufficient liquid funds need to be available to pay the dividend.
Tax
The personal tax position of investors may put them in a position of preferring either dividend
income or capital gains though growing share prices. If the clientele of investors in the company
have a clear preference for one or the other, the company should be wary of altering dividend
policy and upsetting investors.
Other sources of finance
If a firm has limited access to other sources of funds, retained earnings become a very important
source of finance. Dividends will therefore tend to be small. This situation is commonly
experienced by unquoted companies that have very limited access to external finance
These factors limit the 'dividend capacity' of the firm.
Dividend capacity
This can be simply defined as the ability at any given time of a firm's ability to pay dividends to
its shareholders. This will clearly have a direct impact on a company's ability to implement its
dividend policy (i.e. can the company actually pay the dividend it would like to).
Legally, the firm's dividend capacity is determined by the amount of accumulated distributable
profits.
However, more practically, the dividend capacity can be calculated as the Free Cash Flow to
Equity (after reinvestment), since in practice, the level of cash available will be the main driver
of how much the firm can afford to pay out.

7.3 Types of Dividend Policy

In practice, there are a number of commonly adopted dividend policies:
• stable dividend policy
• constant payout ratio
• zero dividend policy
• residual approach to dividends.
Stable dividend policy
Paying a constant or constantly growing dividend each year:
• offers investors a predictable cash flow
• reduces management opportunities to divert funds to non-profitable activities
• works well for mature firms with stable cash flows.
However, there is a risk that reduced earnings would force a dividend cut with all the associated
difficulties.
 
Constant payout ratio
Paying out a constant proportion of equity earnings:
• maintains a link between earnings, reinvestment rate and dividend flow but cash flow is
unpredictable for the investor
• gives no indication of management intention or expectation.
Zero dividend policy
All surplus earnings are invested back into the business. Such a policy:
• is common during the growth phase when growth opportunities are exhausted (no further
positive NPV projects are available):
• should be reflected in increased share price.
• cash will start to accumulate and a new distribution policy will be required.
Residual dividend policy
A dividend is paid only if no further positive NPV projects available. This
may be popular for firms:
• in the growth phase
• without easy access to alternative sources of funds.
However:
• cash flow is unpredictable for the investor
• gives constantly changing signals regarding management expectations.
Ratchet patterns
Most firms adopt a variant on the stable dividend policy – a ratchet pattern of payments. This
involves paying out a stable, but rising dividend per share:
• Dividends lag behind earnings, but can then be maintained even when earnings fall below the
dividend level.
• Avoids ‘bad news’ signals.
• Does not disturb the tax position of investors.
4 Practical dividend policy
In practice there is a tendency for companies to do two things in relation to dividends:
(a) to aim for a steady pattern of dividends e.g. to have a policy of increasing dividends by 5%
p.a.. This enables investors to choose the companies whose dividend policy they prefer, and
avoids the signalling problem.
Clearly, the company can only maintain 5% growth in the long-term provided that they can
achieve the same earnings growth. Therefore they follow a policy that they think is achievable
and trust that years where earning grow in excess of 5% will fund years where earnings grow at
less than 5%. They do however leave themselves open to a dramatic ‘signalling’ problem if they
ever are forced to deviate from their stated policy.
(b) scrip dividends
a very common practice in recent years has been to offer investors the choice between taking
dividends in cash or in shares. This overcomes the ‘liquidity preference’ problem by allowing
each shareholder to choose whichever is best for them.
The advantage to the shareholder of a scrip dividend is that he can painlessly increase his
shareholding in the company without having to pay broker’s commissions or stamp duty on a
share purchase.
The advantage to the company is that it does not have to find the cash to pay a dividend and in
certain circumstances it can save tax.
c) Share repurchase schemes
If a company wishes to return a large sum of cash to its shareholders, then it might consider a
share repurchase rather than a one-off special dividend.
These are schemes through which a company ‘buys back’ its shares from shareholders and
cancels them. The company’s Articles of Association must allow it.
It often occurs when the company:
• has no positive NPV projects
• wants to increase the share price [cosmetic exercise]
• wants to reduce the cost of capital by increasing its gearing.
Advantages to company
Giving flexibility where a firm’s excess cash flows are thought to be only temporary.
Management can make the distribution in the form of a share repurchase rather than paying
higher cash dividends that cannot be maintained.
• Increasing EPS through a reduction in the number of shares in issue.
• Effective use of surplus funds where growth of business is poor, outlook is poor (i.e. adjusting
the equity base to a more appropriate level).
• Buying out dissident shareholders.
• Creation of a ‘market’ where no active market exist for its shares (e.g. if the company is
unquoted).
• Altering capital structure to reduce the cost of capital.
• Reducing likelihood of a takeover.
Advantages to
• Giving a choice, as they can sell or not sell. With cash dividend shareholders must accept the
payment and pay the taxes.
• Saving transaction costs.
Disadvantages
Getting approval by general meeting (arguments about the price at which repurchase is to take
place).
• The company may pay too high a price for the shares.
The shareholders may feel they have received too small a price for their shares.
• Premiums paid are set first against share premium and then against distributable profits (if
against distributable profits, this will reduce future dividend capacity).
• Might be seen as a failure of the current management/company to make better use of the funds
through reinvesting them in the business.
• Shareholders may not be indifferent between dividends and capital gains due to their tax
circumstances .

UNIT 8 :RISK MANAGEMENT

By the end of the course, student should be able to demonstrate understanding of:
i) Explain risk and uncertainty in investment decision making.
ii) Explain sensitivity analysis and perform basic calculations
iii) Explain interest rate risk and exchange rate risk in relation to financial investments.

8.1 Risk and uncertainty

Risk can be applied to a situation where there are several possible outcomes and, on the basis of
past relevant experience, probabilities can be assigned to the various outcomes that could prevail.
Uncertainty can be applied to a situation where there are several possible outcomes but there is
little past relevant experience to enable the probability of the possible outcomes to be predicted.
A risky situation is one where we can say that there is a 70% probability that returns from a
project will be in excess of $100,000 but a 30% probability that returns will be less than
$100,000. If, however, no information can be provided on the returns from the project, we are
faced with an uncertain situation.
In general, risky projects are those whose future cash flows, and hence the project returns, are
likely to be variable. The greater the variability is, the greater the risk. The problem of risk is
more acute with capital investment decisions than other decisions for the following reasons.
(a) Estimates of capital expenditure might be for several years ahead, such as for major
construction projects. Actual costs may escalate well above budget as the work progresses.
(b) Estimates of benefits will be for several years ahead, sometimes 10, 15 or 20 years ahead or
even longer, and such long-term estimates can at best be approximations.
Most business decisions are directly or indirectly associated with some sort of risk. In fact in
finance the higher the return(s) the greater the risk(s).As already mentioned major reservation of
any investment appraisal decision is that the figures used in the calculations are only estimates
and stand to be uncertain. Clearly if any of the cash flows used in the decision turn out to be
different from what was estimated, the decision itself could be affected.
There are a wide range of techniques for incorporating risk into the investment appraisal and one
such technique is sensitivity analysis.

8.2 Sensitivity Analysis

Sensitivity analysis assesses how responsive the project's NPV is to changes in the variables used
to calculate that NPV. The variables may include sales, direct materials costs, direct labour cost,
and cost of capital among others. Each one of these inputs is examined so as to see how much it
should change so as for the NPV to become zero. By considering the sensitivity of each variable
we can ascertain which variables are the most critical and therefore perhaps need more work
confirming our estimates.
Sensitivity = NPV________________ x 100%
Present value of project variable
Example
Doggie Ltd has just set up a new company and estimates that the cost of capital is 10%.
The first project involves investing in K250, 000 of equipment with a life of 10 years and a final
scrap value of K25, 000.
The equipment will produce 15,000 units p.a. generating a contribution of K3.56 each. Doggie
estimates that additional fixed costs will be K20, 000 p.a.
Required:
(a) Determine, on the basis of the above figures, whether the project is worthwhile
(b) Calculate the sensitivity to change of:
i) initial investment cost
ii) contribution
iii) fixed costs
iv) scrap value
v) cost of capital
(c) Comment on the results
WEAKNESSES
1) The method requires that changes in each key variable are isolated. However management is
more interested in the combination of the effects of changes in two or more key variables.
2) Looking at factors in isolation is unrealistic since they are often interdependent.
3) Sensitivity analysis does not examine the probability that any particular variation in costs or
revenues might occur.
4) Critical factors may be those over which managers have no control.
5) In itself it does not provide a decision rule. Parameters defining acceptability must be laid
down by managers.
8.3 Financial Investment and Risk
By the end of this unit, students should be able to:
i) Explain interest and exchange rate risks
ii) Explain the types of derivatives
iii) Discuss the alternative hedging techniques
Interest rate risk
Firms that borrow must pay interest on their debt. An increase in interest rates raises firms’
borrowing costs and can reduce their profitability or even potentially put them into financial
distress. In addition, many firms have fixed long term future liabilities such as capital leases or
pension fund liabilities. A decrease in interest rate raises the present value of these liabilities and
can therefore lower the value of the firm. In short, when interest rates are volatile interest rate
risk is a major concern for firms.
There are some financial products that under circumstances can assist a firm to lower its interest
rate risk. Perhaps the most known contracts are the interest rate swaps. An interest rate swap is a
contract entered into with a bank, in which the firm and the bank agree to exchange payments
(called coupons) from two different types of loans. In standard interest rate swap, the one party
agrees to pay coupons based on a fixed interest rate in exchange for receiving coupons based on
the prevailing market interest rate during each coupon period.
Exchange rate risk
Multinational firms face the risk of exchange rate fluctuations. This can become a major problem
if a firm has an agreement to pay (or receive) money n foreign currencies. Depending on the
relative exchange rate between the firm’s national currency and the currency it needs to use to
make (or receive) a payment there may be significant losses to be realised. The foreign exchange
rates between different currencies are generally affected by the demand and the supply forces in
the currency markets.
Example
Consider XYZ, a US based firm that makes bicycles. XYZ needs to import parts from an Italian
supplier (ABC ltd). If ABC ltd sets the price of its parts in Euros then XYZ faces the risk that the
Dollar may fall, making Euros, and therefore the parts will effectively become more expensive.
IF ABC ltd sets the price of the parts in Dollars then it faces the risk that the Dollar may fall
(compared to Euro) and it will receive fewer Euros for the parts it sells to XYZ.
The problem of exchange rate is a general problem in any import-export relationship. If neither
company will accept the exchange rate risk, the transaction may be impossible to negotiate and it
may never happen. There are many financial products that can assist firms to manage exchange
rate should they are carefully selected. An example of financial products that often apply for
exchange rate risk management are the forward contracts.
A currency forward contract is a contract that sets the exchange rate in advance. It is usually
written between a firm and a bank and it fixes a currency exchange rate for a transaction that will
occur at a future date. A currency forward contract should specify the exchange rate, the amount
of currency to exchange and a delivery date on which the exchange rate will take place. The
exchange rate specified in the contract is known as the forward exchange rate.

8.4 Derivatives & Hedging Overview

A derivative is any financial instrument, whose payoffs depend in a direct way on the value of an
underlying asset at a time in the future. Usually, derivatives are contracts to buy or sell the
underlying asset at a future time, with the price, quantity and other specifications defined today.
Therefore, it is a contract between two or more parties based upon the asset or assets. Its value is
determined by fluctuations in the underlying asset. Derivatives can either be traded over-the-
counter (OTC) or on an exchange. OTC stands for ‘over-the-counter’ and refers to the buying of
a derivative such as option (discussed below) as a private deal from a bank. The company will
approach the bank stating the amount, the future date, and the exchange rate required, and the
bank will quote a premium. It is then up to the company whether or not to accept the quote and
purchase the option. As an alternative to buying a ‘tailor-made’ OTC derivative from a bank, it is
possible to buy and sell for example options on the currency exchanges. A benefit of this is that
the premiums are driven by market forces and the company can therefore be more certain of
paying a fair price. However, traded derivatives are only available between major currencies, at
various quoted exchange rates, exercisable on various quoted dates, and for fixed size units.OTC
derivatives constitute the greater proportion of derivatives in existence and are unregulated,
whereas derivatives traded on exchanges are standardized. OTC derivatives generally have
greater risk for the counterparty than do standardized derivatives.
HEDGING
Hedging is the external management of risks, where two or more parties make an agreement in
which their risks cancel each other out. This is used in areas outside the company’s control such
as exchange rate and interest rate risk. The best way to understand hedging is to think of it as
insurance. When people decide to hedge, they are insuring themselves against a negative event.
This doesn't prevent a negative event from happening, but if it does happen and you're properly
hedged, the impact of the event is reduced. So, hedging occurs almost everywhere, and we see it
every day. For example, if you buy house insurance, you are hedging yourself against fires,
break-ins or other unforeseen disasters.
In financial markets, however, hedging becomes more complicated than simply paying an
insurance company a fee every year. Hedging against investment risk means strategically using
instruments in the market to offset the risk of any adverse price movements. In other words,
investors hedge one investment by making another. Hedging techniques generally involve the
use of derivatives. You will be required to know the following hedging techniques:
1. forward contracts
2. money market hedges
3. currency futures
4. currency options
5. currency swaps
6. Interest rate future
7. Forward rate agreement
8. Interest rate swaps
9. Interest rate options
 

8.5 Hedging Currency exchange rate

risk
Forward contracts
If a company wishes to buy or sell foreign currency at some date in the future, then they can
obtain a quote from the bank today which will apply on a fixed date in the future. Once the quote
has been accepted, that rate is then fixed (on the date, and on the amount specified) and what
happens to the actual (or spot) rate on the date of the transaction is then irrelevant.
Money market hedging
This approach involves converting the foreign currency at the current spot, which therefore
makes future changes in the exchange rate irrelevant. However, if we are (for example) not going
to receive the foreign currency for 3 months, then how can we convert the money today? The
answer is that we borrow foreign currency now at fixed interest, on the strength of the future
receipt.
Currency futures
If we buy a sterling futures contact it is a binding contract to buy pounds at a fixed rate on a
fixed date. This is similar to a forward rate, but there are two major differences:
o Delivery dates for futures contracts occur only on 4 dates a year – the ends of March, June,
September and December.
o Futures contracts are traded and can be bought and sold from / to others during the period up to
the delivery date.
For these two reasons, most futures contracts are sold before the delivery date – speculators use
them as a way of gambling on exchange rates. They buy at one price and sell later – hopefully at
a higher price. To buy futures does not involve paying the full price – the speculator gives a
deposit (called the margin) and later when the future is sold the margin is returned plus any profit
on the deal or less and loss. The deal must be completed by the delivery date at the latest. In this
way it is possible to gamble on an increase in the exchange rate. However, it is also possible to
make a profit if the exchange rate falls! To do this the speculator will sell a future at today’s
price (even though he has nothing to sell) and then buy back later at a (hopefully) lower price.
Again, at the start of the deal he has to put forward a margin which is returned at the end of the
deal plus any profit and less any loss.
The objective is not to speculate with the company’s cash, but to make use of a futures deal in
order to ‘cancel’ (or hedge against) the risk of a commercial transaction.
However, the use of futures is unlikely to produce a perfect hedge (exact match) because of the
following reasons:
a) The futures price on any day is not the same as the spot exchange rate on that date. They are
two different things and the futures prices are quoted on the futures exchanges – in London this
is known as LIFFE (the London International Financial Futures Exchange).More importantly, the
movement in the futures price over a period is unlikely to be exactly the same as the movement
in the actual exchange rate. The futures market is efficient and prices do move very much in line
with exchange rates, but the movements are not the same.
b) In practice any deal in futures must be in units of a fixed size. It is therefore not always
possible to enter into a deal of precisely the same amount as the underlying transaction whose
risk we are trying to hedge against.
Currency Options
If we know that we are going to need to convert currency at a future date but we think that the
exchange rate is going to move in our favour, then it would be more sensible to leave the
transaction to be converted at spot on the relevant date, rather than hedge against the risk and
therefore not receive the benefit of the exchange rate movements.
The above would be perfectly sensible if we were certain that the rate was going to move in our
favour, but of course it is impossible to be completely certain and therefore there would still be a
risk that we were wrong and that the rate moved against us.
In this situation – where we are reasonably confident that the rate will move in our favour – then
it might be worthwhile considering a currency option. With a currency option we have the right
(or option) to convert at a fixed rate on a future date (as with the use of a forward rate), but we
do not have to exercise the right.
As a result, if the exchange rate does move in our favour then we will throw away the option and
simply convert at whatever the spot rate happens to be. If, however, the exchange rate moves
against us then we will use the option and convert at the fixed rate.
Since we will get the benefit of any movement in our favour, but not suffer if the exchange rate
moves against us, options do not come free! We will have to pay (now) for the option whether or
not we eventually decide to use it. The amount we have to pay is called the option premium.
Currency swaps
A currency swap is a financial instrument that helps parties swap notional principals in different
currencies and thus pay interest payments on the received currency. The purpose of currency
swaps is to hedge against risk exposure associated with exchange rate fluctuations, ensure receipt
of foreign monies, and to achieve better lending rates. Swaps are generally arranged by banks
(who act as a ‘dating agency’ finding the parties to a swap).
The bank will arrange guarantees, but they will charge commissions for their service.
More recently there has been a tendency for large companies to arrange swaps directly with each
other (and not using banks, thus saving costs). The tendency is known as ‘disintermediarisation.
However, the counter party risk may be higher compared to using the bank.

8.6 Hedging Interest rate risk

HEDGING INTEREST RATE RISK USING DERIVATIVES
Interest rate options
An interest rate option is the right to deal at the strike rate (an agreed interest rate) at some
future, predetermined maturity date, at a cost known as a premium. At the expiry date the option
holder will decide whether or not to exercise it depending on the difference between the interest
rate of the option and the prevailing interest rates.
Options tend to be more expensive than forward rate agreements (see below).
Options can be purchased tailor-made from the larger banks and include:
 interest rate guarantee – a short-term option used for single transactions, valid for up to one
year;
 interest rate cap – this puts a maximum rate on the transaction and can relate to a number of
transactions over several years;
 interest rate floor – this sets a minimum rate below which interest rates will not fall and is the
converse of the cap;
 interest rate collar – this establishes both a maximum and a minimum rate outside which no
movements will occur, or alternatively within which rates remain fixed.
Interest rate futures options giving the purchaser the right to buy or sell (call or put options) a
futures contract, during a specified period, at a predetermined price, are traded on LIFFE
(London International Financial Futures and Options Exchange) which deals in long, medium-
and short-dated securities such as those listed above and those we discuss in the section on
financial futures below.
Forward rate agreements (FRAs)
These contracts provide for rates to be fixed in advance for a specified period commencing at
some agreed future date; the difference between the actual rates and those set will be paid to the
company by the bank, or vice versa, depending on the direction of interest rate movements. The
rate set generally reflects the bank’s expectations of future rates. Unlike futures (see below),
which are highly standardized contracts, FRAs can be tailored to meet individual needs, though
they tend to be only available for up to 12 months and on loans of £500,000 or more. FRAs are
entirely separate from the principal amount of the loan or deposit, relating only to the interest
element.
Interest rate futures
Interest rate futures are contracts that are similar in outcome to FRAs. They are fixed in terms of
rate, delivery period and amount, and provide an interest rate commitment for a future period
that is agreed at the outset. Common futures are gilt-edged stocks, Japanese, German and US
government bonds, euro interest rates and short-term sterling.
The market for futures is LIFFE (the London International Financial Futures and
Options Exchange).
Interest rate futures are limited in that they must be for a standard amount, but they are a popular
means of speculation, there being no requirement for the speculator actually to be a borrower or
lender of the amounts of the contract and many of the contracts are settled in cash rather than the
supposed underlying security. They are also popular with financial institutions, which are not as
concerned with a perfect match against exposure.
Fixed forward interest contracts
Fixed forwards are agreements to borrow or deposit an agreed amount for a fixed term
commencing from a future date, but with the rate determined at the outset.
Interest rate swaps
This is an agreement between two parties by which each agrees to pay the other’s interest, based
on the underlying notional amount (there is no exchange of the principal sum) and for an agreed
period. The parties must accept counterparty risk in that they are still obliged to ensure that their
original lender is paid by the due date.
Different interest rates apply, e.g. parties may swap fixed rate LIBOR payments for variable
LIBOR payments, or payments may be made between the parties to reflect the different interest
rates available to them, but the net effect will be that both parties are better off as a result of the
swap. Swaps are often used by speculators and companies because they are easy and cheap to
arrange (with only legal fees to pay) and are flexible as to size and duration.

UNIT 9 : CURRENT
DEVELOPMENT& EMERGING
ISSUES
 
By the end of this unit, students should demonstrate understanding of:

i. Working capital management

ii. Earnings management
iii. Transfer princing

9.1 Working Capital Management

What is working capital management?
Working capital is the total amount of cash tied up in current assets and current liabilities and is
calculated by deducting the total amount of current liabilities from the total amount of current
assets. In Financial accounting, as you recall, current assets are assets which are used within the
accounting period (normally one year) such as inventory, receivables, cash and cash equivalent
and prepayments. On the other hand, current liabilities are borrowings which fall due within the
accounting period (normally one year) such as payables, overdraft, and short-term loans. Thus, if
company X has current assets of K5 million and current liabilities of K3 million, then its
working capital resources are K2 million. You need to invest in working capital, in the same way
you make investment in equipment. However, it is the investment in fixed assets that earns
profits for the company. Investment in working capital does not directly earn profits.
If this were the only consideration, then it would be better to invest all the finance available in
fixed assets and to keep working capital to an absolute minimum.
On the other hand, your company would need some working capital (liquidity) in order to keep
the business running on a day to day basis for the following reasons:
 You need to allow customers to buy on credit (and therefore have receivables) otherwise you
would lose business to competitors.
 you need to carry inventories of finished goods in order to be able to fulfil demand
 you need to have a short-term cash balance in order to be able to pay your bills as they fall
due.
Maintaining adequate working capital is not just important in the short term. Adequate liquidity
is needed to ensure the survival of the business in the long term. Even a profitable company may
fail without adequate cash flow to meet its liabilities. It is common that many managers confuse
the terms "cash” and "profit,” using them as if they were interchangeable. The terms are not
synonymous and cannot be used interchangeably. It is, in fact, possible to make an accounting
profit and have no surplus cash.
On the other hand, an excessively conservative approach to working capital management
resulting in high levels of cash holdings will harm profits because the opportunity to make a
return on the assets tied up as cash will have been missed.
Therefore the two main objectives of working capital management are to ensure that your
company has sufficient liquid resources to continue in business and to increase its profitability.
The company therefore faces a trade-off between profitability and liquidity, and it is up to you as
a financial manager to decide on the optimal level of working capital and to ensure that it is
managed properly. These two objectives will often conflict as liquid assets give the lowest
returns.
Overcapitalization
It is essential to ensure that a firm has sufficient working capital to allow it to operate smoothly
and have sufficient funds to pay its bills when they fall due (taking into account the effects of
inflation).However, an organization should be careful not to over-provide working capital and
cause unnecessary cost, a phenomenon known as ‘overcapitalization’. Overinvestment in
working capital leading to excessive stocks, debtors and cash, coupled with few creditors, is
known as overcapitalization. Such a situation will lead to lower return on investment and the use
of long-term funds for short-term assets. Indicators of overcapitalization include long debtor and
stock turnover periods, high liquidity ratios and a low sales/working capital ratio.
OVERTRADING
"Over-trading” describes a business position where, although profit is generated, there is
insufficient cash to maintain the day to day payments of the business as they fall due; payments
for items such as wages and vendor charges. Over-trading is the most common cause of new
business failure. It is apparent that the effective management of cash within the organisation is
essential to its viability, growth and success. Typically this activity is described as the
management of "working capital”. Capital or cash is paid out and received into the organisation,
moving its way through, in line with the timing, duration and nature of activities. The movement
gives rise to the concept of the working capital cycle. It is possible to describe the cycle in terms
of its key attributes.
OPERATING CYCLE
A company’s operating cycle can be thought of as the time taken from the initial input of factors
(materials and labour) to produce stock (referred to as the average age of stock) until the point
where the customer pays for the stock sold to them (referred to as the average customer payment
period or "collection” period). The company will have to pay for the inputs required to
manufacture product and place it in stock. This can involve a period of credit, especially for
materials from external vendors, but also for labour where this is subcontracted. During this time
the company has the use of the cash it would otherwise have paid out.
This payment period reduces the amount of time that the company is tying up its own resources
in the operating cycle. In effect the payment period is an offset against the time taken to receive
cash from customers. This "net” time, for which cash resources are locked up in the company, is
known as the "cash conversion cycle”. Managing the cash conversion cycle is the challenge of
effective working capital management. The aim is to reduce the cycle, thus reducing the length
of time that it needs to be financed while, at the same time, ensuring that the actions taken do not
impact adversely on business relationships.
Trade Receivables
The principal trade-off here is between actions which reduce the time taken to collect cash from
customers and the possible loss of customer goodwill (both for new and potential customers).
Typical actions include reducing credit terms from say, 30 days to 15 days. A more incentive-
based approach can be adopted such as offering discounts for early settlement or payment in
cash. Here, there is a trade-off, in as much as the amount of cash received will be less; perhaps
extinguishing the benefit from reduced collection time.
Trade Payables
The principal trade-off here is between actions which extend the time taken to pay suppliers and
the possible loss of supplier goodwill (both for new and potential suppliers) and early settlement
discounts. In some cases suppliers will make additional charges for "late” settlement, increasing
the cash outlay required to pay off the account.
Inventory
The principal trade-off here is between actions which reduce amount of stock held and the
possible loss of customer and supplier goodwill due to inability to supply. For finished goods
there are external trade-offs.
Customers (existing and potential) may be lost due to the inability to supply the quantity or
product demanded. Supplier goodwill may be lost if delivery volumes are reduced. Additional
trade-offs may arise internally. Where there is a conversion of materials into products for sale,
then the lack of materials stock (a "stock-out”) will cause the production process to stop. Actions
to optimise internal trade-offs are typically based on simulation models (inventory control
models), or supply chain management techniques such as "just-in-time” and "kaizen”.

9.2 Earnings Management

Earnings are the profits of a company. Investors and analysts look to earnings to determine the
attractiveness of a particular stock. Companies with poor earnings prospects will typically have
lower share prices than those with good prospects. Remember that a company's ability to
generate profit in the future plays a very important role in determining a stock's price. Earnings
management is a strategy used by the management of a company to deliberately manipulate the
company's earnings so that the figures match a pre-determined target. This practice is carried out
for the purpose of income smoothing. Thus, rather than having years of exceptionally good or
bad earnings, companies will try to keep the figures relatively stable by adding and removing
cash from reserve accounts.
In 2001, before the collapse of Enron, there was a consensus amongst respondents to the UK
Auditing Practices Board Consultation Paper Aggressive Earnings Management that aggressive
earnings management was a significant threat and actions should be taken to diminish it. It was
considered that aggressive earnings management could occur when there was a need to meet or
exceed market expectations and when directors’ and managements’ remuneration were linked to
earnings – also, but to a lesser extent, to understate profits to reduce tax liabilities or to increase
profits to ensure compliance with loan covenants.

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9.3 Transfer Pricing

Transfer pricing is the setting of the price for goods and services sold between controlled (or
related) legal entities within an enterprise. For example, if a subsidiary company sells goods to a
parent company, the cost of those goods paid by the parent to the subsidiary is the transfer price.
Goods transferred between divisions are known as intermediate products: divisions within the
same organisation will often supply each other with partially completed products or components
that the receiving division will then turn into completed products.
Purposes of Transfer Pricing
There are two main reasons for instituting a transfer pricing scheme:
 Generate separate profit figures for each division and thereby evaluate the performance of
each division separately.
 Help coordinate production, sales and pricing decisions of the different divisions (via an
appropriate choice of transfer prices). Transfer prices make managers aware of the value that
goods and services have for other segments of the firm.
 Transfer pricing allows the company to generate profit (or cost) figures for each division
separately.
 The transfer price will affect not only the reported profit of each center, but will also affect the
allocation of an organization’s resources.

There are different types of transfer pricing.

At market prices: If there are identical or similar goods and services offered externally, transfer
prices based on market prices will neither encourage nor discourage supplying or receiving
segments to trade externally.
At adjusted market prices: Market prices may be reduced in recognition of the lower costs
attached to internal trading, e.g. advertising, administration and financing costs. This method
encourages segments to trade with each other.
At total cost or total cost plus: A transfer price based on total cost will include the direct costs
plus a share of both production and non-production overhead. Total cost-plus methods allow for
some profit. The main problems attached to the total-cost methods is that they build
inefficiencies into the transfer price (as there is no incentive to control costs) and they therefore
encourage sub optimization.
At variable cost or variable cost plus: The variable cost method does not encourage a supplying
segment to trade internally as no incentive is built into the transfer price, but a percentage
addition may provide some incentive since it enables some contribution to be made towards
fixed costs.
However, transfer prices based on variable costs may be very attractive to receiving segments as
the transfer price normally compares favorably with the external price.
Negotiated prices: This method involves striking a bargain between the supplying and receiving
segments based on a combination of market price and costs. As long as the discussions are
mutually determined this method can be highly successful.
Opportunity costs: This method may be somewhat impractical, but if the costs can be quantified
it is the ideal one to adopt. A transfer price based on the opportunity cost comprises two
elements: first, the standard variable cost in the supplying segment, and second the entity’s
opportunity cost resulting from the transaction. It is the second element that is the hardest to
determine.
Transfer Pricing and Multinational Income Taxes:
When divisions transfer product across tax jurisdictions, transfer prices play a role in the
calculation of the company’s income tax liability. In this situation, the company’s transfer
pricing policy can become a tax planning tool. The United States has agreements with most other
nations that determine how multinational companies are taxed. These agreements, which are
called bilateral tax treaties, establish rules for apportioning multinational corporate income
among the nations in which the companies conduct business. These rules attempt to tax all
multinational corporate income once and only once (excluding the double-taxation that occurs at
the Federal and state levels). In other words, the tax treaties attempt to avoid the double-taxation
that would occur if two nations taxed the same income. Since transfer prices represent revenue to
the upstream division and an expense to the downstream division, the transfer price affects the
calculation of divisional profits that represent taxable income in the nations where the divisions
are based.
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