01 technical

materials mix
yield RELEVANT TO ACCA QUALIFICATION PAPER F5

Since long ago, variance analysis has been an area Material usage variance

our production relative to how much we expected to

that evokes fear in students worldwide. Students Most students have relatively little difficulty in
enter the exam hall, desperately running through calculating a straightforward material usage
The material usage variance analyses the difference
the formulae used to calculate all the different variance. As a reminder, let’s recap on what the
variances, fearful of forgetting them before they material usage variance is and how it is calculated.
have managed to put pen to paper. Then the The material usage variance analyses the difference
between how much actual material we used for

inevitable happens: they turn over the exam paper between how much actual material we used for
and a variance question stares back at them. our production relative to how much we expected
Frantically, they scribble down all the formulae to use, based on standard usage levels. So, for
before they are lost forever. Alas, they can’t example, if we made 5,000 items using 11,000kg
remember it quite accurately enough. Is it actual of material A and our standard material usage is
quantity x standard price or standard quantity x only 2kg per item, then we clearly used 1,000kg
actual price? Panic grips them. Logic flies out of material more than we expected to (11,000kg –
of the window. They move desperately on to the [2 kg x 5,000 items]). In terms of how we value
use, based on standard usage levels.

next question. this difference, it must be at standard cost. Any

Does this sound like a familiar story to you? If difference between standard and actual cost would
it does, carry on reading. This article might help be dealt with by the material price variance.
you. Many articles have been written about variance There can be many reasons for an adverse
analysis over the years, but the purpose of this material usage variance. It may be that inferior
one is to cover the area of calculating materials quality material have been purchased, perhaps at
mix and yield variances. While the calculation of a lower price. This may be reflected in a favourable
a mix variance can also be done for sales, this is material price variance: the materials were cheaper
not covered by the Paper F5 syllabus at present. but as a result there was perhaps more waste.
Therefore, I shall concentrate purely on the On the other hand, it may be that changes to
materials variance here. the production process have been made, or that
increased quality controls have been introduced,
resulting in more items being rejected. Whatever
the cause, it can only be investigated after separate
material usage variances have been calculated for
each type of material used and then allocated to a
responsibility centre.
 student accountant issue 04/2010
02
Studying Paper F5?
Performance objectives 12, 13 and 14 are linked

and
variances
Further variance analysis where several materials Mix 1: 10 litres of A and 10 litres of B will yield 18

balances the cost of each of the materials with the

are used litres of C; and
The fact that most products will be comprised

yield that they generate. The yield must also reach

of several, or sometimes hundreds of different Mix 2: 8 litres of A and 12 litres of B will yield 19
materials, leads us back to the more detailed litres of C.
The optimum mix of materials will be the one that

materials mix and yield variances that can be

calculated in these instances. In many industries, Assuming that the quality of C produced is exactly
particularly where the product being made the same in both instances, the optimum mix of
undergoes a chemical process, it may be possible materials A and B can be decided by looking at the
to combine different levels of the component cost of materials A and B relative to the yield of C.
materials to make the same product. This, in turn,
may result in differing yields, dependent on the mix Mix 1: (18 x $30) – (10 x $20) – (10 x $25) =
of materials that has been used. Note, when we talk $90 contribution
about the materials ‘mix’ we are referring to the
quantity of each material that is used to make our Mix 2: (19 x $30) – (8 x $20) – (12 x $25) =
product ie we are referring to our inputs. When we $110 contribution
talk about ‘yield’, on the other hand, we are talking
about how much of our product is produced, ie Therefore, the optimum mix that minimises the
our output. cost of the inputs compared to the value of the
outputs is mix 2: 8/20 material A and 12/20
Materials mix variance material B. The standard cost per unit of C is (8 x
certain quality standards.

In any process, much time and money will have $20)/19 + (12 x $25)/19 = $24.21. However, if the
been spent ascertaining the exact optimum mix of cost of materials A and B changes or the selling
materials. The optimum mix of materials will be the price for C changes, production managers may
one that balances the cost of each of the materials deviate from the standard mix. This would, in these
with the yield that they generate. The yield must circumstances, be a deliberate act and would result
also reach certain quality standards. Let us take the in a materials mix variance arising. It may be, on
example of a chemical, C, that uses both chemicals the other hand, that the materials mix changes
A and B to make it. Chemical A has a standard cost simply because managers fail to adhere to the
of $20 per litre and chemical B has a standard cost standard mix, for whatever reason.
of $25 per litre. Research has shown that various Let us assume now that the standard mix has
combinations of chemicals A and B can be used to been set (mix 2) and production of C commences.
make C, which has a standard selling price of $30 1,850kg of C is produced, using a total of 900kg
per litre. The best two of these combinations have of material A and 1,100kg of material B (2,000kg
been established as: in total). The actual costs of materials A and B
were at the standard costs of $20 and $25 per kg
respectively. How do we calculate the materials
mix variance?
03 technical

showing an adverse variance by simply using brackets. This leads to mistakes.

The variance is worked out by first calculating
what the standard cost of our 1,850kg worth of
C would have been if the standard mix had been
adhered to, and comparing that figure to the
standard cost of our actual production, using our
actual quantities. My preferred approach has always
been to present this information in a table as shown
in Table 1 below.
The materials mix variance will be $46,000 –
$45,500 = $500 favourable.
Remember: it is essential that, for every variance
you calculate, you state whether it is favourable or
adverse. These can be denoted by a clear ‘A’ or ‘F’
but avoid showing an adverse variance by simply
using brackets. This leads to mistakes.
The formula for this is shown below, but if you
were to use it, the variance for each type of material
must be calculated separately.
(Actual quantity in standard mix proportions –
actual quantity used) x standard cost
As a student, I was never a person to blindly learn
formulae and rely on these to get me through. I
truly believe that the key to variance analysis is
to understand what is actually happening. If you
understand what the materials mix variance is
trying to show, you will work out how to calculate
it. However, for those of you who do prefer to use
formulae, the workings would be as follows:
is favourable or adverse. These can be denoted by a clear ‘A’ or ‘F’ but avoid
it is essential that, for every variance you calculate, you state whether it
Material A: (800kg – 900kg) x $20 =
$2,000 Adverse
Material B: (1,200kg – 1,100kg) x $25 =
$2,500 Favourable
Net variance = $500 favourable
In this particular example, I have kept things
simple by keeping all actual costs in line with the
standards. The reality is that, in the real world,
actual costs will often vary from standards. Why
haven’t I covered this above? Because any variance
in materials price is always dealt with by the
materials price variance. If we try and bring this
into our mix variance, we begin distorting the one
thing that we are trying to understand – how the
difference in materials mix has affected our cost,
rather than how the difference in price has affected
our cost.
Why haven’t I considered the fact that although
our materials mix variance is $500 favourable, our
changed materials mix may have produced less of
C than the standard mix? Because this, of course,
is where the materials yield variance comes
into play.
The materials mix variance focuses on inputs,
irrespective of outputs. The materials yield
variance, on the other hand, focuses on outputs,
taking into account inputs.

Table 1: calculating the standard cost of 1,850kg worth of C (standard mix)

Actual usage in standard proportions: Actual usage in actual proportions: Var.

$ $ $
A = 800kg (8/20 x 2,000kg) x $20 16,000 A = 900kg x $20 18,000 2,000A
B = 1,200kg (12/20 x 2,000kg) x $25 30,000 B = 1,100kg x $25 27,500 2,500F
Total 46,000 Total 45,500 500F
 student accountant issue 04/2010
Materials yield variance
Where there is a difference between the actual
level of output for a given set of inputs and
the standard output for a given set of inputs, a
materials yield variance arises. In our optimum
mix, we calculated that 20kg of inputs of A and
B should produce 19kg of our output, C. We are
effectively saying that there is a loss rate of 5%
(20 – 1/20) in our process, ie our outputs, in
kg, should be 95% of our inputs. Applying this
to our example then, we can say that we would
have expected our inputs of 2,000kg to yield
an output of 95% of 2,000kg, ie 1,900 kg. Our
actual yield was only 1,850kg, which is 50kg less
than we would have expected. To calculate the
materials yield variance, all we have to do is value
this difference between the actual yield (1,850kg)
and the expected yield for our given set of inputs
(1,900kg) at the standard cost of our output, C,
ie at $24 per kg. It is easy to see how to calculate
this when we look at it logically and present it in a
very simple table as shown in Table 2.
No formula really needs to be learnt if you
understand the logic behind the materials yield
variance and grasp the principle that any price
differences between actual and standard are always
dealt with by the price variance alone. However, for
those who do prefer to use a formula, the materials
yield variance formula is:
(Actual yield – standard yield from actual input of
material) x standard cost per unit of output
(1,850kg – 1,900kg) x $24 = $1,200 Adverse
Table 2: value difference between actual and expected yield at standard cost of C
Actual yield Standard yield for actual quantities input Difference Standard cost per kg Var.
1,850kg 1,900kg
04
Making observations about variances
Where there is a difference between the actual level of output
From our example, it can be seen that there is
a direct relationship between our materials mix
variance and our materials yield variance. By using
a mix of materials that was different from standard,
we have resulted in a saving of $500, in standard
for a given set of inputs and the standard output for a
cost terms. However, the downside of this is that
our cheaper mix of materials has resulted in a
significantly lower yield of material C than we would
given set of inputs, a materials yield variance arises.
have got had our standard mix of materials been
adhered to. This yield was $1,200 lower than it
would have been, which is over double the amount
that we saved by using a cheaper mix of materials.
Overall, by netting the two variances off against each
other, we have an adverse material usage variance
of $700 ($1,200 A less $500 F). As indicated earlier
on in the article, this could have been calculated
on its own, without breaking it down further into its
mix and yield elements, by comparing the quantity
of materials we expected to use (based on standard
usage) for our actual production to the quantity of
material we actually did use for our production.
Using my preferred method of a table, our
calculations would look like Table 3 on page 5.
Actual production of 1,850kg requires an input of
1,947kg (1,850 x 100/95) in total of A and B
50kg $24 $1,200A
05 technical
it is important to stress the fact that quality issues cannot really be dealt
with by this variance analysis. there is also a direct relationship between

Table 3: calculating the adverse material usage variance ($700)

the mix and the yield variance and that neither of these can be

Standard quantity for actual production Actual quantity Var.

$ $ $
A = 7,780kg (1,947 x 8/20) x $20 15,600 A = 900kg x $20 18,000 2,400A
B = 1,168kg (1,947 x 12/20) x $25 29,200 B = 1,100kg x $25 27,500 1,700F
Total 44,800 Total 45,500 700A

Again, if you like to learn the formula, this is
shown below, although it would have to be applied
separately to each type of material.
(Standard quantity for actual production – actual
quantity) x standard cost
Understanding the bigger picture
Now that you understand how to deal with the
numerical side of materials mix and yield variances,
and the fact that these are simply a detailed
breakdown of the material usage variance, it
is also important to stress the fact that quality
issues cannot really be dealt with by this variance
analysis. I have mentioned the fact that there is
a direct relationship between the mix and the
yield variance and that neither of these can be
considered in isolation. In addition to this, however,
considered in isolation.
Unfortunately, this factor cannot be incorporated
into the materials yield variance. In the long run,
it may be deduced from an adverse sales volume
variance, as demand for the business’s product
decreases, but it is likely to take time for sales
volumes to be affected. Any sales volume variance
that does arise as a result of poor quality products
is likely to arise in a different period from the one
in which the mix and yield variances arose, and the
correlation will then be more difficult to prove.
Similarly, poorer quality materials may be more
difficult to work with; this may lead to an adverse
labour efficiency variance as the workforce takes
longer than expected to complete the work. This, in
turn, could lead to higher overhead costs, and so
on. Fortunately, consequences such as these will
occur in the same period as the mix variance and
are therefore more likely to be identified and the

it is also essential to understand the importance of
producing products that are of a consistently good
quality. It can be tempting for production managers
to change the product mix in order to make savings;
these savings may lead to greater bonuses for them
at the end of the day. However, if the quality of
the product is adversely affected, this is damaging
to the reputation of the business and hence its
long‑term survival prospects. While substituting
poor quality input materials may in some cases
lead to yield volumes that are the same as those
achieved with higher quality materials, the yield may
not be of the same quality.
problem resolved. Never underestimate the extent to
which a perceived ‘improvement’ in one area (eg a
favourable materials mix variance) can lead to a real
deterioration in another area (eg decreased yield,
poorer quality, higher labour costs, lower sales
volumes, and ultimately lower profitability). Always
make sure you mention such interdependencies
when discussing your variances in exam questions.
The number crunching is relatively simple once you
understand the principles; the higher skills lie in the
discussion that surrounds the numbers.
Ann Irons is examiner for Paper F5
 student accountant issue 03/2010
01
For PER support and advice on answering challenge questions
www.accaglobal.com/students/acca/per/support

FOCUS ON per
PO 15: evaluate business/investment opportunities and the required
finance options linked to ACCA qualification papers f9 and p4
ACCA students aspiring to a ¤ researching and appraising Activity could include
business or investment opportunities. these may include assessing

and performing cost benefit analysis of potnetial investments.

career in business or industry available sources of finance determining associated
can be in no doubt about how (which might include thinking revenue and costs (such
the role they will play will risks associated with new opportunities, investigating costs about previously unconsidered as resources and people),
A key component of your role will be to evaluate potential

amount to much more than options, such as factoring, comparing the different
simply recording historic figures. leasing or grants). elements of the project,
Today, accountants are required assessing their individual
to be business partners, The next step is to answer and joint merits (paying
working closely with, and the challenge questions for attention to net cash flow
advising, those in key sales and this objective in the trainee and cost of capital).
operational roles, often at senior development matrix (TDM): – You might attend a client
management or board level. ¤ Outline your experience in meeting regarding a change
A key component of your this area: to service delivery (at your
role will be to evaluate potential – This could be an explanation company’s or the client’s
business or investment of how you might revise request), before which you
opportunities. So, what would you a budget, depending might calculate potential
need to demonstrate to your line on the outcome of a post-change profitability
manager or employer? Relevant particular investment, and make recommendations
activity might include: and demonstrating the to your managers – or,
¤ assessing the risks and potential potential impact on figures if you’re calculating
returns associated with new such as sales, profitability the cost implications
opportunities (eg new territories, or payroll. for the client, then
relocations, acquisitions or – You might include work recommending alternatives
product launches) carried out to determine, to them instead.
¤ unvestigate the costs, features as much as is feasible, ¤ How has research you
and benefits of different the profitability of all new have done been integrated
finance options, before making investment opportunities, into a recommendation
specific recommendations as stand-alone investments for management?
based on your employer’s own or as a multiple exercise, – Consider what has happened
financial circumstances comparing and contrasting to your research once it’s
¤ performing cost-benefit analysis each investment and keeping been submitted it your line
of potential investments in mind the non-financial manager or departmental
(considering aspects of risk and implications (such as head. How has it impacted
potential return) environmental impact, or on any investment decision?
¤ identifying advantages and effect on workforce numbers). If the investment went
constraints of potential ¤ What have you done ahead, how did your
corporate action (eg buyout, to fully analyse recommendations influence
merger, takeover, relocation – investment opportunities? the way the project or action
even closing down a site/office) – Perhaps you’ve been given was organised and planned?
¤ appraising different potential responsibility for assessing Illustrate this with specific
capital investment opportunities the value of a long-term examples of where your
(considering issues such as how investment project, either at figures have been used, eg to
quickly the investment might be the outset or completion, or assist with cost control or in
realised if needed) even as a work-in-progress. forecasting profitability.
 01 technical
target
and lifecycle RELEVANT to ACCA QUAlification paper F5
Target costing and lifecycle costing can be
Target costing and lifecycle costing can be regarded
accounting so it is worth first looking at the approach
regarded as relatively modern advances in
management accounting, so it is worth first looking
at the approach taken by conventional costing.
Typically, conventional costing attempts to work
out the cost of producing an item incorporating
as relatively modern advances in management
the costs of resources that are currently used
or consumed. Therefore, for each unit made the
classical variable costs of material, direct labour
and variable overheads are included (the total of
these is the marginal cost of production), together
with a share of the fixed production costs. The
fixed production costs can be included using a
conventional overhead absorption rate or they
can be accounted for using activity-based costing
(ABC). ABC is more complex but almost certainly
more accurate. However, whether conventional
taken by conventional costing.
overhead treatment or ABC is used the overheads
incorporated are usually based on the budgeted
overheads for the current period.
Once the total absorption cost of units has been
calculated, a mark-up (or gross profit percentage)
is used to determine the selling price and the
profit per unit. The mark-up is chosen so that if
the budgeted sales are achieved, the organisation
should make a profit.
There are two flaws in this approach:
1 The product’s price is based on its cost, but
no‑one might want to buy at that price. The
product might incorporate features which
customers do not value and therefore do not want
to pay for, and competitors’ products might be
cheaper, or at least offer better value for money.
This flaw is addressed by target costing.
2 The costs incorporated are the current costs only.
They are the marginal costs plus a share of the
fixed costs for the current accounting period.
There may be other important costs which are
not part of these categories, but without which
the goods could not have been made. Examples
include the research and development costs
and any close down costs incurred at the end
of the product’s life. Why have these costs been
excluded, particularly when selling prices have to
be high enough to ensure that the product makes
a profit. To make a profit, total revenue must
exceed total costs in the long term. This flaw is
addressed by lifecycle costing.
Target costing
Target costing is very much a marketing approach
to costing. The Chartered Institute of Marketing
defines marketing as:
‘The management process responsible for
identifying, anticipating and satisfying customer
requirements profitably.’
In marketing, customers rule, and marketing
departments attempt to find answers to the
following questions:
¤ Are customers homogeneous or can we identify
different segments within the market?
¤ What features does each market segment want in
the product?
¤ What price are customers willing to pay?
¤ To what competitor products or services are
customers comparing ours?
¤ How will we advertise and distribute our
products? (There are costs associated with those
activities too.)
 student accountant issue 03/2010
02

costing
costing
Marketing says that there is no point in Of course, there will probably be a range of products

dreaming up products and adding on a 50% mark-up then

management, engineers and accountants sitting and prices, but the company cannot dictate to

engineers and accountants sitting in darkened rooms

in darkened rooms dreaming up products, putting the market, customers or competitors. There are
them into production, adding on, say 50% for powerful constraints on the product and its price
Marketing says that there is no point in management,
mark-up then hoping those products sell. At and the company has to make the required product,
best this is corporate arrogance; at worst it is sell it at an acceptable and competitive price and, at
corporate suicide. the same time, make a profit. If the profit is going
Note that marketing is not a passive approach, to be adequate, the costs have to be sufficiently
and management cannot simply rely on customers low. Therefore, instead of starting with the cost
volunteering their ideas. Management should and working to the selling price by adding on the
anticipate customer requirements, perhaps by expected margin, target costing will start with the
developing prototypes and using other market selling price of a particular product and work back
research techniques. to the cost by removing the profit element. This
The really important information relating to a new means that the company has to find ways of not
product is: exceeding that cost.
For example, if a company normally expects a
mark-up on cost of 50% and estimates that a new
product will sell successfully at a price of $12, then
do nt? cus What the maximum cost of production should be $8:
at a tom wil
Wh ers w ers l
hoping those products sell.

t o m pay
Cost + Mark-up = Selling price
cus ?
100% 50% 150%
$8 $4 $12

This is a powerful discipline imposed on the

company. The main results are:
¤ The establishment of multifunctional teams
New consisting of marketing people, cost accountants,
product production managers, quality control
professionals and others. These teams are vital to
the design and manufacturing decisions required
to determine the price and feature combinations
that are most likely to appeal to potential buyers
of products.

What do
competitors
offer?
03 technical

product design and production planning, but those up‑front activities also
cause costs. There might be other costs incurred after a product is sold
target costing places great emphasis on controlling costs by good
¤ An emphasis on the planning and design stage. The aim of value engineering is to maximise use
This becomes very important to the cost of and esteem values while reducing costs.
the product because if something is designed For example, if you are selling perfume, the
such that it is needlessly expensive to make, it design of its packaging is important. The perfume
does not matter how efficient the production could be held in a plain glass (or plastic) bottle, and
process is, it will always be a struggle to make although that would not damage the use value of
satisfactory profits. the product, it would damage the esteem value. The
company would be unwise to try to reduce costs by
Here are some of the decisions, made at the design economising too much on packaging.

such as warranty costs and plant decommissioning.

stage, which can affect the cost of a product: Similarly, if a company is trying to reduce the
¤ the features of the product costs of manufacturing a car, there might be many
¤ how to avoid ‘over design’ components that could be satisfactorily replaced by
¤ the number of components needed cheaper or simpler ones without damaging either
¤ whether the components are standard use or esteem values. However, there will be some
or specialised components that are vital to use value (perhaps
¤ the complexity of machining and construction elements of the suspension system) and others
¤ where the product can be made which endow the product with esteem value (the
¤ what to make in-house and what to sub-contract quality of the paint and the upholstery).
¤ the quality of the product
¤ the batch size in which the product can be made. Lifecycle costing
As mentioned above, target costing places great
You will see from this list that ABC can also play an emphasis on controlling costs by good product
important part in target costing. By understanding design and production planning, but those up‑front
the cost drivers (cost causers) a company can activities also cause costs. There might be other
better control its costs. For example, costs could be costs incurred after a product is sold such as
driven down by increasing batch size, or reducing warranty costs and plant decommissioning.
the number of components that have to be handled When seeking to make a profit on a product it is
by stores. essential that the total revenue arising from the
The concept of value engineering (or value product exceeds total costs, whether these costs
analysis) can be important here. Value engineering are incurred before, during or after the product is
aims to reduce costs by identifying those parts of a produced. This is the concept of lifecycle costing,
product or service which do not add value – where and it is important to realise that target costs
‘value’ is made up of both: can be driven down by attacking any of the costs
¤ use value (the ability of the product or service to that relate to any part of a product’s life. The cost
do what it sets out to do – its function) and phases of a product can be identified as:
¤ esteem value (the status that ownership or
use confers).
 student accountant issue 03/2010
04
revenue arising from the product exceeds total costs, whether these costs
When seeking to make a profit on a product it is essential that the total

are incurred before, during or after the product is produced. This is the

Phase Examples of types of cost Typically, the following pattern of costs committed
Design Research, development, design and costs incurred is observed:
and tooling
Manufacture Material, labour, overheads, machine 100 Costs committed
set up, inventory, training,

% costs committed
production machine maintenance 80
and depreciation

or incurred
Operation Distribution, advertising and 60 Manufacturing
warranty claims and operations
End of life Environmental clean-up, disposal 40 phase
Design
and decommissioning phase End of
life phase
20
There are four principal lessons to be learned from
Costs incurred
lifecycle costing: 0
¤ All costs should be taken into account when
working out the cost of a unit and its profitability. Time
¤ Attention to all costs will help to reduce the cost
per unit and will help an organisation achieve its The diagram shows that by the end of the design
target cost. phase approximately 80% of costs are committed.
¤ Many costs will be linked. For example, more For example, the design will largely dictate material,
attention to design can reduce manufacturing labour and machine costs. The company can try to
and warranty costs. More attention to training haggle with suppliers over the cost of components
can reduce machine maintenance costs. More but if, for example, the design specifies 10 units of
attention to waste disposal during manufacturing a certain component, negotiating with suppliers is
can reduce end-of-life costs. likely to have only a small overall effect on costs. A
concept of lifecycle costing.

¤ Costs are committed and incurred at very
different times. A committed cost is a cost that
will be incurred in the future because of decisions
that have already been made. Costs are incurred
only when a resource is used.
bigger cost decrease would be obtained if the design
had specified only eight units of the component. The
design phase locks the company in to most future
costs and it this phase which gives the company its
greatest opportunities to reduce those costs.
05 technical

performance management depends on cost control, not cost measurement.

recording those costs is different to controlling those costs and
Conventional costing records costs only as they are incurred, but
Conventional costing records costs only as they Solution
are incurred, but recording those costs is different The target cost of the product can be calculated
to controlling those costs and performance as follows:
management depends on cost control, not
cost measurement. (a) Cost + Mark-up = Selling price
100% 40% 140%
A numerical example of target and life cycle costing $15 $6 $21
A company is planning a new product. Market
research information suggests that the product (b) The original lifecycle cost per unit = ($50,000 +
should sell 10,000 units at $21.00/unit. The (10,000 x $10) + $20,000)/10,000 = $17
company seeks to make a mark-up of 40% product
cost. It is estimated that the lifetime costs of the This cost/unit is above the target cost per unit,
product will be as follows: so the product is not worth making.
1 Design and development costs $50,000
2 Manufacturing costs $10/unit (c) Maximum total cost per unit = $15. Some of
3 End-of-life costs $20,000 this will be caused by the design and end of
life costs:
The company estimates that if it were to spend an
additional £15,000 on design, manufacturing costs ($50,000 + $15,000 + $20,000)/10,000
per unit could be reduced. = $8.50

Required Therefore, the maximum manufacturing cost per

(a) What is the target cost of the product? unit would have to fall from $10 to ($15 - $8.50)
(b) What is the original lifecycle cost per unit and is = $6.50.
the product worth making on that basis?
(c) If the additional amount were spent on design, Ken Garrett is a freelance lecturer and author
what is the maximum manufacturing cost per
unit that could be tolerated if the company is to
earn its required mark-up?

FOCUS ON per
PO 16: manage cash using active cash management and
treasury systems
Cash management is an
important aspect of sound
accounting in organisations
large and small. You will need
to proactively manage the cash
that flows in on a daily basis,
using active cash management
and treasury systems and
seek ways to optimise returns
and minimise charges, within
acceptable levels of risk.
Remember, that especially
where business or projects
are managed by non-finance
managers, there may not be as
much attention paid to financial
issues as would be ideal – your
employer may rely on your
financial stewardship to ensure
that those managers are made
aware of the impact of their
actions or decisions on cash flow.
To perform effectively, you’ll
need a good understanding
of how to apply your financial
know-how to optimise returns
for cash held on deposit – as
well as minimising risk through
appropriate spreading of
cash deposits. You’ll have to
manage cash on a centralised
basis to maximise returns and
minimise the charges your
company incurs, and ensure
that financial instruments held
to meet liabilities mature on a
timely basis. You should seek to
minimise charges for each option
you pursue.
Examples of relevant
activities include:
¤ setting up an overseas
deposit to meet a future
overseas liability
student accountant issue 04/2010
For PER support and advice on answering challenge questions
www.accaglobal.com/students/acca/per/support
Cash management is an important aspect of sound accounting ¤ pooling cash from various
sources (which could be
regional branches, different
in organisations large and small. You’ll need to ensure that
bank accounts or non-core
revenue streams, such as
rentals received on property
cash isn’t lying around, earning little or no money for
assets) to place on deposit
¤ setting up and using sweep
accounts to automatically
invest liquid funds, so that
returns and cash flows remain
sufficiently steady, without
compromising on risk, thereby
maximising cash available at
any given time
¤ negotiating short-term sources
of finance, such as overdrafts,
trade credit, leasing or loans
¤ exploring the availability and
cost of long-term sources of
finance – such as bank loans,
share capital or debentures,
or even specific asset sales or
venture capital.
By performing effectively in
this area, you’ll deepen your
understanding of financial and
risk management – knowledge
that’s essential for contributing
to the ongoing viability of
a business.
The next step is to answer
the challenge questions for
your employer.
this objective in the trainee
development matrix (TDM):
¤ What would be the business
impact of you not managing
cash effectively?
– Consider the opportunity
costs that would be borne
if cash was simply left in
accounts that didn’t yield a
high return.
01
– Also think about how
regularly you review your
cash management tools – and
what might happen should
you fail to observe where a
usually reliable source of
return on investment starts to
yield far less.
¤ Explain your role in managing
cash effectively
– Detail your responsibilities,
from receiving funds through
to releasing cash – where
do you typically place it?
How do you evaluate the
return? What steps might
you have had to take in
exceptional circumstances,
eg when dealing with larger
than usual sums, or if
your usual avenues are
unavailable?
¤ How have you improved the
cash management system that
you work with?
– Consider recommendations
of yours that were
accepted and initiated by
your employer – how has
the process improved as
a result, eg in terms of
efficiency, cost or manpower?
What impact have your
recommendations had
on your company’s cash
situation – for instance,
where you have readier
access to funds without
losing out on return?
This performance objective is
linked to Paper F9, Financial
Management, and Paper P4,
Advanced Financial Management
01 technical

throughput
and backflush RELEVANT to ACCA QUAlification paper F5

Throughput accounting and backflush accounting Example 1

focuses on what an organisation’s purpose is – its goal

have been developed in response to relatively Throughput accounting has a very direct relationship Take a not-for-profit organisation which
modern advances in manufacturing: performs a medical screening service in three

– and helps attain it by increasing their ‘goal units’.

1 The increased reliance by manufacturing with decision making and performance management. It sequential stages:
businesses on sophisticated and expensive 1 Take an X-ray.
facilities and machinery. This greatly increases 2 Interpret the result.
the proportion of costs which are fixed. (This 3 Recall patients who need further investigation/tell
was one reason why activity-based costing others that all is fine.
has become more important: if fixed costs
are more significant they should be dealt with The ‘goal unit’ of this organisation will be to
more accurately.) progress a person through all three stages. The
2 A recognition that holding inventory is likely to be number of people who complete all the stages is
a waste of resource. the organisation’s throughput, and the organisation
3 The increased use of just-in-time manufacturing, should seek to maximise its throughput. However,
so that inventory (particularly work-in-progress) there will always be a limit to throughput, and
is much reduced and its valuation is therefore the resource which sets that limit is called
less important. the ‘bottleneck resource’. Adding more detail to the
medical screening process above:
Throughput accounting
Throughput accounting has a very direct Process Time/patient Total hours
relationship with decision making and performance (hours) available/week
management. It begins by focusing on what an Take an X-ray 0.25 40
organisation’s purpose is – its goal – and seeks
to help organisations attain their purpose by Interpret the
increasing their ‘goal units’. The approach can be result 0.10 20
applied to both profit-seeking and not-for-profit
organisations, provided meaningful goal units can Recall patients
be identified. who need further
investigation/
tell others that
all is fine 0.20 30

You can easily see from this table that the

maximum number of patients (goal units) who can
be dealt with in each process is:

X-rays: 40/0.25 = 160

Interpret results: 20/0.10 = 200
Recall etc: 30/0.20 = 150
 student accountant issue 03/2010
02
Studying Paper F5?
Performance objectives 12, 13 and 14 are linked

accounting
accounting

contribution per unit is the difference between the selling price of a

profit-seeking organisation is to use contribution analysis. The
So, the recall procedure is the bottleneck resource. $ $
Throughput, and thereby the organisation’s Selling price 140
performance, cannot be improved until that part of Material 20
the process can deal with more people. Therefore, Labour 30
to improve throughput: Variable overhead 10

The traditional approach to decision making in a

1 Ensure there is no idle time in the bottleneck Fixed overhead 25
resource, as that will be detrimental Total absorption cost 85
to overall performance (idle time in a ­Profit per unit 55
non‑bottleneck resource is not detrimental to
overall performance). The cost card is based on a budgeted output of
2 See if less time could be spent on the 10,000 units.
bottleneck activity. In this example, the marginal cost (the additional
3 Finally, increase the bottleneck resource available. cost caused when one more unit is made) is $60
per unit ($20 + $30 + $10). The contribution per

unit and the marginal cost of a unit.

In Example 1, increasing the bottleneck resource,
or the efficiency with which it is used, might be
relatively cheap and easy to do because this is
a simple piece of administration while the other
stages employ expensive machinery or highly skilled
personnel. There is certainly no point in improving
the first two stages if things grind to a halt in
the final stage; patients are helped only when the
whole process is completed and they are recalled
if necessary.
The traditional approach to decision making in
a profit-seeking organisation is to use contribution
analysis. The contribution per unit is the difference
between the selling price of a unit and the marginal
cost of a unit, where marginal cost consists of the
material, variable labour and variable overhead per
unit. Example 2 will remind you of this approach.
A typical cost card for a product is as follows:
unit is:
$140 - $60 = $80
The contribution is the amount by which you ‘win
the race’: each extra unit sold brings in $140, but
each extra unit made causes costs of $60, so after
making and selling one more unit the business is
better off by $80, the contribution.
The fixed cost element is independent of the
number of units actually made. It is based on
budgeted output and budgeted fixed costs and,
working backwards, the total budgeted fixed costs
must have been:
$25 x 10,000 = $250,000
A typical calculation then made using this
information is to find the break even point, which is
this example is 250,000/80 = 3,250 units.
03 technical
reflect the reality of a modern manufacturing business. the notion that
the assumptions it makes about cost behaviour often do not accurately
in example 2, The contribution approach is not wrong in principle, but
there are significant variable labour and overhead costs is suspect.
In Example 2, contribution is the goal unit. If that
is maximised, so is profit, which is the goal of a
profit-seeking organisation.
The contribution approach is not wrong in
principle, but the assumptions it makes about
cost behaviour often do not accurately reflect the
reality of a modern manufacturing business. In
particular, the notion that there are significant
variable labour and overhead costs is suspect.
Many of these businesses rely on sophisticated
automated systems that run continuously with
relatively little manual involvement. Even when
production is slack, provided the downturn is
expected to be short lived, most employees will
still be paid because it is expensive to dismiss
workers and then to rehire and retrain them. For
short-term fluctuations in production it would be
more accurate to consider labour costs and all
overheads to be fixed, leaving material as the only
truly variable cost.
If all costs except material are fixed, businesses
will become richer provided the sales revenue per
unit exceeds material price per unit. In effect, sales
price less material price is the new contribution
per unit, but to make clear what we are talking
about this is not called ‘contribution’: it is called
‘throughput’.
In fact, ‘throughput’ is sometimes usefully known
as ‘throughput contribution’:
table 1, example 3
Product A Product B Product C
Expected demand/budgeted output (units) 8,000 10,000 6,000
Selling price per unit ($) 130 100
Material cost per unit 33 20
Labour cost per unit 30 24
Variable overhead cost per unit 25 20
Fixed overhead cost per unit 15 12
Machine hours/unit
Labour hours per unit
Quality control time per unit
Throughput = selling price - material
per unit per unit per unit
Throughput = sales revenue - cost of materials
Throughput is generated only when a sale is made.
Increasing inventory does not increase throughput.
See Table 1 in Example 3 below.
Available hours: 5,000 machine hours, 6,000
labour hours, 2,500 quality control hours.
The factory is modern and highly automated.
Despite the presentation of the information, it
is considered that all costs, except material, are
effectively fixed. The first step in managing the
performance of an organisation is to discover the
limits to its performance. What is the bottleneck
resource here?
From the data we can identify the bottleneck
resource as seen in Table 2 opposite. So the
bottleneck resource, the one which limits output,
is machine hours. There is more than enough of the
other two resources.
If the company can’t make everything it wants
to, it has to decide on an optimum production plan.
Because the factory is highly automated and material
is the only truly variable cost, throughput will be the
appropriate measure to use when calculating how
much the manufacture and sale of each unit increases
the company’s wealth (see Table 3 opposite).
135
40
36
30
18
0.25 0.2 0.3
0.25 0.2 0.3
0.1 0.1 0.1
 student accountant issue 03/2010
04

bottleneck resource. These are uniquely precious and must be

table 2, example 3

Needed for full production Available

Machine hours 0.25 x 8,000 + 0.2 x 10,000 + 0.3 x 6,000 = 5,800 5,000
Labour hours 0.25 x 8,000 + 0.2 x 10,000 + 0.3 x 6,000 = 5,800 6,000
Quality control hours 0.10 x 8,000 + 0.1 x 10,000 + 0.1 x 6,000 = 2,400 2,500

in example 3, machine hours have been identified as the

table 3, example 3

Product Selling price Material Throughput/unit

($) ($) ($)
A 130 33 97
B 100 20 80
C 135 40 95

table 4, example 3

Product Throughput/unit Machine hours/unit Throughput/machine hour = Rank

($) return/factory hour ($/hour)

used up in the best possible way.

A 97 0.25 388 2
B 80 0.20 400 1
C 95 0.30 317 3

We can’t simply conclude from this that Product This shows that priority should be given to making
A must be best because it earns more per unit Product B, the highest earner per machine
than the other products. It is essential to take into hour, then to Product A, and finally to Product C.
account the use that each product makes of the The production plan would therefore be as seen in
bottleneck resource. Here, machine hours have been Table 5 on page 5.
identified as the bottleneck resource. These are
uniquely precious and must be used up in the best
possible way.
This can be done by calculating for each unit:

Throughput
Time in bottleneck resource

and then using the answers to rank the products as

shown in Table 4 above.
05 technical

hour in example 3, it is common to express these amounts as ratios, known

Instead of directly comparing return/factory hour to costs/factory
table 5, example 3

Units Machine Machine (bottleneck) Throughput ($)

hours/unit hours used
Product B 10,000 0.20 2,000 10,000 x 80 = 800,000
Product A 8,000 0.25 2,000 8,000 x 97 = 776,000
Product C
(balance) 3,333 0.30 1,000 (balance) 3,333 x 95 = 316,635

Maximum machine hours available 5,000 1,892,635

Total expected non-material costs (from the original budget) =

Product A: 8,000 x (30 + 25 + 15) = 560,000

Product B: 10,000 x (24 + 20 + 12) = 560,000
Product C: 6,000 x (36 + 30 + 18) = 504,000
(1,624,000)

as throughput accounting ratios (TAR).

Profit 268,635

The throughput/machine hour (or return/factory
hour) shows the rate at which throughput can be
earned when making and selling each product.
Similarly, if the total expected non-material costs
are divided by the available machine hours then the
cost per factory hour is obtained:
$1,624,000/5,000 = $324.80
So, for every hour the machine operates (which
really means for every hour the factory operates
as nothing else matters if the machine is the
bottleneck resource), running costs accrue at the
rate of $324.80/hour. The products the factory
makes earn a net $388 for Product A, $400 for
Product B and £317 for Product C.
Products A and B are clearly worth making and
selling because their earning rates (return/factory
hour) exceed the factory spending rate on fixed
costs (cost/factory hour). Product C is more difficult
to deal with. If the factory costs are truly fixed
then Product C is still worth making as it earns a
throughput amount of $317/factory hour – which
is a lot better than earning nothing. However, if the
fixed costs identified with Product C ( $504,000)
could actually be avoided, then Product C should
be abandoned as it costs more to run the factory to
make the product than the product can earn.
Instead of directly comparing return/factory hour
to costs/factory hour, it is common to express these
amounts as ratios, known as throughput accounting
ratios (TAR), as shown in Table 6 opposite.
 student accountant issue 03/2010
table 6, example 3
Throughput accounting ratios
Product A Product B Product C
Return/factory hour 388.00 400.00
Costs/factory hour 324.80 324.80
Throughput accounting ratio 1.17 1.21
The TAR tells us nothing that we have not worked
out already. Its interpretation is:
1 The higher the better (but we already knew
the ranking of the products from the return/
factory hour)
2 The TAR should be greater than 1 if a product
is worthwhile (earning rate greater than
spending rate).
Organisations should focus on how they can
increase their TAR. Obvious routes are to increase
selling prices, decrease material costs, or decrease
factory costs. Provided a TAR is greater than 1 it
will be worth trying to increase throughput, and
this must be done by eliminating idle time in the
bottleneck resource, increasing the bottleneck
resource (until another resource becomes the
bottleneck), or decreasing the use the product
makes of the bottleneck resource.
Backflush accounting
Backflush accounting is a costing short cut. It
relies on a business having immaterial amounts
of work‑in-progress and is therefore particularly
suitable for businesses operating just-in-time
inventory management. If the amount of
work‑in‑progress is negligible, what is the point in
meticulously valuing it? Fretting that some products
might be 25% complete and others 60% complete,
and then adding carefully calculated labour
and overheads to these (immaterial) items, is a
complete waste of time and effort.
06
In backflush accounting, costs are not associated with units
also called delayed costing, as costs are not allocated to
until they are completed or sold. Backflush accounting is
317.00
324.80
0.93
In backflush accounting, costs are not associated
with units until they are completed or sold.
Backflush accounting is sometimes called delayed
production until after events have occurred.
costing, which is a helpful name, as costs are not
allocated to production until after events have
occurred. Standard costs are then used to work
backwards to flush out manufacturing costs into
production, splitting them between stocks of
finished goods (if any) and cost of sales. No costs,
whether material or conversion costs, are allocated
to work-in-progress.
The traditional and backflush approaches can be
illustrated by Figures 1 and 2 on page 8.
Variants of backflush accounting
There are two variants of backflush accounting and
they differ according to what are called ‘trigger
points’. Trigger points are the events which cause
costs to be moved into inventories.
07 technical

stocks of both raw materials and work-in-progress must be negligible. It has

variant 2 of backflush accounting is more radical because no records are
kept of work-in-progress or raw materials, so if this method is to be used,
Variant 1 Note that at some point the creditors account will
This is the less radical variant. There are two have to record correctly what is owing to them so,
inventory accounts, raw materials and finished from time to time, this will be adjusted by a cost
goods, and there are two trigger points: variance. Thus, if the standard cost of raw materials
used was $50,000, but the actual cost of materials
1 Purchase of raw materials was $52,000, an adverse variance of $2,000 has to
be recognised and the creditors account would have
Dr Materials account two entries Cr $50,000 (and Dr $50,000 to finished
Cr Creditors goods), then Cr $2,000 and (Dr $2,000 to profit
and loss account).
The cost of labour and other manufacturing So, are there any benefits in adopting backflush
expenses are debited to a conversion cost account accounting other than avoiding complex recording
and credited to cash or creditors. The conversion and calculations to value immaterial amounts of
cost account can be thought of as a suspense inventory? Let’s consider the trigger point found in
account where amounts are placed temporarily. both variants: costs are transferred when goods are
completed. What would happen if that trigger point
2 On completion of units were changed to permit cost transfer only when
goods were sold?
Dr Finished goods account with the standard cost That would mean conversion costs would remain
of goods produced as costs until goods were sold, rather then being
Cr Materials account with the standard cost transformed into finished stock when goods
of materials were completed. Managers would then have no
Cr Conversion cost account with the standard incentive to make goods unless they were going to
cost of conversion. be sold imminently, otherwise they would simply
be incurring more expense, and that would make
Variant 2 their performance look bad. The purpose of a
This is more radical because no records are kept of manufacturing business is not to make goods; its
work-in-progress raw materials, so if this method purpose is to make and sell goods. Only then is
is to be used, stocks of both raw materials and there throughput, and backflush accounting can be
only one trigger point.

work-in-progress must be negligible. It has only one set up so that costing records encourage managers
trigger point. to adopt this goal-orientated behaviour.
As before, the cost of labour and other
manufacturing expenses are initially debited to Ken Garrett is a freelance writer and lecturer
a conversion cost account and credited to cash
or creditors.
Entries into the finished goods inventory account
are made only when goods are completed, and the
journal entries will be:

Dr Finished goods account with the standard cost

of goods produced
Cr Creditors with the standard cost of material
used in goods produced
Cr Conversion cost account with the standard
cost of conversion.
 student accountant issue 03/2010
08

figure 1: traditional costing

Material

Materials account

Costs in Costs out

WIP stage 1 WIP stage 2 Finished goods
to WIP

Conversion costs
To cost
of sales
Costs in Costs out
to WIP

figure 2: backflush accounting

Material

Materials account

Costs in Costs out to

Finished goods
finished goods

Conversion costs
To cost
of sales
Costs in Costs out to
finished goods
01 technical

trusts and tax

RELEVANT TO ACCA QUALIFICATION PAPER P6 (UK)

This article has been written because the taxation The following aspects of the taxation of trusts are

This article is based on tax legislation as it applies to the tax

of trusts and the transfers of assets to and from excluded from the syllabus:
trustees is a complicated area of the UK tax ¤ the calculation of income tax, capital gains tax,
system. Accordingly, there is a need to set out and inheritance tax payable by the trustees of

year 2009–10 (Finance Act 2009), and is relevant for candidates

the rules that may be examined and those areas a trust
where knowledge is not required. However, trusts ¤ knowledge of situations where property is
represent only a small part of the Paper P6 (UK) transferred between trusts or where the terms or
syllabus and the existence of this article should nature of the trust is altered

sitting the Paper P6 (UK) exam in June or December 2010.

not be seen as an indication that the taxation ¤ knowledge of situations where property within
of trusts is of particular importance. a trust with an immediate post-death interest
This article is based on tax legislation as it passes to the spouse or civil partner of the settlor
applies to the tax year 2009–10 (Finance Act 2009), on the death of the life tenant
and is relevant for candidates sitting the Paper P6 ¤ knowledge of the special rules concerning trusts
(UK) exam in June or December 2010. for the disabled, trusts for bereaved minors,
Students sitting Paper P6 (UK) in 2011 will be transitional serial interest trusts, and age 18 to
examined on the Finance Act 2010, which is the 25 trusts.
legislation as it relates to the tax year 2010–11.
Accordingly, this article is not relevant to these Fundamental changes to the inheritance tax regime
students, who should instead refer to the Finance surrounding trusts were introduced in 2006.
Act 2010 version which will be published on the These changes also affect the capital gains arising
ACCA website in 2011. on transfers into and out of trusts, due to the
The requirements of the Paper P6 (UK) syllabus availability of gifts hold-over relief, where a gift is
in respect of trusts include: immediately chargeable to inheritance tax.
¤ the ability to define and distinguish between the
different types of trust WHY USE A TRUST?
¤ the ability to explain how income tax, capital The ability of trusts to solve problems stems from
gains tax, and inheritance tax apply to the fact that trusts enable the benefits arising
transactions involving trusts out of owning property, for example the receipt
¤ knowledge of the tax implications of creating of rental income in respect of a commercial
a trust – now or in the future – including what investment property, to be enjoyed by someone
will happen when trust property passes to other than the legal owner of the property. The law
the beneficiary of trusts recognises that there can be a beneficial
¤ knowledge of the inheritance tax implications of owner of property, known as the ‘trust beneficiary’,
a settlor dying after creating a trust who is not the same as the legal owner (whose
¤ the ability to explain how trusts can be used in name is on the title deeds to the property), known
tax and financial planning. as the trustee.
 student accountant issue 03/2010
Performance objectives 19 and 20 are linked
becomes reasonably clear that, for example, the trustees will pay income tax on
body of trustees, as a separate taxable person. Once this point is recognised it
When thinking about trusts and tax it is helpful to regard the trust or, the
This split of legal and beneficial ownership gives
rise to various possibilities including:
¤ the benefits of owning property can be
transferred to minors while leaving control over
the assets, together with the responsibilities
of managing and maintaining them, with
the trustees
¤ the income generated by assets can be made
available to one group of individuals while the
capital is preserved and protected for another
individual or group
¤ provision can be made in a will for assets, or
the income generated by them, to be directed
towards those in financial need in the years
following the death of the testator (the person
who made the will)
¤ the creator of the trust can retain control over
the income generated by the trust assets.
the assets.
In addition, a number of tax planning opportunities
arise, including:
¤ assets may be transferred into trust such that
they are removed from the settlor’s estate (the
settlor is the person who establishes the trust)
¤ assets may be transferred into trust such that
they will increase in value outside of both the
settlor’s and the beneficiaries’ estates
¤ trustees of a discretionary trust can direct
income towards beneficiaries who are
non‑taxpayers such that there will be a repayment
of the tax paid by the trust.
TYPES OF TRUST
A trust is created when a settlor transfers the
legal ownership of property to the trustees
who hold the property for the benefit of
the beneficiaries.
Where a beneficiary is entitled under the trust
deed to the income from the property or to use
the property, the trust is an ‘interest in possession
trust’ and the beneficiary is known as the ‘life
tenant’. The person who receives the trust property
on the death of the life tenant is known as the
‘remainderman’ and their interest is known as a
‘reversionary interest’.
02
Studying Paper P6?
This form of trust may be used in a will where
there is a surviving spouse and children. The
surviving spouse (life tenant) is entitled to the
income generated by the assets but does not have
access to the assets themselves. The children
(remaindermen) will receive the assets on the death
of the surviving spouse. Under this arrangement,
if, for example, the spouse remarries, the capital
is protected and will eventually be transferred to
the children.
Where the trustees have discretion as to the
accumulation and distribution of trust income and
assets such that a particular beneficiary only has
the possibility, rather than a right, of receiving a
benefit under the trust, the trust is known as a
‘discretionary trust’.
This form of trust enables a settlor to make
general provision for the future needs of the
beneficiaries in a flexible manner. The trustees
will decide how to meet the precise needs of the
beneficiaries as and when they arise in the future.
Property can be transferred into trust by a settlor
whilst they are alive or via their will. In addition,
following an individual’s death, a trust can be
created via a deed of variation.
TRUSTS AND TAX
When thinking about trusts and tax it is helpful
to regard the trust, or the body of trustees, as a
separate taxable person. Once this point is recognised
it becomes reasonably clear that, for example, the
trustees will pay income tax on the income generated
by the trust assets. Beneficiaries receiving income
from a trust are then entitled to a tax credit in
respect of the tax paid by the trustees. (Note that the
calculation of the income tax liability of trustees is
not examinable.)
03 technical

because they have an impact on the inheritance tax due on subsequent gifts
made by the settlor on the death of the settlor or the future life tenant.
Trusts created prior to 22 March 2006 are treated differently from those
created on or after that date. It is not possible to ignore the old rules
The transfer of assets to a trust, just like any Trusts created prior to 22 March 2006 – ‘Old trusts’
other transfer of assets, brings to mind capital The inheritance tax implications of transferring
gains tax and inheritance tax. Both taxes must, assets to an old trust, and of property passing
of course, be considered again where property absolutely from such a trust to a beneficiary are
passes absolutely from the trustees to a beneficiary. summarised in Table 1 on page 6. It can be seen
In both situations it is important to apply the from the table that:
basic rules of the two taxes – the fact that the ¤ the lifetime creation of an ‘interest in possession
question concerns trusts should not be allowed trust’ or an ‘accumulation and maintenance trust’
to cloud the issue. (Note that the calculation of (see following point) was a potentially exempt
capital gains tax or inheritance tax payable by the transfer whereas the creation of a discretionary
trustees on the transfer of assets to a beneficiary is trust was a chargeable lifetime transfer. This
not examinable.) becomes relevant when calculating any further
Capital gains made by the trustees while they are inheritance tax due on the death of the settlor.
managing the trust assets will give rise to capital ¤ on the death of a life tenant of an ‘old’ interest
gains tax. Trustees may also have to pay inheritance in possession trust the trust property must
tax in respect of the property held within the trust. be included in the deceased life tenant’s
These payments are made every 10 years at a death estate.
maximum of 6% of the value of the assets within
the trust. (Again, note that the calculation of these Note that Table 1 refers to an ‘accumulation and
tax liabilities of the trustees is not examinable.) maintenance trust’. This was a particular type
of discretionary trust, which had advantages for
Inheritance tax inheritance tax purposes. From 6 April 2008, such
As far as inheritance tax is concerned, it is trusts become ‘relevant property trusts’ (see below
important to recognise when a trust was created and Table 2 on page 7). The conditions that had to
and to know the relevant tax implications. It is be satisfied for a trust to be an accumulation and
then necessary to consider the inheritance tax maintenance trust are not examinable.
valuation rules together with the availability of
reliefs (particularly business property relief) and Trusts created on or after 22 March 2006 – ‘New trusts’
exemptions as well as chargeable transfers in the The inheritance tax implications of transferring
previous seven years. assets to a new trust, and of property passing
Trusts created prior to 22 March 2006 are treated absolutely from such a trust to a beneficiary are
differently from those created on or after that date. summarised in Table 2. It can be seen from the
It is not possible to ignore the old rules because table that:
they will have an impact on the inheritance tax due ¤ the transfer of property to any new trust is a
on subsequent gifts made by the settlor and on the chargeable transfer.
death of the settlor or the life tenant in the future. ¤ property comprised within an ‘immediate
Accordingly, there are two sets of rules to learn. post‑death interest trust’ (see following point) is
regarded as belonging to the life tenant such that
it will be included in the deceased life tenant’s
death estate.
 student accountant issue 03/2010
04

As far as capital gains tax is concerned it should be remembered that there

has not arisen on death, it is necessary to consider whether the assets are
is no capital gains tax on death. Where the transfer to or from the trust
¤ all other new trusts are known as ‘relevant EXAMPLE 1
property (mainstream) trusts’ and are subject Alfred
to the 10-year charge and an exit charge when Alfred is married with three children. His main
the property passes to the beneficiary. It should assets are a valuable art collection and a number of
be noted that these charges are at a maximum investment properties. Alfred is writing his will and
of 6% (30% of the lifetime tax rate of 20%) wants to provide for his wife, Molly, while ensuring
which may not be significant in the context of the that the capital value of his estate is preserved for
planning that is taking place. his children.
Alfred could establish a trust with an immediate
Note that Table 2 refers to a trust with an post-death interest via his will. Molly would be the
immediate post-death interest. This is a particular life tenant and would have the right to use the trust
type of interest in possession trust, and is treated assets and receive any income during her lifetime.
differently from all other ‘new’ trusts in that the On her death the assets would pass to the children.
trust property is treated as belonging to the Alfred would need to be advised that on the
life tenant for the purposes of inheritance tax. transfer of the assets to the trustees:
Such a trust can only be created on the death of ¤ there will be no capital gains tax as the trust will
the settlor. be created on his death
¤ there will be no inheritance tax, as he will be
Capital gains tax regarded as having left his estate to Molly such
As far as capital gains tax is concerned it should that the spouse exemption will apply.
be remembered that there is no capital gains tax
on death. Where the transfer to or from the trust While the assets are in the trust:
has not arisen on death, it is necessary to consider ¤ the trustees will be subject to income tax and
whether the assets are chargeable or exempt. If capital gains tax on the income and gains arising
they are chargeable, and a gain has arisen, the in respect of the trust assets; Molly will also be
availability of reliefs, particularly gifts hold-over taxed on the income but will receive a credit for
relief, should also be considered. the tax paid by the trustees
The capital gains tax implications of transferring ¤ there will be no 10-year charge.
assets to a trust, and of property passing
absolutely from a trust to a beneficiary, are On the death of Molly and the transfer of the assets
chargeable or exempt.

summarised in Table 3 on page 8. These rules to the children:

apply to transfers made on or after 22 March 2006. ¤ there will be no capital gains tax on the gains
The rules that applied prior to that date are not made while the assets have been within the
examinable. Table 3 shows that: trust, because the assets are transferred as a
¤ there can be no chargeable gain on the creation consequence of a death
of a trust with an immediate post-death interest ¤ the trust property will be included in Molly’s
as it can only be created on death. death estate for the purposes of inheritance tax.
¤ due to the availability of gifts hold-over relief, no
capital gains tax need be paid on the transfer of
any assets to or from a relevant property trust.
05 technical
EXAMPLE 2
Carolyn and Eric
Carolyn and Eric are in their 30s and have been
married for 10 years. They have two young
children. They run a successful property investment
company, Caric Ltd, which generates a significant
amount of income and is rapidly increasing in
value. They are looking for a way to reduce the value
of their estates by transferring some of the shares
in Caric Ltd to their children.
Where assets are increasing in value it is
advisable to give them away sooner rather than
later as the value for inheritance tax purposes is
the value at the time of the gift. This is often not an
issue with unquoted shares due to the availability of
100% business property relief. However, Caric Ltd
is an investment company and therefore does not
qualify for business property relief.
Carolyn and Eric will want to retain control
over the shares in order to retain control over the
future of the company. This can be achieved by
transferring the shares to a trust and appointing
themselves as trustees. The trust will then hold the
shares for the benefit of the children.
The type of trust to use will depend on what they
want to achieve. For example, they may need to use
a discretionary trust if they wish to accumulate
income or retain a degree of flexibility over its
distribution. However, because the trust is not
being created on death, the tax implications will
be the same regardless of whether the trust is
discretionary or subject to an interest in possession.
Carolyn and Eric would need to be advised that
on the transfer of the shares to the trust:
¤ the transfer will be a chargeable lifetime transfer
¤ gifts hold-over relief will be available, even
though Caric Ltd is an investment company,
because the transfer is immediately chargeable to
inheritance tax.
When advising on the tax implications of using a trust you should consider
all three relevant taxes, income tax, capital gains tax and inheritance
While the shares are in the trust:
¤ the trustees will be subject to income tax and
capital gains tax on the income and gains arising
in respect of the trust assets; a repayment of
income tax paid may be available where income is
distributed to non-taxpayers or those paying tax
at the basic rate
tax, unless the question requirement states otherwise.
¤ inheritance tax will be charged every 10 years
on the value of the assets within the trust at a
maximum of 6%.
On the transfer of assets to the beneficiaries:
¤ an exit charge will arise for the purposes of
inheritance tax again at a maximum of 6%
¤ gifts hold-over relief will be available even though
Caric Ltd is an investment company, because
the transfer is immediately chargeable to
inheritance tax.
CONCLUSION
Trusts can be used to solve practical problems
where there is a desire to transfer wealth while
protecting the capital or retaining a degree of
control over the assets. They also represent a useful
tax-planning tool.
When advising on the tax implications of using a
trust you should consider all three relevant taxes,
income tax, capital gains tax and inheritance tax,
unless the question requirement states otherwise.
Apply the fundamental rules of these taxes to the
precise circumstances of the question in order to
maximise the marks obtained.
Rory Fish is examiner for Paper P6 (UK)
The comments in this article do not amount to advice
on a particular matter and should not be taken as such.
No reliance should be placed on the content of this
article as the basis of any decision. The author and
ACCA expressly disclaim all liability to any person in
respect of any indirect, incidental, consequential or
other damages relating to the use of this article.
 student accountant issue 03/2010
06

TABLE 1: INHERITANCE TAX AND TRUSTS CREATED PRIOR TO 22 MARCH 2006

Transfer into trust 10-year charge? Property passes

absolutely to a beneficiary
‘Interest in possession trust’ In settlor’s lifetime: No On the death of the life tenant:
¤ potentially exempt transfer ¤ part of the life tenant’s
On death: estate
¤ part of the deceased’s estate On any other occasion:
¤ transfer of value by the
life tenant
¤ no IHT if property passes to
the life tenant
¤ a potentially exempt transfer
if it is to an individual
¤ otherwise a chargeable
lifetime transfer

‘Accumulation and As for ‘interest in possession trusts’ Yes From tax year 2008–09:
maintenance trust’ (But not before ¤ trustees pay a maximum
the tax year of 6%
2008–09)

‘Discretionary trust’ In settlor’s lifetime: Yes ¤ Trustees pay a maximum

¤ chargeable lifetime transfer of 6%
On death:
¤ part of the deceased’s estate
07 technical

TABLE 2: INHERITANCE TAX AND TRUSTS CREATED ON OR AFTER 22 MARCH 2006

Transfer into trust 10-year charge? Property passes

absolutely to a beneficiary
Trusts with an immediate Can only be created on death: No On the death of the life tenant:
post-death interest ¤ part of the deceased’s estate ¤ part of the life tenant’s
estate
On any other occasion:
¤ transfer of value by the
life tenant
¤ no IHT if property passes to
the life tenant
¤ a potentially exempt transfer
if it is to an individual
¤ otherwise a chargeable
lifetime transfer

Relevant property (mainstream) In settlor’s lifetime: Yes Trustees pay a maximum

trusts (ie all other trusts) ¤ chargeable lifetime transfer of 6%
On death:
¤ part of the deceased’s estate
 student accountant issue 03/2010
08
51

Table 3: CAPITAL GAINS TAX AND TRUSTS CREATED ON OR AFTER 22 MARCH 2006

Transfer into trust on or after Property passes absolutely to

22 March 2006 a beneficiary
Trusts with an immediate Can only be created on death: On the death of a life tenant:
post-death interest ¤ no CGT on death ¤ no CGT on gains made while assets
¤ trustees acquire assets at held by trustees
probate value On any other occasion:
¤ compute gain by reference to
market value
¤ gifts hold-over relief is available in
respect of qualifying business assets
and on any assets if the transfer is
immediately subject to IHT

Relevant property (mainstream) In settlor’s lifetime: ¤ compute gain by reference to

trusts (ie all other trusts) ¤ compute gain by reference to market value
market value ¤ gifts hold-over relief is available
¤ ¤ gifts hold-over relief is available in because the transfer is immediately
respect of qualifying business assets subject to IHT
and on any assets if the transfer is
immediately subject to IHT
On death:
¤ no CGT on death
¤ trustees acquire assets at probate value
 01
international
RELEVANT TO ACCA QUALIFICATION PAPER P6 (UK)
This article is based on tax legislation as it applies to the tax year
2009–10 (Finance Act 2009), and is relevant for candidates
sitting Paper P6 (UK) in June or December 2010.
technical
This article is based on tax legislation as it applies
to the tax year 2009–10 (Finance Act 2009), and is
relevant for candidates sitting the Paper P6 (UK)
exam in June or December 2010.
Liability to tax in the UK depends on an
individual’s residence, ordinary residence and
domicile status, together with the location of their
assets and the sources of their income. It is a
tricky area and can be confusing. This article aims
to clear up any confusion you may have. It begins
with some basic rules, an understanding of which
enables us to identify the particular areas of tax
affected by an individual coming to, or leaving, the
UK. It then goes on to review those areas in some
detail, and provides a clear set of questions to ask
in order to determine an individual’s liability to UK
taxes. Finally, it deals briefly with the impact of
double tax relief and treaties.
Some basic rules
Generally, the UK tax position of an individual who
has always lived and worked in the UK (ie someone
who is resident, ordinarily resident and domiciled in
the UK) is as follows:
¤ income tax (IT) on worldwide income
¤ capital gains tax (CGT) on worldwide assets
¤ inheritance tax (IHT) on worldwide assets.
Similarly, the UK tax position of an individual who
has always lived and worked outside of the UK (ie
someone who is not resident, ordinarily resident or
domiciled in the UK) is as follows:
¤ IT on UK source income only
¤ no CGT (unless the asset sold is used in a
UK trade)
¤ IHT on UK assets only.
Read the above points carefully, think about them,
and recognise that they result in the following:
¤ UK source income is always subject to UK IT,
regardless of the status of the individual
¤ there is no UK CGT, even on (most) UK assets,
where the individual is based outside of the UK
¤ UK assets are always subject to UK IHT,
regardless of the status of the individual.
UK assets include land, buildings and chattels
in the UK, cash in UK bank accounts, and UK
registered securities.
UK source income consists of income in respect
of UK assets, employment income in respect of
duties performed in the UK, and trading income in
respect of trades carried on in the UK.
Completing the picture
The rules, as set out above, raise three fundamental
questions:
1 Foreign income: At what point does foreign
income become subject to UK IT?
2 Liability to UK CGT: When are gains on UK and
foreign assets subject to UK CGT?
3 Liability to UK IHT on foreign assets: At what
point do foreign assets become subject to
UK IHT?
This article identifies the order in which the key
factors of residence, ordinary residence, and
domicile should be considered when answering
these questions. A brief reminder of the rules used
to determine an individual’s residence, ordinary
residence and domicile status is included in
the appendix.
1 Foreign income
The key factor when considering the taxation of
foreign income is the individual’s residence position.
Figure 1 indicates the liability of foreign investment
income and trading income to UK IT.
 student accountant issue 04/2010
02
Studying Paper P6?
Performance objectives 19 and 20 are linked

travellers
Figure 1: UK IT on foreign investment income Note the following:

Liability to tax in the UK depends on an individual’s residence,

and trading income ¤ Where an individual is non-UK resident, foreign
income is not subject to UK IT. There is no need

ordinary residence and domicile status, together with the

to consider the person’s ordinary residence or
Foreign domicile status. This is true even if the individual

location of their assets and the sources of their income.

income is not brings the income into the UK.
UK resident?
No subject to ¤ Where an individual is UK resident, foreign
UK IT income is subject to UK IT. The manner in which
Yes it is taxed depends on the individual’s ordinary
residence and domicile status. The remittance
basis is available if the individual is non-ordinarily
Foreign resident or non-domiciled.
income is ¤ An individual who is non-ordinarily resident or
subject to non-domiciled may be taxed on the remittance
UK IT basis. Where unremitted foreign income and/or
gains is less than £2,000, no claim is required.
Where a claim is required, individuals who have
been resident in the UK for seven of the nine tax
Foreign years prior to the year in question must pay a fee
income of £30,000 in order to be taxed on the remittance
UK ordinarily is subject to basis. Individuals who claim the remittance
resident and UK IT basis are not entitled to the income tax personal
UK domiciled? Remittance allowance. Individuals can choose each year
No basis whether or not to pay tax on the remittance basis.
available ¤ Under the remittance basis, income is subject
Yes to UK IT only if it is brought into the UK. An
individual with foreign bank interest will not pay
UK IT on that interest if he can show that it has
UK IT on not been brought into the UK. This could be
all foreign achieved by, for example, showing that it has not
income been removed from the foreign bank account.

Example 1: Adele
Adele came to the UK in 2008/09 but did not
Figure 1 relates to the taxation of foreign become resident until 2009/10. She is domiciled
investment income and trading income only. It has outside the UK. Adele has employment income in
already been recognised that UK source income respect of her job in the UK and interest arising on
is always subject to UK IT regardless of the a foreign bank account of £4,000 per year. Adele’s
individual’s tax status. Foreign employment income liability to UK IT is as follows:
is considered below, following Example 1. ¤ Her employment income is in respect of UK
duties. Accordingly, it will be subject to UK IT in
both 2008/09 and 2009/10.
¤ In 2008/09, the foreign bank interest will not
be subject to UK IT as Adele is not resident in
the UK.
04 technical

The key factors in determining an individual’s liability to UK CGT are residence

and ordinary residence. Domicile is only relevant where gains have been
¤ In 2009/10, Adele is UK resident and will be Figure 2 relates to the taxation of foreign
taxed on her foreign bank interest as well as her employment income only and is slightly different
UK source employment income. However, she from Figure 1. A UK resident and ordinarily resident
can claim to be taxed on the remittance basis as but non-UK domiciled individual can not be taxed on
she is not domiciled in the UK. There will be no the remittance basis unless the employer is foreign
need for Adele to pay the £30,000 charge as she and the duties are performed wholly outside the UK.
has not been UK resident for seven of the nine The rules set out above (in the notes below
tax years prior to 2009/10. Figure 1) regarding the £30,000 fee and the
remittance basis apply equally here.
Figure 2 below indicates the liability of foreign
employment income, ie income in respect of foreign 2 Liability to UK CGT
duties, to UK IT. The key factors in determining an individual’s
liability to UK CGT are residence and ordinary
residence. Domicile is only relevant where gains
Figure 2: UK IT on foreign have been realised on foreign assets. Figure 3
employment income indicates the liability of an individual to UK CGT on
both UK and foreign assets.
Foreign
UK resident? income is not Note the following:
subject to ¤ To be outside of UK CGT, an individual must be
No UK IT both non-resident and non-ordinarily resident,
Yes
and must not be a temporary non-resident.
Foreign ¤ UK CGT applies to worldwide assets. Once
income is an individual is subject to UK CGT it is then
subject to necessary to consider the person’s domicile
UK IT status to determine the treatment of gains on
foreign assets.

realised on foreign assets.

¤ The rules set out above (in the notes below
Foreign Figure 1) regarding the £30,000 fee and the
income is remittance basis apply to capital gains as well
UK ordinarily as to income. Note that the de minimis limit of
resident? subject to UK IT
Remittance £2,000 applies to the total of unremitted income
No and gains. Individuals who claim the remittance
basis available
basis are not entitled to the capital gains tax
Yes annual exemption.
UK domiciled? ¤ Income
in respect The rules for temporary non-residents were
No of duties
performed introduced in order to prevent individuals avoiding
wholly abroad UK CGT by going abroad for a relatively short period
Yes for a foreign of time, becoming non-resident and non-ordinarily
employer –
UK IT on remittance
resident, and then selling assets outside of UK CGT.
foreign income basis available
¤ Other income
on receipts – receipts
basis basis
 student accountant issue 04/2010
04

assets is domicile. Foreign assets are subject to UK IHT where the individual is
The key factor in determining an individual’s liability to UK IHT on foreign
Figure 3: Liability to UK CGT Example 2: Bosun
Bosun has always been UK resident, ordinarily
resident and domiciled. On 1 June 2009 he left the
UK resident UK and became non-resident and non-ordinarily
or ordinarily resident. His intention was to remain outside of
resident? Yes the UK for four years. In 2010/11 Bosun sold some
shares (acquired in 2002), and a painting (acquired
in 2010).
No Bosun’s liability to UK CGT is as follows:
¤ Bosun is non-resident and non-ordinarily resident.
Accordingly, he will not be subject to UK CGT
Temporary UK CGT on unless he is caught by the rules for temporary
non-resident? UK assets either domiciled or deemed domiciled in the UK. non-residents.
Yes ¤ If Bosun returns to the UK as planned he will
have been outside the UK for less than five years
No and will therefore be a temporary non-resident.
The gain on the shares will be taxed in the year
he returns.
No CGT on ¤ If he is non-resident for more than five years, the
(most) UK gain on the shares will not be subject to UK CGT.
assets and all UK domiciled?
¤ The gain on the painting will not be subject to UK
foreign assets CGT as the painting was acquired after Bosun left
Yes No the UK.

3 Liability to UK IHT on foreign assets

Remittance The key factor in determining an individual’s liability
UK CGT basis available to UK IHT on foreign assets is domicile. Foreign
on all foreign in respect of assets are subject to UK IHT where the individual is
assets gains on either domiciled or deemed domiciled in the UK.
foreign assets The deemed domicile rules relate to IHT only
and are not relevant for the purposes of IT or CGT.
The rules can apply to individuals coming to, and
leaving, the UK.
The rules apply to individuals: An individual who comes to the UK with the
¤ who have been UK resident for at least four of the intention of returning, in due course, to their home
seven tax years prior to the year of departure; country is likely to retain a non-UK domicile. This
and is true even where the individual remains in the UK
¤ who leave the UK for a period of less than for a considerable period of time. However, once
five years. the individual has been resident for 17 out of the
last 20 tax years, he is deemed domiciled for the
Gains made on assets owned at the time of leaving purpose of UK IHT. As a result, any foreign assets
the UK, but sold while the individual is outside of become subject to UK IHT even though he has not
the UK, remain subject to UK CGT. Gains on assets acquired true UK domicile.
purchased after leaving the UK are not subject to
UK CGT.
05 technical

specific and precise in your terminology; Be careful to address only those

When answering a question that includes an international traveller Be

issues asked for in the requirement; and Ensure that you are always clear
An individual who leaves the UK and acquires a Conclusion
non-UK domicile is still deemed domiciled in the UK International travellers add an extra dimension
for a further three years. Accordingly, any foreign to exam questions because their liability to
assets continue to be subject to UK IHT until he has UK taxes changes as they move to, or from, the
been non-domiciled for more than three years. UK. When answering a question that includes an
international traveller:
Double tax relief and treaties ¤ Be specific and precise in your terminology.
An individual who is liable to UK IT on worldwide ¤ Be careful to address only those issues asked for
income may find that income arising in respect in the requirement.
of foreign assets is taxable in two countries – the ¤ Ensure that you are always clear as to which tax
UK, and the country in which the income arises. A you are writing about.
similar situation may arise in respect of CGT or IHT.
Relief may be available via either a double tax treaty Appendix: Residence, ordinary residence
or double tax relief. and domicile
A double tax treaty, between the UK and the The rules governing residence, ordinary residence
country in which the income arises, will set out how and domicile are complex, and depend on the time
double taxation is to be avoided or minimised. The spent in the UK and the intention of the individual
treaty could state that the income will only be taxed concerned. The tables opposite provide examples of
in one of the countries concerned (for example, the the more common situations.
as to which tax you are writing about.

country in which the income arises). Alternatively, Table 1 shows the situation for an individual
it could impose a maximum rate of tax in one of coming to the UK.
the countries. Table 2 shows the situation for an individual
UK double tax relief is available where there is leaving the UK.
no treaty or where an element of double taxation
occurs, despite the existence of a treaty. Foreign Rory Fish is the examiner for Paper P6 (UK)
tax suffered, up to a maximum of the UK tax on the
foreign income (or transaction, subject to CGT or The comments in this article do not amount to advice
IHT), is deducted from the UK tax liability. on a particular matter and should not be taken as such.
No reliance should be placed on the content of this
article as the basis of any decision. The author and
ACCA expressly disclaim all liability to any person in
respect of any indirect, incidental, consequential or
other damages relating to the use of this article.
 student accountant issue 04/2010
06

Table 1: an individual coming to the uk becomes:

UK resident UK ordinarily resident UK domiciled

¤ If in the UK for 183 days or more in ¤ If resident from year to year ¤ If all links with the former country of
a tax year, deemed resident for that domicile have been cut; and
tax year ¤ Intending to remain in the
UK permanently

¤ From year of arrival, if in the UK for ¤ From year of arrival, if in the UK for an
an average of 91 days or more for average of 91 days or more for four
four tax years and this intention was tax years and this intention was clear
clear from the outset from the outset

¤ From date of arrival if intending ¤ From date of arrival if intending to stay

to stay for two years or more for three years or more

Table 2: an individual leaving the uk becomes:

Non-UK resident Non-UK ordinarily resident Non-UK domiciled

¤ For the tax year if outside the UK for ¤ If outside the UK for at least ¤ If all links with the UK have been cut;
that year three years and
¤ Intending to remain in the new
¤ For a period of absence resulting from ¤ From a period of absence resulting country permanently
leaving the UK under a full-time from leaving the UK under a full-time
contract of employment, where that contract of employment, where that
period includes a complete tax year period includes a complete tax year

¤ From date of departure if intending to ¤ From date of departure if intending to

leave UK for three years or more leave UK for three years or more

The rules governing residence, ordinary residence and domicile are

complex, and depend on the time spent in the UK and the intention
of the individual concerned.
 01 technical
been provided by the IAASB’s Practice Alert Audit Considerations in Respect of
Going Concern in the Current Economic Environment, issued in January 2009.
well-established source of guidance for auditors. additional direction has
during the recent global economic crisis, ISA 570, Going Concern has been a
RELEVANT to ACCA Qualification paper P7
The recent global economic
crisis, commonly referred to as
the credit crunch, has provided
many challenges for both the
preparers and the auditors of
published financial statements.
For auditors, ISA 570, Going
Concern is a well-established
source of guidance, and
additional direction has been
provided by the IAASB’s Practice
Alert Audit Considerations in
Respect of Going Concern in the
Current Economic Environment,
issued in January 2009. In the
UK, the APB issued the Bulletin
Going Concern Issues During the
Current Economic Conditions in
December 2008. Both of these
are examinable documents for
the Paper P7 exams in 2010.
going
The auditor’s objectives in relation
to going concern
ISA 570 contains well‑established
guidance on going concern,
including the following objectives
for the auditor:
¤ to obtain sufficient appropriate
audit evidence regarding
the appropriateness of
management’s use of the
going concern assumption
in the preparation of the
financial statements
¤ to conclude, based on the audit
evidence obtained, whether
a material uncertainty exists
related to events or conditions
that may cast significant
doubt on the entity’s ability to
continue as a going concern,
and
¤ to determine the implications
for the auditor’s report.
All audits should involve
an assessment of the
appropriateness of the going
concern assumption, and it is
obvious to say that the auditor
may well have to perform
additional procedures when there
are heightened risks relating
to going concern, caused by
difficult economic and market
conditions. But going concern
should be considered at all
stages of the audit, not just in
terms of specific procedures.
It is important to remember
that going concern is not just
something considered at a
particular stage in the audit
cycle, but should be an issue
that permeates the whole
performance and review of
an audit.
Auditors should consider the
current economic circumstances
and their impact on a particular
audit when:
¤ assessing risk at the planning
stage of the audit, and when
re-assessing risk as the
audit progresses
¤ designing and performing audit
procedures to respond to the
assessed risks
¤ evaluating and concluding on
the results of audit procedure,
and
¤ forming an audit opinion.
Assessing risk at the planning stage
of the audit
Auditors are required by ISA 315,
Identifying and Assessing the
Risks of Material Misstatement
through Understanding the Entity
and Its Environment, to gain an
understanding of the audit client’s
business and the economic
environment in which it operates.
This understanding should then
lead to the identification of
business risks, which are then
evaluated in terms of any risks
of material misstatement in the
financial statements.
 student accountant issue 03/2010
02
Studying Paper P7?
Performance objectives 17 and 18 are relevant to this exam

concern
Business risks include risks The evaluation of business ¤ incorrect measurement or

something considered at a particular stage in the audit cycle,

that could reduce the company’s risks should lead to the disclosure of provisions or
profit and/or cash inflows, assessment of specific financial contingent liabilities caused by

but should be an issue that permeates the whole performance

and could ultimately mean statement risks. For a company restructuring of operations.
It is important to remember that going concern is not just

that either a company is not a facing going concern difficulties,

going concern, or that there are the fundamental financial Designing, performing and
significant doubts over its ability statement risk is whether the evaluating audit procedures
to continue as a going concern. financial statements have been Where risks, such as the ones
Identification of this heightened prepared under the correct mentioned above, have been
risk at this initial stage in the assumption, or whether any identified, the auditor must
audit cycle means that additional significant uncertainties have respond to the risks by designing
audit procedures can be planned been disclosed in the financial and performing appropriate
as a response to the specific statements. However, there are audit procedures. Clearly the
risks identified. more specific financial statement procedures should address the
All of this means that the risks including: specific risks identified, and
auditor must gain a detailed ¤ potential overstatement so extra procedures may be
understanding of the economic of non‑current assets if needed on many balances and
environment in which a impairments caused by transactions such as the ones
company is operating, and more reduced market value or outlined above.
specifically, an understanding of value in use have not been More generally, audit
the particular market conditions recognised procedures are necessary in
affecting its operations. Risks ¤ potential overstatement of order to evaluate how the key
can arise from many factors, inventory if net realisable management personnel have
including reduced demand for value has fallen due to satisfied themselves that it is
goods and services, customers’ reduced demand appropriate to adopt the going
inability to pay for goods and ¤ potential overstatement of concern basis in preparing the
services already provided, and receivables if bad debts not financial statements. Procedures
an inability to raise necessary provided for should include:
finance. Such factors must ¤ incorrect measurement and ¤ analysing and discussing cash
and review of an audit.

be assessed for their specific recognition of gains or losses flow, profit and other relevant
impact on a company’s on financial instruments due to forecasts with management
operations. It is important inactive markets ¤ reviewing the terms of
to remember that difficult ¤ incorrect measurement and loan agreements and
economic or market conditions disclosure of assets held for determining whether they have
do not necessarily mean that a sale or discontinued operations been breached
material uncertainty exists about ¤ reading minutes of board
a company’s ability to continue meetings and relevant
as a going concern. committees for any discussion
of financing difficulties
03 technical
¤ reviewing events after the
year end to identify factors
relevant to the going concern
assumption as a basis
for the preparation of the
financial statements.
Paragraph A15 of ISA 570
contains examples of additional
procedures that may be used.
Analysis of cash flow is
usually a key feature of any
going concern evaluation. In this
evaluation the auditor should
pay particular attention to the
reliability of the company’s
systems for generating the cash
flow information, and whether the
assumptions underlying the cash
flow appear reasonable.
In evaluating going concern,
the auditor will consider whether
necessary borrowing facilities
are in place and in doing so will
attempt to obtain confirmations
from the company’s bankers.
In evaluating going concern, the auditor will consider whether necessary
borrowing facilities are in place and in doing so will attempt to
However, the bankers may be In rare circumstances, where
reluctant to confirm whether the financial statements have not
the borrowing facilities will been prepared under the going
be available, in which case concern assumption (for example,
the auditor should consider using a liquidation basis), and
the significance of this to the the auditor agrees with the use
entity’s ability to continue of this alternative basis for the
as a going concern, and also preparation of the financial
consider, through discussion with statements, the audit report will
management, whether there are not be qualified, as there is no
obtain confirmations from the company’s bankers.
other strategies or sources of basis for a disagreement, but the
finance available. auditor may consider it necessary
to include an Emphasis of
Forming an audit opinion Matter paragraph in the audit
In forming the audit opinion, report to highlight the unusual
the auditor should consider circumstances to the users of the
two issues: have the financial financial statements.
statements been prepared It is much more likely that
using the appropriate going the auditor disagrees with the
concern assumption, and is level of disclosure of material
there adequate disclosure of any uncertainties, rather than
material uncertainty regarding disagreeing with the use of
the going concern status. the going concern assumption.
First, the auditor may conclude ISA 570 contains detailed
that management’s use of the guidance in this area, which is
going concern assumption is briefly summarised below:
inappropriate. This means that ¤ Where the disclosure of
the financial statements are material uncertainty is
effectively rendered meaningless, considered adequate, the
and ISA 570 requires the auditor auditor includes an Emphasis
to express an adverse opinion on of Matter paragraph within the
the financial statements. audit report to highlight the
uncertainty to the users of the
financial statements.
 student accountant issue 03/2010
even though the global economy may show signs of recovery, the effects in
difficult times as a one-off exercise, but as an issue to be continually addressed.
time. auditors should not approach the assessment of going concern in
some markets and for many companies are not likely to be seen for some
¤ Where there are multiple Ethical matters
significant uncertainties In the current economic climate,
that relate to the financial with severe restrictions on
statements as a whole, a borrowing facilities in many
disclaimer of opinion may be jurisdictions, auditors are likely
considered more appropriate to be asked by audit clients to
than an Emphasis of Matter perform non-audit services which
paragraph. ISA 570 comments may create self review, advocacy
that this is in extremely rare or management threats to
cases only. objectivity and independence. For
¤ Where the disclosure of example, the audit firm may be
material uncertainty is not asked to perform:
considered adequate, the ¤ a review of the business
audit opinion should be either including advising on
qualified due to disagreement, restructuring options
or an adverse opinion should ¤ a review of prospective
be given, depending on the financial information, possibly
level of significance of the lack for presentation to potential
of disclosure. providers of finance
¤ advising on corporate finance
options, or negotiating
such options.
The problem created is that
the audit firm may not be able
to objectively assess going
concern factors when in addition
becoming involved with non-audit
services pertaining to the going
concern status of the company.
The audit firm should carefully
consider the appropriateness of
providing such non-audit services
in these circumstances.
04
Safeguards may be able to
reduce the threats to objectivity
and independence to an
acceptable level. Safeguards may
include:
¤ a review of the going concern
assessment and conclusion
reached by a partner who is not
a member of the audit team
¤ additional procedures as part
of an Engagement Quality
Control Review
¤ confirmation from the audit
client that they remain
responsible for any decisions or
actions taken as a result of the
non-audit service provided.
Conclusion
In the current economic climate,
auditors must be extra vigilant
in relation to the audit of going
concern matters, and should also
remember the possible ethical
implications of being involved
in non-audit services relevant
to going concern. Even though
the global economy may now
be showing signs of recovery,
the effects in some markets and
for many companies are likely
to be seen for some time, so
auditors should not approach
the assessment of going concern
in difficult times as a one-off
exercise, but as an issue to be
continually addressed.
Lisa Weaver is examiner for
Paper P7
01 technical

change in
paper p7 will be amended to embed the question requirement
This short article highlights a change in the style Second, ACCA’s recent Qualifications Survey
of question requirements which will be introduced canvassed the opinion of employers and tutors

into the question scenario. Typically, the scenario will

from June 2010 for Paper P7 (UK) and (IRL), and worldwide. The survey indicated that employers in
from June 2011 for all adaptations of Paper P7. particular would welcome a more ‘real-life’ slant
contain an email or other type of communication, to the paper, which will be addressed through the
Change in question requirement style new style of question requirement.
The style of some of the question requirements Finally, the change will bring Paper P7 more
in Section A of the paper will be amended to into line with the other Professional level papers,
embed the question requirement into the question which contain embedded question requirements.
scenario. Typically, the scenario will contain an Paper P6, Advanced Taxation, for example, is
email or other type of communication, to which the frequently taken with Paper P7 and this paper has
candidate will respond. This is best illustrated with always presented requirements in this manner.
an example. Shown on page 2 is a redrafted version
to which the candidate will respond.

of requirement (d) from the December 2009 exam Summary

paper. This is a small illustration showing how one The change is in how some question requirements
requirement could be embedded into the question will be presented, and is not intended to make the
scenario. In future papers, a majority, or all, of the questions more difficult. It is hoped that this new
requirements of a question could be introduced and presentation is more in line with the real world and
embedded in this manner. gives the paper a more practical style.
For June 2010 and December 2010 exam sittings,
Reasons for the change in requirement style this change will affect only one of the Section A
There are several reasons why the change in question requirements, and will only affect the UK
question requirement style is being made. First, and IRL adapted paper.
Paper P7 is used as a means towards achieving From June 2011 onwards, the new style of
an Audit Practising Certificate in a number question requirement will be introduced across all
of countries, including the UK. As a result of adaptations of the paper, and may involve several
this, Paper P7 comes under the scrutiny of the requirements in both Section A questions.
Professional Oversight Board (POB), part of the
Financial Reporting Council. POB has recommended Lisa Weaver is examiner for Paper P7
that Paper P7 should contain question requirements
which are embedded in the question scenario, in
order to give the questions a more practical nature.
 student accountant issue 03/2010
02
Studying Paper P7?
Performance objectives 17 and 18 are linked

question
requirements
RELEVANT to ACCA QUAlification paper p7

Section A question requirements, and will only affect the

Redrafted Question 1, December 2009 in Farland. This expansion was a huge drain on

For June 2010 and December 2010 exam sittings, this change
You are the manager responsible for the audit cash resources, as it involved significant capital
of Papaya Co, a listed company, which operates expenditure, as well as an expensive advertising

of question requirement will affect only one of the

a chain of supermarkets, with a year ending
31 December 2009. There are three business
segments operated by the company – two segments
are supermarket chains which operate under
internally generated brand names, and the third
segment is a new financial services division.
The first business segment comprises stores
branded as ‘Papaya Mart’. This segment makes
up three quarters of the supermarkets of the
company, and are large ‘out of town’ stores,
located on retail parks on the edge of towns and
cities. These stores sell a wide variety of items,
including food and drink, clothing, household
goods, and electrical appliances. In September
2009, the first overseas Papaya Mart opened
campaign to introduce the Papaya Mart brand
in Farland.
The second business segment comprises the
rest of the supermarkets, which are much smaller
stores, located in city centres, and branded as
‘Papaya Express’. The Express stores offer a
reduced range of products, focusing on food
and drink, especially ready meals and other
convenience items.
The company also established a financial
services division on 1 January 2009, which
offers loans, insurance services and credit cards
to customers.
The audit engagement partner has today sent to
you the following email.

To: Audit manager of Papaya Co

From: Audit engagement partner

UK and IRL adapted paper.

Attachment: Notes from meeting held 29 November 2009

Hello

We are due to hold the audit planning meeting for Papaya Co next week. In preparation for this, I
am asking you to produce some briefing notes which assess the financial statement risks relevant
to our new audit client. The notes that were taken at a recent meeting with the client are attached
to the email.

Required:
(d) Respond to the email from your partner (16 marks)

Requirement (d) contains professional marks which will be awarded for the format of the answer and
for the clarity of the assessment provided
(2 marks)