University of Strathclyde – MBA CBFS

Provided by

College of Banking and Financial Studies

FMA
Accounting and Performance
Measurement

Prepared & Presented By

Muhammadh Farzan

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University of Strathclyde – MBA CBFS

Additional Notes 2
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University of Strathclyde – MBA CBFS

Financial Accounting & Management Accounting

Financial accounting

Financial accounting is concerned with the production of financial statements for external
users. These are a report on the directors’ stewardship of the funds entrusted to them by the
shareholders.

Investors need to be able to choose which companies to invest in and compare their
investments. In order to facilitate comparison, financial accounts are prepared using accepted
accounting conventions and standards. International Accounting Standards (IASs) and
International Financial Reporting Standards (IFRSs) help to reduce the differences in the way
that companies draw up their financial statements in different countries.

The financial statements are public documents, and therefore they will not reveal details about,
for example, individual products’ profitability.

Management accounting

Management require much more detailed and up-to-date information in order to control the
business and plan for the future. They need to be able to cost-out products and production
methods, assess profitability and so on. In order to facilitate this, management accounts
present information in any way which may be useful to management, for example by operating
unit or product line.

Management accounting is an integral part of management activity concerned with identifying,

presenting and interpreting information used for:

• formulating strategy
• planning and controlling activities
• decision making
• optimising the use of resources.

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Users of the financial statements

• Management need detailed information in order to control their business and plan for
the future. Budgets will be based upon past performance and future plans. These
budgets will then be compared with actual results. Information will also be needed about
the profitability of individual departments and products. Management information must
be very up to date and is normally produced on a monthly basis.

• Investors and potential investors are interested in their potential profits and the
security of their investment. Future profits may be estimated from the target company’s
past performance as shown in the income statement. The security of their investment
will be revealed by the financial strength and solvency of the company as shown in the
balance sheet. The largest and most sophisticated groups of investors are the
institutional investors, such as pension funds and unit trusts.

• Employees and trade union representatives need to know if an employer can offer
secure employment and possible pay rises. They will also have a keen interest in the
salaries and benefits enjoyed by senior management. Information about divisional
profitability will also be useful if a part of the business is threatened with closure.

• Lenders need to know if they will be repaid. This will depend on the solvency of the
company, which should be revealed by the balance sheet. Long-term loans may also be

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University of Strathclyde – MBA CBFS

backed by ‘security’ given by the business over specific assets. The value of these
assets will be indicated in the balance sheet.
• Government agencies need to know how the economy is performing in order to plan
financial and industrial policies. The tax authorities also use financial statements as a
basis for assessing the amount of tax payable by a business.

• Suppliers need to know if they will be paid. New suppliers may also require
reassurance about the financial health of a business before agreeing to supply goods.

• Customers need to know that a company can continue to supply them into the future.
This is especially true if the customer is dependent on a company for specialised
supplies.

• Competitors wish to compare their own performance against that of other companies
and learn as much as possible about their rivals in order to help develop strategic plans.

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Attributes of Good Information (Features of Effective Information)

Accurate – Information should be as accurate as it needs to be. The degree of accuracy

required will depend on the reason why the information is needed. A problem in
accounting can be that reports are produced showing figures to the nearest dollar, when
managers are only interested in figures to the nearest hundred thousand or ten thousand.
On the other hand, when calculating the cost of a unit of product manufactured in a
factory, managers might want the cost to be accurate to the nearest cent.

Complete – Information should be as complete as it needs to be, but it should not be

excessive. Managers should be given all the information they need to make their
decisions, but it is often helpful to draw their attention to what seems significant. In control
reports, for example, actual results might be compared with planned results, with
differences between actual and plan reported as ‘variances’.

Cost-effective – The value of information should not exceed the cost of producing it.
Management information has a value because it helps a manager to make decisions. If a
decision by a manager is different from what it would have been without the information,
the value of the information could be measured by the amount of money that has been
saved as a result. The value of information results from actions by decision makers who
use the information to improve profitability. This value should not be greater than the
costs involved in obtaining it.

Understandable – It should be understandable. A manager should be able to understand

what the information is telling him. If he doesn’t understand it, he will not use it to make a
decision. If he misunderstands it, he might make a bad decision. There can be a
particular problem with the use of technical language (‘jargon’), and accountants should
always be careful about the way in which they present financial information to non-
financial managers.

Relevant – It should have a purpose and be relevant for that purpose. There is no point in
providing a manager with a report if the manager does not know why he has been given
it, or what he is expected to do with it. Similarly, the information within a report should be
relevant to its purpose and should not contain details that can be ignored.

Timely – It should be timely. This means that it should be provided to a manager in time for
the manager to do something with it. For example, suppose that a business produces
monthly performance reports for its cost centres, and that in May the manager of cost
centre X receives a report about actual costs incurred by the centre in January. This
information would be over three months old, and the cost centre manager is likely to
ignore it because it is not relevant to his current situation.

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Accounting Policies
The specific accounting bases selected and followed by an entity as being, in the opinion of
management, appropriate to its circumstances and best suited to present fairly its results and
financial position.

Example, from the various possible methods of depreciation, the accounting policy may be to
use straight line method of depreciation.

Creative Accounting
A form of accounting which gives a biased impression (generally favorable) of the company’s
performance.

Creative Accounting Could involve:

– Income smoothing – move profit from one year to next

– Inflating reported profits and EPS
– Reporting profits without generating equivalent cash
– Reporting lower borrowings

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Financial Performance Measurement

Usually companies use the following indicators to evaluate their performance

1. ROCE - Return On Capital Employed

2. ROSF (ROE) - Return on Share Holders Fund
3. RI - Residual Income
4. EVA - economic Value added
5. MVA - Market Value Added

Residual income
Pre-tax profit less an imputed interest charge for invested capital used to asses the
performance.

Example:
What is the pre-tax income (profit) remaining after deducting a notional interest charge for the
use of capital?

DIVISIONS X Z £000’s

Operating profit (EBIT) 18 1,500

Capital employed 100 10,000

ROCE 18% 15%

Suppose weighted average cost of capital (WACC) is 10% for both divisions.

DIVISIONS X Z £000’s

Operating profit (EBIT) 18 1,500

Less: Notional interest charge (10) (1,000)
Residual income 8 500

Division Z gives higher income to shareholders

Some companies prefer RI as managers focus on £ rather than %. (rather like NPV preferred
to IRR)

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Economic Value Added

EVA is a special version of the RI calculation that has increased in popularity. However, the
Major differences between RI and EVA can be summarised as follows

1. EVA considers Profit after tax where as RI takes profit before tax
2. In EVA calculation net interest (interest after tax) is considered where as RI takes the
whole interest.
3. The profit used in EVA is adjusted or purified for possible creative accounting practices.

EVA equals after-tax profit minus the (after-tax) tax adjusted weighted average cost of capital
multiplied by total capital emploed.

Example

X Z
*Profit after tax (before interest) 13 1,050
Interest charge (net of tax) (7) (700)
EVA 6 350

Z gives higher EVA than does X

*Adjusted for creative accounting practices (purified profit)

Market Value Added

The difference between a company’s market value and the book value is called MVA. MVA
shows the value addition to a company’s share since the time it was started to date.

Market value = Market value per share * No of Ordinary Shares

Book value = Share capital + reserves

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Accounting Based Measurements and their Limitations

1. Encourage short termist actions

2. Lack strategic focus and fail to provide data on quality, responsiveness and flexibility
3. Encourage managers to minimise the variances from standard rather than seek to
continuous improvement
4. Fail to provide information on what customers want and how competitors are performing
5. Narrow financial focus.

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The Kaplan and Norton Balanced Scorecard

Framework

• Financial Perspective: How do we look to our shareholders?

• Customer Perspective: How do customers see us?

• Internal Business Perspective: What must we excel at?

• Innovation and Learning Perspective: How do we continue to improve and create

value?

The Balanced Scorecard (BS) is an approach to performance measurement, developed by

Kaplan and Norton in 1996. Rather than assessing organizational performance from a purely
financial point of view, this approach uses a variety of financial and non-financial indicators.
The four perspectives on performance suggested by Kaplan and Norton are:

Financial Perspective: This considers how the organisation can create value for its
stakeholders, especially to the shareholders. Unlike in traditional performance
measurement techniques, the finical performance is only one aspect in the overall
performance evaluation in the BS approach. Objectives and performance measures are
likely to include criteria such as;

Objective Measurement(s)
Profitability GP, Operating Profit, NPAT
Financial Stability Liquidity & Gearing Ratios
Business Growth Sales Growth, Market Share
Shareholder Value Market Price per Share

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Customer Perspective: This looks at how existing and potential customers see the
organisation. The business success of an organisation is usually reflected by the manner
in which customers view the business. Objectives and performance measures are likely
to include criteria such as;

Objective
Customer Satisfaction
Customer Retention / Loyalty
Customer Awareness
Measurement(s)
Number of Complaints, On-
time Deliveries, Customer
Feedback
% of Sales from Existing
Customers
Sales Growth, % of Sales
from New Customers, Market
Share

Internal Business Perspective: This considers the processes at which an organisation must
excel if it is to achieve customer satisfaction and financial success. In today's complex
business world firms should focus heavily on quality and innovation to remain
competitive. Objectives and performance measures are likely to include criteria such as;

Objective Measurement(s)
Efficiency Ratios, Flow of
Internal Process Efficiency
Business Process
Process Improvements
Innovation Achieved, Generation of
Ideas
Customer Feedback,
Quality Complaints, After Sales
Services

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Learning & Growth Perspective: This looks at the organisation’s capacity to maintain its
competitive position through the acquisition of new skills and the development of new
products and services. Objectives and performance measures are likely to include
criteria such as;

Objective Measurement(s)
Rate of Learning, Employee
Improve Learning
Development
Rate of New Product
New Product Development Launches, R&D Expense as
a % of Sales
Growth in Operations, Market
Growth
Share & Organisation Size

Kaplan and Norton view the balanced scorecard as a management system rather than just a
performance measurement device. It can be used as a method of implementing and controlling
the delivery of an organisation’s chosen strategy.

Advantages of the Balanced Scorecard Approach

! It measures performance in a variety of ways, rather than relying on just one aspect of
performance.

! Managers are unlikely to be able to manipulate the performance measure.

! Bad performance is difficult to hide if multiple performance measures are used.

! Success in the four key areas should lead to the long term success of the organisation.

! It is flexible, what is measured can be changed over time to reflect changing priorities
and strategies.

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Budget Theory

A budget is a quantitative expression of a plan of action prepared in advance of the period to which it
relates. Budgets set out the costs and revenues that are expected to be incurred or earned in future
periods.

For example, if you are planning to take a holiday, you will probably have a budgeted amount that you
can spend. This budget will determine where you go and for how long.

Most organisations prepare budgets for the business as a whole. The following budgets may also be
prepared by organisations:

– Departmental budgets.
– Functional budgets (for sales, production, expenditure and so on).
– Income statements (in order to determine the expected future profits).
– Cash budgets (in order to determine future cash flows).

Purposes of budgeting

The main aims of budgeting are as follows:

• Planning for the future – in line with the objectives of the organisation.
• Controlling costs – by comparing the plan of the budget with the actual results and investigating
significant differences between the two.
• Co-ordination of the different activities of the business by ensuring that managers are working
towards the same common goal (as stated in the budget).
• Communication – budgets communicate the targets of the organisation to individual managers.
• Motivation – budgets can motivate managers by encouraging them to beat targets or budgets set
at the beginning of the budget period. Bonuses are often based on ‘beating budgets’. Budgets, if
badly set, can also de-motivate employees.
• Evaluation – the performance of managers is often judged by looking at how well the manager
has performed ‘against budget’.
• Authorization – budgets act as a form of authorization of expenditure.

How are budgets prepared?

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Before any budgets can be prepared, the long-term objectives of an organisation must be defined so that
the budgets prepared are working towards the goals of the business. Once this has been done, the budget
committee can be formed, the budget manual can be produced and the limiting factor can be identified.

• Budget committee is formed – a typical budget committee is made up of the chief executive,
budget officer (management accountant) and departmental or functional heads (sales manager,
purchasing manager, production manager and so on). The budget committee is responsible for
communicating policy guidelines to the people who prepare the budgets and for setting and
approving budgets.

• Budget manual is produced – an organisation’s budget manual sets out instructions relating to
the preparation and use of budgets. It also gives details of the responsibilities of those involved
in the budgeting process, including an organisation chart and a list of budget holders.

• Limiting factor is identified – in budgeting, the limiting factor is known as the principal budget
factor. Generally there will be one factor that will limit the activity of an organisation in a given
period. It is usually sales that limit an organisation’s performance, but it could be anything else,
for example, the availability of special labour skills.

If sales is the principal budget factor, then the sales budget must be produced first.

• Final steps in the budget process – once the budget relating to the limiting factor has been
produced then the managers responsible for the other budgets can produce them. The entire
budget preparation process may take several weeks or months to complete. The final stages are
as follows.

o Initial budgets are prepared.

o Initial budgets are reviewed and integrated into the complete budget system.
o After any necessary adjustments are made to initial budgets, they are accepted and the
master budget is prepared (budgeted income statement, balance sheet and cash flow).
o This master budget is then shown to top management for final approval.
o Budgets are reviewed regularly.

Comparisons between budgets and actual results are carried out and any differences arising are
known as variances.

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