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Peter Atrill Eddie McLaney David Harvey Ling Mei Cong - Accounting_ an Introduction-Pearson Education Australia 2020 1 1
Peter Atrill Eddie McLaney David Harvey Ling Mei Cong - Accounting_ an Introduction-Pearson Education Australia 2020 1 1
Accounting
An Introduction
Edition 8
Dedication
In memory of David Harvey, loving father to Jonathan, Matthew, James and Paul.
Accounting
An Introduction
Edition 8
Atrill
McLaney
Harvey
Cong
Copyright © Pearson Australia (a division of Pearson Australia Group Pty Ltd) 2021
Pearson Australia
www.pearson.com.au
Authorised adaptation from the original UK editions, entitled Accounting and Finance for Non-Specialists
11th Edition (ISBN: 9781292244013) by Peter Atrill & Eddie McLaney Copyright © 2019 (print and
electronic), and Accounting and Finance: An Introduction 8th Edition (ISBN: 9781292088297) Copyright ©
2016 (print and electronic), both published by Pearson Education Limited. Licensed for sale in Australia
and New Zealand only.
Eighth adaptation edition published by Pearson Australia Group Pty Ltd, Copyright © 2021 by
arrangement with Pearson Education Limited, United Kingdom.
The Copyright Act 1968 of Australia allows a maximum of one chapter or 10% of this book, whichever is
the greater, to be copied by any educational institution for its educational purposes provided that that
educational institution (or the body that administers it) has given a remuneration notice to Copyright
Agency Limited (CAL) under the Act. For details of the CAL licence for educational institutions contact:
Copyright Agency Limited, telephone: (02) 9394 7600, email: info@copyright.com.au
All rights reserved. Except under the conditions described in the Copyright Act 1968 of Australia and
subsequent amendments, no part of this publication may be reproduced, stored in a retrieval system or
transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise,
without the prior permission of the copyright owner.
This text was in the final stages of production during the COVID-19 pandemic of 2020. Content included
in this text which relates to COVID-19 and its broader impacts was correct at the time of printing.
Printed in Malaysia
ISBN 9781488625695
1 2 3 4 5 25 24 23 22 21
Foreword
The three of us were, for many years, academic colleagues at Plymouth Business School, University of
Plymouth, in the United Kingdom, often working very closely together on various teaching and writing
projects. We always found David to be a great collaborator. He was unfailingly full of enthusiasm, always
coming up with good ideas, reliable and hardworking. These attributes seemed to rub off on us. He was
always good-natured and, very importantly, great fun to work with.
Just after David left Plymouth to take up a post in Australia, the two of us were given the opportunity to
write the first UK edition of Accounting and Finance for Non-specialists. This book proved to be a relative
success, to the extent that the publishers, Pearson, wanted to bring out an Australian version. The
obvious person to adapt the book was David, who took on the task with his characteristic drive and
enthusiasm. The two of us were delighted to be collaborating with David once again. There is no doubt
that David’s input to the Australian version of the book, his writing skills, ideas and knowledge of the local
commercial and legal scenes, did very much to enhance its reputation.
Losing David, with his dedication, integrity and good nature, leaves us both with a great sense of personal
loss.
Peter Atrill
Eddie McLaney
2020 has been an extraordinary year. Australia experienced the most catastrophic bush fires in decades,
and regional towns in New South Wales and Victoria were severely hit. Australians could see the vivid
impacts of climate change on their lives. My Australian co-author, David Harvey, was passionate about
sustainability accounting issues and the accounting literacy of every student. So am I. We revamped
Chapter 7 of the eighth edition of this book with recent sustainability reporting developments, including
integrated reporting and latest CSR implementation successes and failures. We also expanded the Real
World examples in each chapter (e.g. the recent ban in Australia of non-reusable plastics), to help
readers to bring accounting to life. In addition, we included Reflection questions and Capstone Cases for
users to reflect and synthesise learning throughout the book, develop graduate capabilities, and transit
into the next career stage.
It was a great privilege working with David on this edition for more than a year. David mentored me in
many ways with his abundant experience, and provided valuable advice on numerous professional and
personal matters. It was therefore devastating to hear of David’s sudden passing early in the year. Sadly,
David is not able to see the eighth edition in print. Just typical David, his last wish was for people to
donate to Cancer Research in lieu of flowers. His working ethics, generosity, empathy and optimism will
forever inspire many people, including myself.
As I am working from home writing the foreword, the entire world is threatened by the COVID-19
pandemic, which is expected to have a much more profound effect on the economy than the 2008–09
global financial crisis. Businesses and organisations are being forced to shift to the online model, and
small and medium-sized enterprises are particularly heavily impacted. Hopefully, the accounting and
finance knowledge in this book can help you understand how to survive in the worst scenarios, when they
unfortunately become reality, how to manage finance properly, pursue cost reduction, maintain cash flow,
achieve financial targets, balance financial and social responsibilities, and strive for long-term growth.
David was looking forward to the publication of the eighth edition. The successful completion of this
edition to a high quality is our tribute to his hard work and inspirational ideas.
Brief contents
About the Australian authors xiii
Preface xiv
Reviewers xviii
1 Introduction to accounting 1
11 Budgeting 474
Glossary 669
Index 677
Full contents
About the Australian authors xiii
Preface xiv
Reviewers xxi
Educator resources xx
Management accounting 19
Not-for-profit organisations 28
Summary 39
References 41
Discussion questions 41
Case study 42
Solutions to activities 44
Classifying claims 61
Valuing assets 74
Summary 83
Discussion questions 85
Application exercises 86
Case study 90
Solutions to activities 92
What is the basis for transferring the inventory cost to cost of sales? 124
Profit measurement and the problem of bad and doubtful debts 129
The traditional approach 129
Summary 143
Reserves 174
Borrowings 176
Dividends 184
Summary 186
Notes 219
Summary 225
Summary 266
Summary 317
References 318
Liquidity 346
Current ratio 346
Summary 368
Contribution 394
Profit–volume (PV) charts 394
Summary 415
Summary 461
Summary 511
Inflation 536
Risk 537
Summary 560
Summary 607
Summary 654
Glossary 669
Index 677
After qualifying as an accountant in the United Kingdom, David began lecturing in 1971 at Portsmouth
Polytechnic (now Portsmouth University) with a subsequent move to Plymouth Polytechnic (now the
University of Plymouth) in 1977. During his time in the United Kingdom, he developed a keen interest in
curriculum development and teaching methods, and was involved with the writing of several books with
an open learning style, many of these in collaboration with Peter Atrill and Eddie McLaney. During this
time, he also completed a Master’s degree in Managerial Financial Controls and a PhD in the areas of
investment and financing decisions. This research work covered both traditional investment appraisal and
corporate strategy.
In 1991 David moved to Australia to take up the position of Professor of Accounting and Head of the
Centre for Accounting and Finance at the University of New England (Northern Rivers), which
subsequently became Southern Cross University. In 1992 he became the Dean of the Faculty of Business
and Computing, a position he held until 1996, before reverting to his professorship. In 2000 he took up the
position of the Dean of the Faculty of Commerce at the University of Southern Queensland. In 2001 the
Faculty of Commerce was merged with the Faculty of Business and David became Dean of the enlarged
Faculty of Business. David had extensive experience in both developing and teaching programs
internationally. His most recent position was as Pro Vice-Chancellor (International Quality), a position he
held from 2004 until his retirement in 2005.
David continued to write and study in his retirement. He also remained professionally active, including
being a member of the board of a local Health Service for nine years. This included a period of five years
as Chair, during which time a brand-new hospital was built.
Although diagnosed with a serious illness during the writing of this new edition, David continued to work
on the text, showing his tenacious spirit and commitment to the book, and successfully delivered a
completed manuscript. Very sadly he passed away while this new edition was in production.
Dr Ling Mei Cong is a Senior Lecturer in Accounting at the Graduate School of Business and Law
(GSBL), RMIT University. She is currently the Deputy Dean, Learning and Teaching at GSBL, a position
she has held since 2018. Ling Mei has nearly 20 years of experience at the tertiary level in the Asia
Pacific region, and is a fellow of the ACCA. Ling Mei holds a PhD in accounting from Curtin University.
Her main research areas include corporate governance (with focuses on ownership structure,
internationalisation strategy and firm performance), financial reporting quality and sustainability reporting.
Ling Mei has a passion for digital pedagogies and innovative teaching, and has rich experience in
curriculum design. During her academic career, she has received a number of teaching awards, including,
for example, the 2019 Learning and Teaching Impact Award at the RMIT College of Business and Law. In
2017, Ling Mei won a Teaching with Technology Award and received the Open University of Australia
Commendation for being an online global performance leader. She publishes on technology-enhanced
learning topics, and is currently leading a project on building a virtual assistant.
Her prior leadership experience includes the Program Manager for the Master of Corporate Accounting at
Curtin University from 2010 to 2014, and Acting MBA Director at RMIT in 2017. She serves on the
Academic Board at RMIT University.
Preface
The why?
This text is the eighth Australian edition of a UK book. It provides a broad-based, non-specialist
introduction to accounting and finance for those who wish, or need, to acquire an understanding of the
main concepts and their practical application in decision-making, but who do not require in-depth
theoretical or technical detail. It is aimed primarily at students who are studying a single unit in accounting
and finance as part of a university undergraduate or MBA course, including courses in business studies,
economics, engineering and a range of other non-specialist accounting courses. Given the content and
style of the text, it is suitable for students studying at a distance, and for those who are studying
independently, perhaps with no formal qualification in mind.
In writing the text, we have been particularly mindful that most of its readers will not have studied
accounting and finance before. We have, therefore, tried to write in an accessible style, avoiding technical
jargon. Throughout, we have endeavoured to ensure that basic concepts are thoroughly explained.
Underpinning the text’s coverage is an ‘open learning’ approach—that is to say, it involves the reader in a
way that is not traditionally found in textbooks, delivering topics much as a good lecturer would do and
encouraging readers to interact with the text. This approach distinguishes itself through a variety of
integrated and end-of-chapter assessment material, which has been largely updated for this edition and is
outlined below.
Hallmark features
The following features focus on developing an understanding of key accounting principles through the use
of relevant and engaging examples.
Accounting and You: These important and unique sections relate the content of the chapter to the
individual student reader. All too often students feel that the content is oriented towards big business
and has nothing really to do with them. This section illustrates that what the students are learning has
real relevance to their everyday lives.
Real World Examples: Each chapter typically includes between four and six (sometimes more)
examples, which aim to provide a link between theory and current practice. These have been updated
—and the total number increased—to reflect what has occurred since the last edition of the book.
They illustrate what is actually happening in the real world, and include views that are contentious or
may conflict with each other, but reflect some of the practical issues and problems that are found in
practice. Following each Real World example are several class discussion points, which should
provide ideas to stimulate further discussion of the example.
End-of-chapter Case Study: Some of these are simply more complicated problems, but in the main
they are questions based on contemporary news media articles. Their aim is to encourage students to
think in a broader manner than usual, and to develop a wider approach to dealing with issues that are
real and current.
To further develop understanding, the following features apply the concepts through a number of practice
activities:
In-chapter Activities: Interspersed throughout each chapter are numerous activities, with one for
every learning objective. These are relatively short ‘quick-fire’ questions of a type a lecturer might
pose to students during a lecture or tutorial. They are intended to serve two purposes: to give students
the opportunity to check that they have understood the preceding section; and to encourage them to
think beyond the immediate topic and make links to topics either previously covered or covered in the
next section. An answer to each activity is provided at the end of the chapter, but readers should refer
to these only after they have attempted the activity.
Concept Check Questions: At the end of each learning objective section, we include two or three
concept check questions. These short questions aim to provide students with a means of ensuring
they have a sound understanding of the basic concepts introduced in the section. They are generally
in the form of multiple-choice questions.
Self-Assessment Questions: Towards the end of each chapter, but also at an appropriate earlier
point in some chapters, there is a self-assessment question or questions. These are much more
demanding and comprehensive than the activities, in terms both of the breadth and depth of the
material they cover. As with the activities, it is important to make a thorough attempt at each question
before referring to the solution at the end of the chapter.
Application Exercises: These are also positioned at the end of all but the first chapter. They are
categorised as easy, intermediate or challenging. Typically, they are of a numerical type, and are
designed to enable students to further apply and consolidate their understanding of topics.
Discussion Questions: Featured at the end of each chapter, these are relatively short, typically
require a descriptive or analytical answer, and are intended to enable students to assess their
recollection and critical evaluation of the main principles in each chapter. They might be used as the
basis for tutorial discussion.
Reflections: A new feature in this edition is the introduction of what we have called Reflections, with
usually between four and six such questions per chapter. These are not the same as any of the other
exercises, being much more open-ended, with (generally) no right or wrong answer. Their aim is to get
students to think about a range of issues, including how they might develop their business generally,
how some practical choices about how a specific decision might be made (and why), exploring
attitudes to social and environmental issues, the attitude towards wealth creation, attitudes to risk,
ethics and integrity, the role of social media and big data, and others.
Capstone Case Study: This edition introduces two new Capstone Case Studies to consolidate
students’ learning in the financial and management accounting parts of the textbook. The purpose of
the Capstone Case Studies is to help students integrate and synthesise the range of knowledge and
skills learned in individual chapters, and apply them in order to solve complicated cases simulating the
real-world scenarios.
Online additional topics: For this edition, online additional topics are available to be downloaded by
students and instructors from the Pearson website, and they are also included in Revel and the
eBook. They are: Additional Topic 1: Recording transactions—the journal and ledger accounts;
Additional Topic 2: Accounting systems and internal control.
Throughout the text, we have been conscious of the need to develop generic skills where possible, as
well as the more traditional accounting skills. Generic skills targeted include communication, teamwork,
critical thinking, problem-based learning, ethics, self-management, planning and organisation. It is
impossible to do this extensively in a single book, but we believe that this book should facilitate a
curriculum-wide approach to developing these kinds of skills.
The content provides an opportunity to use the discussion questions and cases to develop oral and
presentational skills and to develop teamwork.
The whole book is problem-based, so problem-solving skills should be enhanced.
Self-management and organisation skills development should be facilitated by the open learning
approach and the use of activities.
Reference to ethics and governance, particularly in Chapters 1 , 5 and 7 , provide a focus for
ethics and ‘green’ issues.
Critical thinking is encouraged by the use of appropriate cases and questions, together with current
Real World examples and the Accounting and You feature. By way of illustration, Chapters 5 and
7 , in particular, raise major issues relating to governance and sustainability that need to be
approached critically. Critical thinking is definitely enhanced by the inclusion of the Reflections, which
encourage individualised or personal perspectives on issues, some of which might be particular, but
many more would be broad or general in scope, such as ethics.
It is perhaps worth noting that all four authors are qualified accountants. However, their career paths and
interests are rather different. The main areas of interest include financial accounting, management
accounting, finance and corporate strategy. Specific areas of expertise include behavioural aspects of
accounting, and the links between finance theory and corporate strategy. All have experience of
curriculum development, ranging from thorough to comprehensive. One has extensive experience
internationally. The net result is a writing team of considerable diversity of experience, which is aware of
the need to try to balance the accounting skills requirement with the need to develop more broadly based
skills.
When we examined the order and level of content for the sixth edition, we realised that, as business and
accounting were becoming more complicated, so it was also becoming more difficult to cover these
issues in a reasonably straightforward way, using the structure of earlier editions. So, in the sixth edition
we introduced (in Chapters 2 and 3 ) two of the major accounting statements in the context of
relatively simple business organisations, mainly sole proprietorships and partnerships, or very simple
companies. This enabled us to cover the basic accounting statements without adding the complications of
a complex corporate regulatory framework. Once the underlying principles and nature of the statement of
financial position (the balance sheet) and the statement of financial performance (the income statement)
were understood, we could then complicate it by adding on (in Chapters 4 and 5 ) companies and
their regulatory framework. The eighth edition continues with this approach, reflecting a clear focus on the
non-specialist market.
We have ordered the chapters and their component topics to reflect what we consider to be a logical
sequence. For this reason, we advise students to work through the text in the order presented, particularly
since we have been careful to ensure that earlier chapters do not refer to concepts or terms that are not
covered until a later chapter.
Chapters 1 –8 can be said to be broadly oriented to financial accounting, Chapters 9 –11 focus
on what are clearly management accounting areas, and Chapters 12 –14 focus on what is generally
regarded as financial management. Having said this, much of the first eight chapters underpin the later
chapters, and students should not get too hung up on which area is which.
Chapter 1 provides a general introduction to the scope, purpose and interrelationships of the text’s
core coverage—financial accounting, management accounting and financial management—together with
a brief overview of the main financial statements. It also examines user groups and their needs,
introduces the main types of business organisation, together with the way in which a business is typically
organised and managed, and identifies ways in which business and accounting have been changing over
time. This chapter includes more on ethics and ethical behaviour in business, and the role of social media
and big data, than the previous editions.
Chapter 2 explains the nature and purpose of the statement of financial position. This is done in the
context of relatively simple organisations, so as not to unnecessarily complicate things. The method in
which the statement is built up and its typical format are both covered, followed by the main factors that
influence the content and values in the statement. Finally, the main uses and limitations of the statement
are examined. Chapter 3 explains the nature and purpose of a statement of financial performance,
usually referred to as an income statement. The way in which the statement is built up and the way in
which it is typically presented are covered comprehensively, for relatively simple organisations.
Chapter 4 introduces limited companies in some detail, including the main financial statements.
Chapter 5 explains the importance of company law, accounting standards, the stock exchange and the
importance of good corporate governance. Corporate governance remains an ongoing issue for many
businesses. The chapter then identifies the main requirements relating to the published annual report,
and explains the concept of a group of companies and the need for a set of consolidated accounts.
Chapter 6 focuses on the statement of cash flows and the importance of cash to any business. It also
introduces the idea of using the financial statements framework for planning and budgeting purposes.
Chapter 7 introduces the areas of corporate social responsibility (CSR) together with social and
environmental accounting, and also explains theories and the current state of development of
sustainability reporting. It introduces popular reporting frameworks such as the United Nation’s
Sustainable Development Goals, the Global Reporting Initiative and integrated reporting. This chapter
also explores CSR challenges, including climate change, a range of other environmental issues, peak oil,
world poverty, child labour abuse, and human rights and responsibilities generally, and the important
factors for successful implementation of sustainability reporting using real-world examples.
Chapter 8 deals with the analysis and interpretation of the main financial statements.
Our formal coverage of management accounting begins in Chapter 9 with a discussion of the
interrelationships between costs, volume and profit in decision-making. Chapter 10 covers full costing
and activity-based costing. Chapter 11 focuses on short-term planning and control, and deals with
various aspects of budgeting. The chapter now also includes a section on Beyond Budgeting.
Chapter 12 is the first chapter that relates to what is generally termed ‘financial management’. It deals
with capital budgeting and the decision to invest in medium- and long-term assets, and considers how
businesses appraise such projects. Chapter 13 deals with the management of short-term assets and
liabilities. Chapter 14 covers the main sources of finance available to a business when making an
investment.
Peter Atrill
Eddie McLaney
David Harvey
Ling Mei Cong
Reviewers
The dedicated contributions of many individuals helped make this book a reality and contributed to
refinements and improvements in this and previous editions. An impressive cast of reviewers provided in-
depth chapter feedback, as well as many helpful suggestions, constructive criticisms and enthusiasm for
the organisation and content of the text. Both the authors and publisher are grateful to each of them. They
include:
Special thanks from the authors and publisher Angela Tan-Kantor for carrying out the technical editing for
this edition.
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For students: How do I use this book?
Learning objectives
These are listed at the beginning of each chapter and explain the key concepts that you should
understand after studying the chapter. They are restated in the chapter, so you know where these
objectives are covered. End-of-chapter questions are also keyed to the objectives.
Reflection boxes
Open-ended questions that allow the student to think more deeply about a range of issues.
Real world examples
Integrated throughout the text, these illustrative examples highlight the practical application of accounting
concepts and techniques by real businesses, including extracts from published financial reports, articles
from the media, survey data and other interesting insights from business.
In-chapter self-assessment questions
More demanding and comprehensive than the activities, these challenge you to put into practice your
understanding of key concepts. The self-assessment question solutions are to be found online, available
on MyLab Accounting and www.pearson.com.au/9781488612589
Summary
At the end of every chapter, the summary correlates learning objectives with the method used to achieve
them. Use this as a great revision tool.
End-of-chapter questions and problems
These help reinforce your understanding of chapter content. All questions are keyed to their
corresponding learning objectives so you can pick and choose the areas you want to work on. The
questions are divided into level of difficulty—easy, intermediate and challenging. They include:
discussion questions to help you assess your recall of the main principles covered in each chapter
application exercises to help you apply and consolidate your understanding of accounting in practice.
Case studies
These give you real-world examples of accounting in practice, and encourage you to think critically about
accounting issues and controversies.
Solutions manual
The Solutions Manual provides educators with answers to all of the end-of-chapter questions and
problems in the textbook.
Test bank
Available in Word® format, the Test Bank provides educators with a wealth of accuracy-verified testing
material for homework and quizzing. Updated for the new edition, each chapter offers a wide variety of
questions, arranged by learning objective and tagged by AACSB standards.
Learning objectives
When you have completed your study of this chapter, you should be able to:
Since this book is mainly concerned with accounting and financial decision-
making for private-sector businesses, we shall devote some time to
examining the business environment. We shall, therefore, consider the key
financial purpose of a private-sector business, the main forms of business
enterprise, and the ways in which a business may be structured, organised
and managed. These are all important as they help to shape the kind of
accounting and financial information that is produced.
Accounting is concerned with the collection, analysis and communication of economic information.
Such information can be used as a tool of decision-making, planning and control. This is to say that
accounting information is useful to those who need to make decisions and plans about businesses, and
for those who need to control those businesses. Unless the financial information being communicated can
lead to better decisions being made, there is really no point in producing it.
accounting
Examples of the kind of decisions for which the managers of businesses may need accounting
information include the following:
Reflection 1.1
You might spend a few moments reflecting on the implications of some of these. Some decisions
have far-reaching consequences. Consider, for example, the situation where you are working for a
major call centre associated with a telecommunications business, working in a regional centre,
employing approximately 120 staff, when an announcement is made that the business plans to
take the call-centre activities offshore. What possible impacts could this have on the business, its
workforce, and the local and regional community?
Although managers working in a particular business are likely to be significant users of accounting
information, they are by no means the only people who are likely to use accounting information about that
particular business. People outside the business (whom we shall identify later) may need information to
help them make decisions such as whether to invest in the business—as owner or lender—whether to
grant credit for goods provided, or whether to enter into a major contract with the particular business.
It is generally recognised that accounting fulfils two distinct roles: a ‘stewardship’ role and a ‘decision-
usefulness’ role. Traditionally, accounting focused more on providing a stewardship, or accountability,
report on the status of transactions for the period; that is, what was the position at the beginning of the
period, what happened during the period, and what the position was at the end of the period. More
recently, accounting has been seen as a way of assisting a wide range of users to make informed choices
about the allocation of scarce resources. Sometimes, the impression is given that the purpose of
accounting is simply to prepare financial reports on a regular basis. (Strictly speaking, financial reports
consist of primary financial statements, notes to the financial statements and the directors’ declaration.
However, the term ‘financial reports’ is used interchangeably with ‘financial statements’ in the real world.
Hence, this book does not differentiate the two terms.) While it is true that accountants do this kind of
work, it does not represent an end in itself. The ultimate purpose of accountants’ work is to discharge the
accountability function of management and to influence the decisions of those who use the information
produced. This decision-making perspective of accounting is central to the theme of this book and shapes
the way we deal with each chapter.
fundamental qualities
relevance
materiality
The quality of information that has the potential to alter the decisions that
users make.
faithful representation
To provide a perfectly faithful representation, the information should be complete. In other words, it
should incorporate everything needed for users to understand what is being portrayed. It should also
be neutral, which means that the information should be selected and presented without bias. No
attempt should be made to manipulate the information in such a way as to influence user attitudes and
behaviour. Finally, it should be free from error. This is not the same as saying that it must always be
perfectly accurate; this may not be possible. Accounting information often contains estimates, such as
future sales or costs, which may turn out to be inaccurate. Nevertheless, estimates can still be
faithfully represented providing they are properly described and prepared.
Activity 1.1
In practice, do you think that each piece of accounting information produced will be perfectly complete,
neutral and free from error?
Note that accounting information must satisfy both fundamental qualities of relevance and provide a
faithful representation of what it purports to represent if it is to be useful. There is little point in producing
information that is relevant, but which lacks faithful representation, or producing information that is
irrelevant, but which is faithfully represented.
Further qualities
Where accounting information is both relevant and faithfully represented, there are other qualities that, if
present, can enhance its usefulness. These are comparability, verifiability, timeliness and
understandability. Each of these qualities is now considered.
Comparability . This quality helps users to identify similarities and differences between items of
information. It may help them, for example, to identify changes in the business over time (such as the
trend in sales revenue over the past five years). It may also help them to evaluate the performance of
the business in relation to similar businesses. Comparability is enhanced by treating items that are
basically the same in the same manner for accounting purposes. It is also enhanced by making clear
the policies that have been adopted in measuring and presenting the information.
Verifiability . This quality provides assurance to users that the accounting information provided
faithfully represents what it is supposed to represent. Accounting information is verifiable where
different, independent experts would be able to reach a consensus that it provides a faithful portrayal.
Verifiable information tends to be supported by evidence, such as an invoice stating the cost of an
item included in inventories.
Timeliness . Accounting information should be produced in time for users to make their decisions. A
lack of timeliness will undermine the usefulness of the information. Normally, the later the accounting
information is produced, the less useful it becomes.
Understandability . Accounting information should be set out as clearly and concisely as possible.
It should also be able to be understood by those at whom the information is aimed.
comparability
A quality that helps users identify similarities and differences between items of
information.
verifiability
timeliness
understandability
Clearly set out to facilitate understanding.
Activity 1.2
Do you think that accounting reports should be understandable by those who have not studied
accounting?
Despite the answer to Activity 1.2 , the onus is clearly on accountants to provide information in a way
that makes it as understandable as possible for non-accountants.
It is worth emphasising that the four further qualities just discussed cannot make accounting information
useful. They can only enhance the usefulness of information that is already relevant and faithfully
represented. It is also worth noting that the qualitative characteristics may conflict.
There are no easy answers to the problem of weighing costs and benefits. Although it is possible to apply
some ‘science’ to the problem, a lot of subjective judgement is normally involved.
The qualities, or characteristics, influencing the usefulness of accounting information, which have been
discussed above, are summarised in Figure 1.1 .
Figure 1.1 The characteristics that influence the usefulness of accounting information
Two fundamental qualities determine the usefulness of accounting information. In addition, four qualities
enhance the usefulness of accounting information. The benefits of providing the information, however,
should outweigh the costs.
The figure shows the four sequential stages of an accounting information system. The first two stages are
concerned with preparation, and the last two stages are concerned with using the information collected.
Given the decision-making emphasis of this text, we shall concentrate on the final two elements of the
process—the analysis and reporting of financial information. We are concerned with how information is
used by, and is useful to, decision-makers rather than with how it is collected and recorded.
Concept check 1
The purpose of accounting is to:
A. Provide information to assist users’ decision-making
B. Report on the status of transactions for the period
C. Prepare financial reports on a regular basis
D. Provide financial information to clients
E. None of the above is true.
Concept check 2
The two most important qualities for accounting information are:
A. Relevance and materiality
B. Relevance and accuracy
C. Faithful representation and relevance
D. Completeness and relevance
E. Freedom from error and relevance.
Concept check 3
The usefulness of accounting information is increased by:
A. Not being overly complex
B. Being provided on schedule (e.g. not late)
C. Being supported by reasonable evidence
D. All of the above
E. None of the above.
Users of accounting information
LO 2 List the main groups that use the accounting reports of a business entity, and summarise the
different uses that can be made of accounting information
Accounting seeks to satisfy the needs of a wide range of users. In a particular business, there may be
various groups who are likely to have an interest in its financial health. (Although the points made in this
chapter and throughout this book may apply to a variety of organisations—such as public-sector business
enterprises, local authorities and charities—we concentrate on private-sector businesses.)
The major user groups for a business organisation are shown in Figure 1.3 .
The figure shows that several user groups have an interest in the financial information relating to a
business organisation. Most of them are outside the business but, nevertheless, have a stake in it. This is
not meant to be an exhaustive list of potential users, but the user groups identified here are normally the
most important.
Activity 1.3
Ptarmigon Insurance Ltd (PI) is a large motor insurance business. Taking the user groups identified in
Figure 1.3 , suggest for each group the sorts of decisions likely to be made about PI and the factors to
be taken into account when making these decisions.
Activity 1.3 illustrates that each user group looks at the business from a different perspective and has
its own particular interest. Inevitably there will be occasions when these perspectives and interests may
clash. One of the more likely causes relates to the way in which the wealth of the business is generated
and distributed. Recent years have seen considerable debate as to the salary level of management
teams, especially that of the chief executive officer (CEO). High bonus payments in a year in which
performance has not been judged to be good do not sit well with investors. Another area of potential
conflict is likely to be between investors and lenders, with lenders wishing to be sure that the money lent
has been invested appropriately and with due regard to their interests, while borrowers are likely to want
to be able to have maximum flexibility.
Reflection 1.2
You are very concerned about climate change and have become something of an activist. You are
particularly worried about one particular coal mine, and regularly go to rallies against the mining
company. One of your friends is not so adamant in his ‘anti’ views, and uses the financial
information provided by the company to justify his stance. Should these both be seen as members
of legitimate user groups?
Stakeholder theory uses a similar approach to that set out above, but additionally provides some
useful insights into just what makes a successful business, and illustrates how the various user groups
can interact. User groups can clearly be thought of as stakeholders in a business. Stakeholder theory was
effectively introduced by R. Edward Freeman in 1984 in his book Strategic Management: A Stakeholder
Approach. Freeman’s main point was that, at that time, business pretty much saw managerial self-interest
and shareholder profit as the driving force of business. Freeman argued that this wasn’t the view of the
people who actually did business. They had other motivations and responded to other people—
employees, customers, suppliers, regulators, industry bodies, trade unions, community groups—which
Freeman called stakeholders. We shall come back to stakeholder theory later in the chapter.
stakeholder theory
A theory which argues that organisations have a variety of interested parties, and
that these interests need to be considered and incorporated in a harmonised
manner in order to achieve the best overall outcomes.
Concept check 4
Accounting seeks to satisfy the needs of which of the following users?
A. Shareholders
B. Prospective shareholders
C. Government (e.g. Australian Taxation Office)
D. Stakeholders
E. Creditors.
Concept check 5
Stakeholder theory:
A. Recognises that organisations have a variety of interested users
B. Attempts to meet the needs of the primary users
C. Was introduced by R.E. Freeman in 1986
D. All of the above
E. None of the above.
Financial and management accounting
LO 3 Compare and contrast financial and management accounting
In providing information for the various user groups identified, accounting has divided into two main areas:
management accounting and financial accounting. Management accounting , as the name suggests,
is concerned with providing managers with the information they require for the day-to-day running of the
organisation. Financial accounting is concerned with providing the other users with useful
information.
management accounting
An approach that aims to provide managers with the information they require to
run the organisation.
financial accounting
Financial accounting provides financial information for a variety of users, with the
information being of a general-purpose nature.
The main differences between the two types of accounting reflect the range of recipients, as follows:
Nature of the reports produced. Financial accounting tends to produce general-purpose financial
reports; that is, they contain financial information that will be useful for a broad range of users and
decisions. Management accounting reports, on the other hand, are often specific-purpose reports,
designed with either a particular decision or manager in mind.
Level of detail. Financial accounting reports provide users with a broad overview of the position,
performance and cash flows of the business for a period. As a result, information is aggregated and
detail is often lost. Management accounting reports, however, often provide managers with
considerable detail to help them with a particular decision.
Regulations. Financial reporting for many businesses is subject to legal and accounting regulations
that seek to ensure that specified content is presented in a fairly standard form. Because management
accounting reports are for internal use only, there are no restrictions on the form and content of the
reports. This means that reports can be, and are, designed to meet the needs of particular managers.
Reporting interval. For most businesses, financial accounting reports are produced on an annual
basis. However, large companies may produce half-yearly reports, and a few produce quarterly
reports. Management accounting reports may be produced as frequently as required by managers. In
many businesses, managers are provided with certain weekly or monthly reports to allow them to
check progress on a regular basis.
Time horizon. Financial accounting reports reflect the performance and position of the business to
date. In essence, they are backward-looking. Management accounting reports, on the other hand,
often provide information on expected future performances as well as past performance. It is an
oversimplification, however, to suggest that financial accounting reports never incorporate
expectations concerning the future. Occasionally, businesses will release forecast information to other
users in order to raise capital or to fight off unwanted takeover bids. Even preparation of the routine
financial reports typically requires making some judgements about the future, as we shall see in
Chapter 3 .
Range of information. Financial accounting reports concentrate on information that can be quantified
in monetary terms. Management accounting produces such reports, too, but is also more likely to
produce additional reports on non-financial matters, such as measures of physical quantities of
inventory (stocks) and output. Financial accounting places greater emphasis on objective, verifiable
evidence when preparing reports. Management accounting reports intended for managers may use
information that is less objective and verifiable, but which nevertheless provides managers with the
information they need. So the basic accounting statements will be used historically by the financial
accountant, where the emphasis is on information which is as reliable and as objective as possible,
whereas the management accountant may well use the same format to assist in some decisions, but
will inevitably also use estimates which are clearly less reliable. This does not detract from the
usefulness of the forecasts.
We can see from the above list that management accounting is less constrained than financial
accounting. It may draw from a variety of sources and use information that has varying degrees of
reliability. The only real test of the value of the information produced for managers is whether or not it
improves the quality of decisions made.
Activity 1.4
Can you think of any areas of overlap between the information needs of managers and those of other
users? (Hint: Think about the time orientation and the level of detail of accounting information.)
The distinction between the two areas reflects, to some extent, the differences in access to financial
information. Managers have much more control over the form and content of the information they receive.
Other users have to rely on what managers are prepared to provide or what the financial reporting
regulations state must be provided. Although the scope of financial accounting reports has increased over
time, fears over loss of competitive advantage and fears of user ignorance about the reliability of forecast
data have led businesses to resist making information available to users other than managers.
There is little doubt that in the past financial accounting has been the dominant partner, and many of the
ground rules reflect this. However, modern accounting systems typically are developed in a manner that
enables both the specific external reporting requirements to be fulfilled and relevant management
accounting reports to be prepared. Financial accounting and management accounting should not be seen
as two different topics, but rather as different perspectives reflecting the justifiable needs of users.
Concept check 6
Which of the following is true?
A. Financial accounting provides greater detail than management accounting.
B. Management accounting is subject to the same standards as financial accounting.
C. The financial accountant can plan their annual two-week vacation more reliably than
the management accountant.
D. Financial accounting is forward-looking.
E. None of the above.
Concept check 7
Which of the following is false?
A. Management accounting provides more scope for creativity than financial
accounting.
B. There are more rules to follow in financial accounting than in management
accounting.
C. Management accounting reports tend to provide a wider range of information than
that provided by financial accounting.
D. All of the above are false.
E. None of the above is false.
What is the financial objective of a business?
LO 4 Identify the main purpose of a business (while recognising a range of other influences), and
explain the traditional risk–return relationship
A business is normally created to enhance the wealth of its owners. Throughout this book we shall
assume that this is its main objective. This may come as a surprise, as there are other objectives that a
business may pursue that are related to the needs of others associated with the business. For example, a
business may seek to provide good working conditions for its employees, or it may seek to conserve the
environment for the local community. While a business may pursue these objectives, it is normally set up
with a view to increasing the wealth of its owners. In practice, the behaviour of businesses over time
appears to be consistent with this objective.
Within a market economy there are strong competitive forces at work that ensure that failure to enhance
owners’ wealth will not be tolerated for long. Competition for the funds provided by the owners and
competition for managers’ jobs will normally mean that the owners’ interests will prevail. If the managers
do not provide the expected increase in ownership wealth, the owners have the power to replace the
existing management team with a new team that is more responsive to owners’ needs. Does this mean
that the needs of other groups associated with the business (employees, customers, suppliers, the
community and so on) are not really important? The answer to this question is certainly no, if the business
wishes to survive and prosper over the longer term.
Satisfying the needs of other groups is usually consistent with increasing the wealth of the owners over
the longer term. A business with disaffected customers, for example, may find that those customers turn
to another supplier, resulting in a loss of shareholder wealth. A dissatisfied workforce may result in low
productivity, strikes and so forth, which will in turn have an adverse effect on owners’ wealth. Similarly, a
business that upsets the local community with unacceptable behaviour, such as polluting the environment
or ignoring human rights issues, may attract bad publicity, resulting in a loss of customers and incurring
heavy fines.
While the idea of an objective of wealth enhancement is still reasonable, there is now considerably more
awareness of the damage that can be done to individuals, to the environment and to society at large by
unconstrained wealth maximisation. Real World 1.1 , written when the global financial crisis was in the
forefront of most people’s minds, provides clear recognition of the potential problems that can arise.
Thirty years ago, retailers would be quite content to source the shoes they wanted to sell as
cheaply as possible. The working conditions of those who produced them was not their concern.
Then headlines and protests developed. Society started to hold them responsible for previously
invisible working conditions. Companies like Nike went through a transformation. They realised
they were polluting their brand. Global sourcing became visible. It was no longer viable to define
success simply in terms of buying at the lowest price and selling at the highest.
Financial services and investment are today where footwear was thirty years ago. Public anger at
the crisis will make visible what was previously hidden. Take the building up of huge portfolios of
loans to poor people on US trailer parks. These loans were authorised without proper scrutiny of
the circumstances of the borrowers. Somebody else then deemed them fit to be securitised, and
so on through credit default swaps and the rest, without anyone seeing the transaction in terms of
its ultimate human origin.
Each of the decision makers thought it okay to act like the thoughtless footwear buyer of the
1970s. The price was attractive. There was money to make on the deal. Was it responsible?
Irrelevant. It was legal, and others were making money that way. And the consequences for the
banking system if everybody did it? Not our problem.
The consumer has had a profound shock. Surely we could have expected the clever and wise
people who invested our money to be better at risk management than they have shown
themselves to be in the present crisis? How could they have been so gullible in not challenging the
bankers whose lending proved so flaky? How could they have believed that the levels of bonuses
that were, at least in part, coming out of their savings could have been justified in ‘incentivising’ a
better performance? How could they have believed that a ‘better’ performance would be one that is
achieved for one bank without regard to its effect on the whole banking system? Where was the
stewardship from those exercising investment on their behalf?
The answer has been that very few of them do exercise that stewardship. Most have stood back
and said it doesn’t really pay them to do so. The failure of stewardship comes from the same
mindset that created the irresponsible lending in the first place. We are back to the mindset that
has allowed us to poison the well: never mind the health of the system as a whole, I’m making
money out of it at the moment. Responsibility means awareness for the system consequences of
our actions. It is not a luxury. It is the cornerstone of prudence.
Source: Extract from Mark Goyder, M., ‘How we’ve poisoned the well of wealth’, Financial Times, 16 February 2009. © The Financial Times Limited 2009. All rights
reserved. ‘FT’ and ‘Financial Times’ are trademarks of The Financial Times Ltd.
We should be clear that generating wealth for the owners is not the same as seeking to maximise the
current year’s profit. Wealth creation is concerned with the longer term. It relates not only to this year’s
profit but to that of future years as well. In the short term, corners can be cut and risks taken that improve
current profit at the expense of future profit.
Reflection 1.3
You have been given the position of sustainability manager at BHP. How might a company like
BHP measure social and environmental impacts?
Stakeholder theory
Stakeholder theory was introduced in the earlier section on users of accounting information, but the
theory now goes way beyond what users might need from accounting. Freeman has been developing his
theory for the past 30 years. A sense of his current thinking is summarised in Real World 1.2 .
As we saw earlier, Freeman argued strongly that managerial self-interest and shareholder profits,
which he described as ‘the old story’, were not the driving force of business. He felt that people
were interested in, and motivated by, far more than profit, and that all of their interests needed to
be given appropriate recognition. Of course, profits were part of the story, but profits were seen as
the outcome rather than the aim.
So, what makes a successful business? Obvious elements include good products or services, a
good and committed workforce, reliable suppliers who provide goods and services at the right
quality, and a good relationship with the community at large.
Freeman now talks about working to ‘harmonise’ the various stakeholders’ interests. There will of
course be some conflict between some stakeholders, but such conflict should be seen as an
opportunity to value-create.
Value is perceived by Freeman as much broader than simply financial value. He believes ‘we
create value when we do things that people find valuable’.
The traditional approach is reasonably easily associated with measurement. Most businesses
know how to measure customer satisfaction and whether they are creating value for their
customers. Other areas, such as value for employees and the community, are less commonly
addressed—and these need to be worked on.
Source: Eva Tsahuridu and David Walker, ‘R. Edward Freeman—The Stakeholder Revolutionary’, INTHEBLACK, 1 April 2015.
It is recommended that you read the entire article referred to in Real World 1.2 .
Clearly stakeholder theory has had considerable influence over time, but whether accounting is doing
enough in this area remains debatable. What is not in doubt is that social and environmental accounting
has become much more important in assessing performance. Freeman believes that the way in which
these have been ‘bolted on’ to the old business model of financial accounting suggests that there is a long
way to go. We shall see in Chapter 7 just how many improvements have been made in reporting on
social and environmental aspects and impacts, more commonly now called sustainability reporting or
integrated reporting. There also remains scope for considerably more work to be carried out to deal with
some of the issues implicit in Freeman’s theory. Just how easy it will be to find appropriate ways of
dealing with the issues he raises remains to be seen.
Real World 1.5 , found later in the chapter, provides examples of ethical failures, where some
stakeholders’ interests have been clearly abused. Some of the situations, especially those examined by
the Financial Services Royal Commission, illustrate the need for considerably more discussion of this
area.
Reflection 1.4
In recent years the banks have been the subject of much criticism. You have just been appointed
to the management team of a small regional bank. You have been asked to consider how the bank
should balance the conflicting needs of shareholders (owners), customers, (both borrowers and
depositors) and government. Outline your approach.
It is interesting to note that in August 2019 the Business Roundtable of America changed its statement of
purpose as a corporation from one which emphasised the primacy of shareholders to one which
recognised that there is a commitment to all of the stakeholders, including customers, employees,
suppliers and communities, alongside the shareholders. All are seen as essential.
Balancing risk and return
In considering wealth enhancement as our primary goal, we must also recognise the need to balance the
required return with the risk level associated with the business.
return
risk
The likelihood that what is projected to occur will not actually occur.
All decision-making involves the future. Business decision-making is no exception. The only thing certain
about the future, however, is that we cannot be sure what will happen. Things may not turn out as
planned, and this risk should be carefully considered when making financial decisions.
As in other aspects of life, risk and return tend to be related. Evidence shows that returns relate to risk in
something like the way shown in Figure 1.4 .
Activity 1.5
Look at Figure 1.4 below and state, in broad terms, where an investment in:
This relationship between risk and return has important implications for setting financial objectives for a
business. The owners will require a minimum return to induce them to invest at all, but will require an
additional return to compensate for taking risks; the higher the risk, the higher the required return.
Managers must be aware of this, and must strike the appropriate balance between risk and return when
setting objectives and pursuing particular courses of action.
The turmoil in the banking sector as a result of the global financial crisis has shown that the right balance
is not always struck. Some banks took excessive risks in pursuit of higher returns and, as a consequence,
incurred massive losses. There is little doubt that the risk appetite of the banks then changed dramatically
over the next few years, and with good reason. Whether this change in appetite was permanent is
doubtful. Over the past few years we have seen considerable easing of conditions surrounding
mortgages, followed by a move back to much tighter controls, leading to a downturn in the housing
market.
Concept check 8
A corporate mission statement would usually include an objective relating to:
A. Provision of good working conditions for employees
B. Conservation of the environment
C. Earning of profits in the short term
D. Enhancement of the wealth of its owners
E. The need to be an industry leader.
Concept check 9
Which of the following statements is false?
A. The expected level of return increases as the level of risk increases.
B. The global financial crisis is a good example of the consequences of appropriate risk
behaviour.
C. Life without risk is death.
D. Managers and organisations must strike a balance between risk and return.
E. None of the above. All are true.
The main financial reports—an overview
LO 5 Provide an overview of the main financial reports prepared by a business
Financial accounting
Financial accounting grew from the old idea of stewardship accounting, where stewards
(managers/representatives) gave an accounting of how they had fulfilled their responsibilities. When you
remember that this was happening throughout the Industrial Revolution, you should realise that these
statements were all about wealth. There was little concern about staff (workers), social issues or the
environment. Human rights was not a term even thought about, other than as it related to the bosses!
Times have changed, as we shall see as we progress through the book. However, the need for basic
financial statements remains. A very simple illustration is given next. You will find that the rules and
regulations surrounding these statements have become more rigorous as time has passed and business
has become more complicated.
The main financial statements are designed to provide a picture of the overall financial position and
performance of the business. To do this, the accounting system normally produces three main financial
reports on a recurring basis. These financial statements are concerned with answering the following
questions:
What cash movements (i.e. cash in and cash out) took place over a particular period?
How much did wealth increase over a particular period as a result of operating and other activities? In
other words, how much profit did the business generate from its overall activities?
What is the financial position of the business at the end of a particular period?
These questions are all addressed by the three main financial reports listed below:
The statement that shows the sources and uses of cash for a period.
The statement that measures and reports how much wealth (profit) has been
generated in a period. Also called a ‘profit and loss (P and L) statement.’
A statement that shows the assets of a business and the claim on those assets at
a point in time.
balance sheet
A statement that shows the assets of a business and the claims on the business.
Assets must always equal claims. Claims will relate to external liabilities and
owners’ claims (known as ‘equity’).
In due course we will also introduce a fourth statement, the statement of changes in equity , but this
statement is really only important for limited companies and so we will leave discussion until the
appropriate later chapter. Basically, equity is the term used to indicate the share of the business which
represents the owners’ interests.
Taken together, the three main statements provide an overall picture of the financial health of the
business. Perhaps the best way to introduce the financial reports is to look at an example of a very simple
business (Example 1.1 ). From this we shall be able to see what sort of useful information each of the
statements can provide. It is worth pointing out that, while a simple business is our starting point, the
principles for preparing the financial statements apply equally to the largest and most complex
businesses. This means that we shall frequently encounter these principles again in later chapters.
EXAMPLE
1.1
Paul was unemployed and unable to find a job. He decided to embark on a business venture to
meet his living expenses. As Christmas was approaching, he decided to buy gift-wrapping from a
local supplier and sell it on the corner of his local main street. He felt that the price of wrapping
paper in the shops was excessive, and that this would give him a useful business opportunity.
He began the venture with $600 in cash. On the first day of trading he purchased wrapping paper
for $600. This is called stock (of goods) or inventory. Later in the day he sold three-quarters of his
inventory for $660 cash.
1260
Sales 660
Profit 210
Note that only the cost of the wrapping paper sold is matched against the sales to find the profit,
not the whole cost of wrapping paper acquired. Any unsold wrapping paper (known as inventory or
stock) will be charged against future sales.
Note that the profit has led to an increase in wealth ($210). In this particular business, all of the
business wealth is the entitlement of Paul, so Paul’s equity can be seen to be $810. As we shall
see in the next chapter, the situation in which there are no other claims on the business wealth is
unusual. The situation in practice is rather more involved than that found in this simple example.
On the second day of trading, Paul purchased more wrapping paper for $300 cash. He managed
to sell all of the new wrapping paper and half of the earlier stock for a total of $540.
The statement of cash flows on day 2 is as follows:
1200
Sales 540
Profit 165
The statement of financial position (balance sheet) at the end of day 2 is:
Cash 900
We can see that the total business wealth increased to $975 by the end of day 2. This represents
an increase of $165 (i.e. $975−$810) over the previous day. Note that this is the amount of profit
made during day 2 as shown on the statement of financial performance.
We can see from the financial reports in Example 1.1 that each provides part of the picture of the
financial performance and position of the business. We begin by showing the cash movements. Cash is
vital for any business to function effectively: to meet obligations, to acquire other resources (such as
stock/inventory), to satisfy operating expenses, and to meet ownership distributions. Cash has been
described as the ‘life blood’ of a business, and movements in cash are usually given close scrutiny by
users of financial statements.
It is clear that reporting cash movements alone would not be enough to portray the financial health of the
business. The changes in cash over time do not fully reveal the profit generated. The statement of
financial performance provides an insight into this aspect of performance. For day 1, for example, we saw
that the cash balance increased by $60 but the profit generated, as shown in the statement of financial
performance, was $210. The increase in wealth ($210) was represented by $60 cash and $150 in the
form of stock (inventory).
To determine the total wealth of the business, a statement of financial position is drawn up at the end of
the day. Cash is only one form in which wealth can be held. In the case of this business, wealth is also
held in the form of inventory (stock of goods for resale). Drawing up the statement of financial position
involves listing both forms of wealth held. In the case of a large business, there may be many other forms
of holding wealth, such as land and buildings, equipment and motor vehicles.
Activity 1.6
On the third day of his business venture, Paul purchased more stock for $600 cash. However, it was
raining hard for much of the day and sales were slow. After Paul had sold half of his total stock for $390,
he decided to stop trading until the following day. Have a go at drawing up the three financial reports for
day 3 of Paul’s business venture.
The solution to Activity 1.6 shows that the total business wealth increased by $52.50 (i.e. the amount
of the day’s profit) even though the cash balance declined. This is due to the fact that the business is
holding more of its wealth in the form of inventory rather than cash, compared with at the end of day 2.
Note that the statement of financial performance and the statement of cash flows are both concerned with
measuring flows (of wealth and cash, respectively) over time. The period of time may be one day, one
month, one year, etc. The statement of financial position (balance sheet), however, is concerned with the
financial position (or wealth) at a particular moment in time (the end of one day, one week, etc.). Figure
1.5 illustrates this point. The statement of financial performance, statement of cash flows and statement
of financial position, when taken together, are often referred to as the ‘final accounts’ of the business.
Figure 1.5 The relationship between the statement of financial position, the statement of financial
performance and the statement of cash flows
The figure shows how the statement of financial performance and the statement of cash flows are
concerned with measuring flows of wealth over time. The statement of financial position, however, is
concerned with measuring the stock of wealth at a particular moment in time.
For external users of the accounts, these reports are normally backward-looking and are based on
records of past events and transactions. This can be useful as feedback on past performance, and for
identifying trends and clues to future performance. However, the reports can also be prepared using
projected data in order to help assess likely future profits, cash flows, etc. The financial reports are
normally prepared on a projected basis for internal decision-making purposes only. Managers are usually
reluctant to publish these projected figures for external users.
Nevertheless, as external users have to make decisions about the future, projected financial reports
prepared by managers are likely to be useful for this purpose. Managers are, after all, in a good position
to assess future performance, and so their assessments are likely to provide valuable information. In
certain circumstances, such as raising fresh capital or resisting a hostile takeover bid, managers are
prepared to depart from normal practice and issue projected figures to external users. Where publication
does occur, some independent verification of the assumptions underlying the forecasts is often provided
by a firm of accountants to lend credibility to the figures produced.
Management accounting
By now it should be clear that management accounting uses financial information (and increasingly non-
financial information) in a variety of different ways, with the general aim of achieving good decisions. The
main areas of use include: prediction of future financial performance as part of long-term planning;
budgeting as a means of both planning and control; cost control and savings; pricing; and project
appraisal.
Concept check 10
The statement of financial position is also known as:
A. The income statement
B. The profit and loss statement
C. The balance sheet
D. The statement of comprehensive income.
Concept check 11
Which statement shows all changes in the owners’ interest in the business?
A. The statement of changes in equity
B. The balance sheet
C. The statement of financial performance
D. The statement of comprehensive income
E. The statement of cash flows.
Concept check 12
Which financial statements are videos rather than snapshots?
A. The income statement and the balance sheet
B. The statement of cash flows and the statement of financial position
C. The balance sheet and the statement of cash flows
D. The statement of financial performance and the statement of cash flows
E. None of the above.
SELF-ASSESSMENT QUESTION
1.1
While on holiday on the Gold Coast, Helen had her purse with her credit cards stolen from a beach
where she was swimming. She was left with only $120 cash, which she had left in her hotel room.
There were three days of her holiday remaining. She was determined to continue her holiday, and
so decided to make some money in order to be able to complete her holiday. She decided to sell
orange juice to holiday-makers on the local beach. On day 1 she purchased 80 cartons of orange
juice at $1.50 each for cash, and sold 70 of these for $2.40 each. On the following day she
purchased 60 cartons for cash and sold 65 at $2.40 each. On the third and final day she
purchased another 60 cartons for cash. However, it rained and as a result business was poor. She
managed to sell 20 at $2.40 each, but was forced to sell the rest of her stock at $1.20 each.
So far in this chapter we have talked in general terms about the kind of accounting information that might
be used by various user groups. In practice, however, the forms of business ownership and the differing
types of business activities engaged in will influence these needs. In the next section we will consider
some of these factors.
We shall now consider the first two in reasonable detail, and limited companies in outline. Chapters 4
and 5 will provide more detail for limited companies.
Sole proprietorship
Sole proprietorship (also known as ‘sole trader’), as the name suggests, is where an individual is the
sole owner (known as the proprietor) of a business. This type of business is often quite small in terms of
total income or profits, and number of employees. However, the number of businesses that operate as
sole proprietors is very large, far greater than the number of businesses that operate as companies.
Examples of sole proprietor businesses can be found in most sectors, but the service sector
predominates. Hence, services such as electrical repairs, plumbing, picture framing, photography, driving
instruction, retail shops and hotels have a large proportion of sole proprietor businesses.
sole proprietorship
An individual in business on his or her own account. Also known as a ‘sole trader’.
A sole proprietor business is easy to set up, with no formal procedures being required. Operations can
generally commence immediately (unless special permission is required because of the nature of the
trade or service, such as running licensed premises). The owner has considerable discretion as to how
the business is to be conducted, and is able to restructure or dissolve the business whenever it suits.
A sole proprietorship has no separate legal identity. From a legal perspective there is no distinction
between the owner (Bill Bloggs) and the business (Bill’s Diner). However, from an accounting perspective
we distinguish clearly between the owner (Bill Bloggs) and the business (Bill’s Diner). The accounting
entity (Bill’s Diner) will recognise transactions between the owner (Bill Bloggs) and the business. These
transactions concern capital (funds) contributed to the business by the owner, profit earned by the
business and not distributed to the owner, and distributions to the owner. Distributions to the owner, which
are often labelled ‘drawings’, may be any of the following:
Another consequence of the fact that the law does not recognise the sole proprietor business as being
separate from the owner is that the business will cease on the death of the owner.
A sole proprietor has unlimited liability, and no distinction is made between the proprietor’s personal
wealth and that of the business if there are business debts to be paid.
The important characteristics of the sole proprietorship entity structure from the perspective of both the
owner and other people or other entities dealing with this business are summarised in Table 1.1 .
Limited life. The sole proprietorship structure has a limited life. The life of the business is restricted to the period in which the owner
continues in that position. This does not mean that the activity of the business necessarily stops when the owner dies, retires or leaves
the business, but that sole proprietorship business ceases and possibly another commences (e.g. new owner, new name).
Unlimited liability. The owner of a sole proprietorship has unlimited liability with respect to the activities of the business. That is, he or
she is fully responsible for the obligations and debts of the business.
Minimum reporting regulations. Regulations for financial recording and reporting are minimal compared with those for other entity
structures. However, the introduction of the Goods and Services Tax (GST) has increased the requirement for regular detailed reports.
Limited access to funds. Access to funds is potentially limited. With a sole proprietorship, the ownership funding is restricted to the
personal resources of a single owner. Additionally, certain forms of borrowing are not available to sole proprietors that may be available to
companies, and lenders may be more reluctant to provide credit or funds to sole proprietorships.
The costs to establish a sole proprietorship structure are normally much lower than for other entity structures. By costs we are
referring to those involved in setting up the business entity, not the costs to make the business operational (e.g. the necessary resources,
property, plant, equipment, inventories, staff and other expenditure).
A sole proprietor will usually need some indication of the financial performance and position of the
business, and certainly will need to provide the taxation authorities with accounting information sufficient
to satisfy their needs. However, there is no legal requirement to produce accounting information relating
to the business for other user groups, although some may have the power (e.g. a lending bank) to
demand accounting information about the business. All of this means that the range and quality of the
accounting information required by a sole proprietor is likely to vary quite a bit. It is reasonable to assume
that a report explaining the calculation of income for use by the Australian Taxation Office would be a
minimum. Of course, many sole proprietors will require much more than this minimum and will look for as
much accounting information as is considered useful.
Having highlighted some key features of the sole proprietorship entity structure, we can determine its
advantages and disadvantages. The advantages include:
Potential disadvantages of the sole proprietorship structure when compared to other structures include:
the liability of the owner is unlimited, and personal assets may have to be used to satisfy business
debts
access to ownership funds is restricted to the personal resources of the proprietor
experience and knowledge are limited to the extent that the sole owner is frequently the sole manager
access to non-ownership funding (suppliers of goods and services on credit, external loans) is often
limited.
Partnership
The partnership structure represents the relationship that two or more individuals share with the aim of
generating a financial profit. Partnerships are usually quite small in size (although some, such as
partnerships of accountants and solicitors, can be large). Partnerships are also easy to set up. They may
be established by a formal partnership agreement or an informal arrangement between the parties, or
agreement may be simply inferred by the actions of two or more individuals. The partners can agree
whatever arrangements suit them concerning the financial and management aspects of the business.
Similarly, the partnership can be restructured or dissolved by agreement between the partners.
partnership
The relationship that exists between two or more persons carrying on a business
with a view to profit.
The partnership represents a separate accounting entity distinct from the owners (partners). However, as
with the sole proprietorship, there is no separate legal entity. From the viewpoint of the law there are just
the individual owners. Contracts with third parties must be entered into in the name of individual partners.
The partners of a business usually have unlimited liability.
Limited life. The partnership has a limited life, as each time there is a change in ownership (partners leave, new partners are
introduced), the current partnership concludes and a new partnership commences.
Unlimited liability. The liability of partners jointly and separately is unlimited with respect to the debts of the business. This means that
each partner’s personal assets can be called on to satisfy the claims of business creditors, well beyond the amount of the individual
partner’s share of the business.
Mutual agency. Each partner is responsible for the business actions of all other partners as if they had taken the action themselves.
Co-ownership of assets. The partnership assets are owned by the partners in aggregate rather than individually.
Co-ownership of profits or losses. The partnership profits or losses belong to the partners equally or in otherwise agreed proportions.
Limited membership. There are certain restrictions on how many partners can belong to a partnership entity structure. While this is
normally limited to 20, there are some exceptions in certain professions (e.g. accounting practices). Given the expanded number of
owners, the access to ownership funds is normally much greater than for a sole proprietorship.
Increased regulation. Most states have Partnership Acts which provide direction for the activities of partnerships and the rights and
responsibilities of partners.
It is worth noting that, because of the fact that a partnership is not a separate legal entity, the partnership
will pay no tax. The partnership profit or loss will be distributed to each partner, who will then include it in
his or her tax return (just like a sole trader).
there would normally be greater access to capital since there are two or more owners
the partners normally bring different skills to the partnership (professional, administrative, technical)
greater management flexibility is gained by having more than one owner
taxation advantages often arise when the partnership income can be spread among the partners; this
applies particularly to ‘husband and wife’ activities.
When considering the potential disadvantages of partnerships, it is important to identify the entity
structure with which the partnership is being compared. In comparison with a sole proprietorship, the
disadvantages could include:
While not legally necessary, it is sensible for partners to have a formal and detailed partnership
agreement in order to avoid the problems that invariably arise over the operation of the partnership and
the relations between partners. When problems between partners cannot be resolved without recourse to
the law, the requirements of the relevant Partnership Act will apply.
On the distribution of partnership profit, most Partnership Acts indicate the following:
partners are not entitled to a ‘salary or wage equivalent’ related to their input (physical or mental) into
the business operations
partners are not entitled to an ‘interest equivalent’ on the capital contributions they make to the
business
the profit or loss is to be divided equally among the partners.
However, these rules apply only in the absence of an agreement. Partners can (and should) agree to
share profits in any way they choose, including payment of interest on capital and the equivalent of a
wage to partners.
With regard to the accounting requirements of a partnership, the only major difference between this and a
sole proprietorship is that there is more than one owner. This means that the income figure will need to be
divided between the partners as will the calculation of owners’ wealth (equity). Typically, the partnership
maintains individual records of each partner’s transactions with the partnership, as follows:
Limited company
A limited company is a business that is owned by multiple investors, each of which owns a share of
the company. Hence the owners of a limited company are often known as ‘shareholders’. Limited
companies can range in size from quite small to very large. The number of individuals who invest in the
company and become part-owners (known as ‘subscribing capital’) may be unlimited, which provides the
opportunity to create a very large-scale business, although many are quite small. The liability of owners,
however, is limited (hence ‘limited’ company), which means that those individuals subscribing capital to
the company are liable only for debts incurred by the company up to the amount that they have agreed to
invest. This cap on the liability of the owners is designed to limit risk and to produce greater confidence to
invest. Without such limits on owner liability, it is difficult to see how a modern capitalist economy could
operate. In many cases, the owners of a limited company are not involved in the day-to-day running of the
business, and will therefore invest in a business only if there is a clear limit set on the level of investment
risk.
limited company
An artificial legal entity that has an identity separate from that of those who own
and manage it.
The benefit of limited liability , however, imposes certain obligations on such companies. To start up a
limited company, an application must be made to the Australian Securities and Investments
Commission (ASIC) for registration of the company, and every person who agrees to be a
shareholder, director or company secretary must register. The company will be allocated an Australian
Company Number, which acts as an identifier. The company must also register for an ABN, a number
which assists in transactions relating to various aspects of taxation. The Corporations Act, which covers
most companies, provides a framework for company procedures and the way in which companies
conduct their affairs, including the accounting and reporting requirements. Part of this regulatory
framework requires annual financial reports to be made available to owners and lenders, and usually an
annual general meeting of the owners has to be held to approve the reports. In addition, a copy of the
annual financial reports must be lodged with ASIC for public inspection. In this way, the financial affairs of
a limited company enter the public domain.
limited liability
The situation in which an investor in a business (a limited company) has his or her
liability limited to a maximum specified amount; namely, the maximum that he or
she has agreed to subscribe to the business.
With the exception of small proprietary companies, there is also a requirement for the annual financial
reports to be subject to an audit . This involves an independent firm of accountants examining the
annual reports and underlying records to see whether the financial reports provide a true and fair view of
the financial health of the company, and whether they comply with the relevant accounting rules
established by law and by accounting rule-makers. Limited companies are considered in more detail in
Chapters 4 and 5 . All of the large household-name Australian businesses (BHP Billiton,
Woolworths, Telstra, IAG and so on) are limited companies.
audit
A process in which a range of activities are checked to ensure that the activities
have been completed in accordance with a set of rules or guidelines.
This book concentrates on the accounting aspects of limited liability companies, because this type of
business is by far the most important in economic terms. However, there are a number of complications
associated with limited companies that do not exist with sole proprietorships or partnerships. Some of
these relate to the structure of limited companies, and some relate to the increased regulation associated
with companies. The next two chapters will introduce you to the basic accounting concepts with reference
to sole proprietorships and partnerships, together with some very simple company structures. Once we
have dealt with the basic accounting principles, which are the same for all three types of business, we can
then go on to see how they are applied in more detail to limited companies. It must be emphasised that
there are no differences in principle in the way these three forms of business keep their day-to-day
accounting records. However, in preparing their periodic financial statements, there are certain
differences that need to be considered. These differences are not ones of principle, however, but of detail.
Nearly all businesses that involve more than a few owners and/or employees are set up as limited
companies. Finance will come from the owners (shareholders) in the form of a cash investment in the
company or by leaving in the business profits to which they are entitled. Finance can also come from
lenders who earn interest on the amount lent to the business, or from suppliers who provide goods on
credit. Credit means that goods and services are provided with a payment date agreed for some time in
the future (typically one to three months).
In larger limited companies, the owners (shareholders) tend not to be involved in the daily running of the
business. They appoint a board of directors to manage the business on their behalf. The board is
charged with three major tasks:
board of directors
The board of directors represents the most senior level of management. Below this level, managers are
employed, with each manager typically being given responsibility for a particular part of the business’s
operations. Just how a particular business organises its operations is up to the board. Possibilities
include:
splitting the business up into separate departments, often on functional lines (e.g. production,
finishing, distribution, marketing, personnel and finance)
running the business on geographical lines, or
any number of combinations of these and others.
The implications of complicated organisations of this type are considerable for both the user and the
accountant. There is a need to consider just how to best provide relevant information to help in the
management process, and management accounting reports will be appropriately detailed. In the area of
financial accounting we need to consider how to best provide general-purpose accounting information that
provides relevant information to assess performance of the business.
strategic management
An approach that seeks to provide a business with a clear sense of purpose, and
to ensure that appropriate action occurs to achieve that purpose.
It is vitally important that businesses plan their future. Whatever a business is trying to achieve, it is
unlikely to be successful unless its managers are clear what the plans are. Planning is vital for businesses
of all sizes, but where a business involves more than one manager it is vital also that all their actions
coordinate. For example, it is crucial to a manufacturing business that production levels and sales levels
are related to one another. It is not feasible for sales and production to go their own separate ways. There
must be plans to ensure that production and sales levels match each other. This is not to say that plans,
once made, cannot be revised. Unexpected changes in the market or unforeseen production problems
may well demand the revision of all plans likely to be affected by these new circumstances.
Closely linked to planning is decision-making. Planning involves making decisions about the best course
of action.
1. Setting the objectives or mission of the business. This is what the particular business is
basically trying to achieve. The objectives are likely to reflect the attitudes of owners (shareholders)
and managers. They tend to be framed in broad, generalised, non-numerical terms. Once the
objectives have been established, they are likely to remain in force for the long term—for example,
10 years. For most private-sector organisations, wealth generation is likely to be the main
financial/economic objective. However, businesses typically have objectives other than the
financial ones—for example, being environmentally friendly or providing employment for the family.
In practice, therefore, any decision is likely to be the result of a compromise between more than
one objective.
2. Setting long-term plans. These are plans setting out how the business will aim to achieve its
objectives over a period of, say, five years. They are likely to deal with such matters as:
type of products or services to be offered by the business
amounts and sources of finance required by the business
capital investments (e.g. in new plant and machinery) required
sources of raw materials
labour requirements.
In the case of each of these, the pursuit of the established objectives of the business over the
planning horizon (perhaps five years) will lay the foundation for the plans. Long-term plans tend to
be stated in financial terms.
3. Setting detailed short-term plans or budgets. A budget is a financial plan for the short term,
typically one year. Its role is to convert the long-term plans into actionable blueprints for the
immediate future. Budgets usually define precise targets in areas such as:
cash receipts and payments
sales, broken down into amounts and prices for each of the products or services provided by
the business
detailed inventory (i.e. stock of goods held for sale) requirements
detailed labour requirements
specific production requirements.
budget
It must be emphasised that planning (and decision-making) is not the role of accountants; it is the role of
managers. However, much of the planning will be expressed in financial terms, and most of the data for
decision-making are of an accounting nature. Therefore, accountants, because of their background
knowledge, expertise and skills, together with their understanding of the accounting system, are very well
placed to give technical advice and assistance to managers in this context. It is the managers of the
various departments of the business who must actually do the planning, however. Only in respect of the
accounting department, of which the most senior accountant will be the manager, should an accountant
be taking decisions and making plans.
Reflection 1.5
The approach described above suggests that decision-makers will examine all of the various
courses of action available and then systematically rank them in order of preference.
Do you think this is what decision-makers really do? Is this how you approach decisions—for
example, choosing a career?
Control
However well planned the activities of the business may be, they will come to nothing unless steps are
taken to try to put them into practice. The process of making planned events actually occur is known as
control. Control can be defined as compelling events to conform to the plan. This definition of control is
valid in any context. For example, when we talk about controlling a car, we mean making the car do what
we intend it to do. Our plan may be made only split seconds before we act on it, but, if the car is under
control, it is doing what the driver intended.
control
To compel events to conform to the plan.
In a business context, accounting is very useful in the control process. This is because it is possible to
state both plans and actual outcomes in the same accounting terms, thus making comparison between
actual and planned outcomes relatively easy. Where actual outcomes are at variance with the detailed
plans (which are called ‘budgets’), this should be highlighted in the accounting information. Managers can
then take steps to get the business back on track towards the achievement of the plans (budgets). Figure
1.6 shows the decision-making, planning and control process in diagrammatic form.
The figure shows the key steps in the planning and control process as described in this chapter.
The accountant must be aware of the fact that people can process only so much information. Too much
information can be as bad as too little information, as it can overload and confuse people. This, in turn,
can lead to poor evaluations and poor decisions. The information provided to managers must be
restricted to what is relevant to the particular decision and to what can be absorbed. In practice, this may
mean that information is produced in summarised form, and that only a restricted range of options will be
considered.
Not-for-profit organisations
Although the focus of this book is accounting as it relates to private-sector businesses, there are many
not-for-profit organisations (NPOs) that do not exist mainly for the pursuit of profit. Examples
include:
charities
clubs and associations
universities
local government authorities
national government departments and associated agencies
churches, and
trade unions.
An organisation whose main aim is not to make a profit, but to achieve some
other clear goal, usually of a social nature.
Such organisations also need to produce accounting information for decision-making purposes. Various
user groups need accounting information about these types of organisations to help them to make
decisions. These groups are often the same as, or similar to, those identified for private-sector
businesses. They may have a stake in the future viability of the organisation, and may use accounting
information to check that the wealth of the organisation is being properly controlled and used in a way that
is consistent with its objectives. Not surprisingly, therefore, the accounting needs of NPO tend to be very
similar to those of commercial businesses. As a result, much of the contents of this book applies to
charities, clubs and government, both local and central, equally as much as it does to commercial, profit-
seeking businesses.
As with many commercial businesses, certain NPO suffer from inadequate accounting systems and a lack
of financial skills among its managers. Real World 1.3 describes how one Australian charity found itself
in financial strife.
White Ribbon Australia, the anti-domestic violence agency, was reported to be in a ‘parlous’
financial state in November 2018, with a number of sponsors withdrawing. When its 2018 annual
report came out, it showed an annual loss of $840,826. This was a dramatic change of fortune and
suggests that the board and executive had completely taken their eyes off the financial ball. The
organisation had been through three CEOs in the previous year, with one only lasting three
months. Staff expenses had gone up by about 40 per cent on the year, to $4 million, about two-
thirds of its total revenues, a figure which is probably too high. The total of administration and
employee costs represents 96 per cent of the total revenue. At the end of the financial year,
financial liabilities (debt) stood at $150,000, compared with zero the previous year. Several
controversies had had an impact on donations. The charity is clearly going through a difficult time,
which has not been helped by a seeming lack of financial control and accountability.
Sources: White Ribbon Australia, Annual Report 2017–2018. Jenna Price, ‘As its dramatic debt is revealed, can White Ribbon survive?’, The Sydney Morning
Concept check 13
You’ve decided to follow Bill Gates and dump university to go into business. You will
probably set up your business initially as a:
A. Limited company
B. Partnership
C. Not-for-profit organisation (NPO)
D. Sole trader
E. Any of the above.
Concept check 14
Advantages of a sole proprietorship include:
A. Separate legal entity
B. Minimum reporting requirements
C. Unlimited liability
D. Limited life
E. Limited access to funds.
Concept check 15
Disadvantages of a partnership include:
A. Not a separate legal entity
B. Increased regulation (Partnership Acts)
C. Unlimited liability
D. Have to share profits with partners
E. All of the above.
The changing face of business and accounting
LO 7 Identify ways in which business and accounting have been changing, together with some current
issues confronting businesses and their associated reporting, including current thinking on ethics in
business
Over the past 40 years, the environment within which businesses operate has become increasingly
turbulent and competitive. Various reasons have been identified to explain these changes, including:
This new, more complex environment has brought new challenges for managers and other users of
accounting information. Their needs have changed, and both financial accounting and management
accounting have had to respond. The changing business environment has given added impetus to the
search for a clear conceptual framework, or framework of principles, upon which to base financial
accounting reports. Various attempts have been made to clarify their purpose, and to provide a more solid
foundation for the development of accounting rules. The conceptual frameworks that have been
developed try to address such fundamental questions as:
As a result of criticisms that the financial reports of some businesses are not clear enough to users,
accounting rule-makers have tried to improve reporting rules to ensure that the accounting policies of
businesses are more comparable and more transparent, and that they portray economic reality more
faithfully.
The importance of this work has been reinforced by a number of scandals over the past couple of
decades, typically relating to the financial reports prepared for general-purpose external users. These
scandals have become front-page news in Australia, and a major talking point among those connected
with the world of business. Unfortunately, this attention has been for all the wrong reasons. We have seen
that investors rely on financial reports to help keep an eye on their investment and on the managers.
However, these scandals clearly indicate that cases have arisen where managers have been providing
misleading information to their investors.
The global financial crisis has highlighted, among many other things, inadequacies and loopholes in
financial reporting regulations and reporting practices. Lehman Brothers, the biggest corporate failure in
history, sent the whole world into shock. It was revealed that the company had used a sale and
repurchase mechanism to inflate its cash and reduce its liabilities by billions of dollars. In 2015, the well-
known Japanese conglomerate Toshiba was sued by 15 groups and individuals after its admission to
reporting overstated profits going back to 2008. More recently, an investigation found revenue at Fuji
Xerox’s Australia and New Zealand operations were overstated by $450 million over the five years from
2012 to 2017.
In the wake of these scandals, there was much closer scrutiny of businesses’ financial reports by
investment analysts and investors. This has led to further businesses, in Australia and worldwide, being
accused of using dubious accounting practices to bolster profits. Various reasons have been put forward
to explain this spate of scandals. Some may have been caused by the pressures on managers to meet
investors’ unrealistic expectations of continually rising profits; others by the greed of unscrupulous
executives whose pay is linked to financial performance. However, they may all reflect a particular
economic environment.
Whatever the causes, the result of these accounting scandals has been to undermine the credibility of
financial statements and to introduce much stricter regulations concerning the quality of financial
information. Overall, in general they are seen as a failure of corporate governance—the way in which
companies are managed and account for their actions.
Management accounting has also changed by becoming more outward-looking and more customer-
focused. In the past, information provided to managers has been largely restricted to that collected within
the business. However, the attitude and behaviour of customers and rival businesses have now become
the object of much information-gathering. Increasingly, successful businesses are those that are able to
secure and maintain competitive advantage over their rivals. In addition, information about the costs and
profits of rival businesses—which can be used as ‘benchmarks’ by which to gauge competitiveness—is
gathered and reported.
To compete successfully, businesses must also find ways of managing costs. The cost base of modern
businesses is under continual review, and this in turn has led to the development of more sophisticated
methods of measuring and controlling costs.
Linked to, and overarching, all of the above is the advent of big data and analytics. It has often been said:
‘You can’t manage what you don’t measure’. This idea provides considerable support for the accounting
role, which has measurement as a major function. However, the growth of digital information is clearly
changing the world of decision-making. There is now a vast array of digital data available, collected from
a variety of online activities, particularly via smartphones. This data is often unstructured, but detailed
analysis and development of algorithms provides potentially unlimited new ways of obtaining a
competitive advantage. It seems fairly certain that data-driven businesses are likely to be the most
successful in the future. Accounting information represents an important part of that future, but just how
important remains to be seen Real World 1.4 illustrates how the recent COVID-19 crisis has impacted
businesses, including the overall economy and markets, survival strategies and financial implications.
The outbreak of COVID-19 in 2020 has seen a revision of global growth predictions. Economists
see the effects as far-reaching. For example, China could well see a rise in new bad loans in the
vicinity of $800 billion, with growth levels the lowest since the 2008 global financial crisis. Although
the exact implications for the US economy are not yet apparent, it will not escape unscathed:
‘economists expect a hard hit ..., and the timing of the subsequent recovery remains uncertain’.
Nevertheless, such ‘volatile conditions create an opportunity to protect against downside risk and
increase income’. With COVID-19’s effect on the markets unfolding, it is prudent to ‘collectively
remain vigilant as we navigate through this period of uncertainty together’.
Source: Brian Menickella, ‘COVID-19 worldwide: the pandemic’s impact on the economy and markets’, Forbes, 8 April 2020, https://www.forbes.com/sites/
brianmenickella/2020/04/08/covid-19-worldwide-the-pandemics-impact-on-the-economy-and-markets/#234dbb0928c3.
McKinsey’s Kevin Sneader and Shubham Singhal state that in order to navigate through the
COVID-19 crisis, businesses need to act proactively in five stages:
Resolve: Combat ‘immediate challenges ... to the institution’s workforce, customers, technology
and business partners’.
Resilience: Handle the short-term ‘cash-management challenges and broader resilience issues’
experience with ‘shutdowns and economic knock-on effects’.
Source: Kevin Sneader and Shubham Singhal, ‘Beyond coronavirus: the path to the next normal’, McKinsey, March 2020,
https://www.mckinsey.com/industries/healthcare-systems-and-services/our-insights/beyond-coronavirus-the-path-to-the-next-normal.
KPMG’s Bruce Sweeney says that COVID-19 is throwing up ‘profound’ challenges for private, mid-
market and family businesses in Australia: ‘While some industries are experiencing a surge in
activity, many are facing a rapid decrease in revenue and an evaporation of their cash reserves.’
Sweeney advises that most effective response is drilling down meaningfully into businesses’ costs,
as this will be ‘çritical’ in giving businesses ‘the best chance of surviving through this upheaval’ and
positioning them for the future. However, cost optimisation extends beyond any short-term
tightening of expenditure, and involves a broader and deeper appreciation of a business’s costs.
He contends that ‘sustained business success’ is tied to ‘the effectiveness of your operating model
and if your products, channels and markets still make sense in the current environment, and
potential future state’.
Source: Bruce Sweeney, ‘COVID-19: focus on costs is key for sustainability of SMEs’, KPMG, 20 April 2020, https://home.kpmg/au/en/home/insights/2020/04/covid-
19-coronavirus-cost-optimisation-for-sme.html.
ethics
A considerable amount of work on ethics has been done over the years. The IFAC’s International Code of
Conducts for Professional Accountants includes the following five fundamental principles: integrity;
objectivity; professional competence and due care; confidentiality; and professional behaviour
(https://www.ethicsboard.org/international-code-ethics-professional-accountants). Ethics are important not
only for accountants, but also for senior management. Lynn Paine in a 1994 article in the Harvard
Business Review said that, in terms of integrity, ethics management is to ‘define and give life to an
organization’s guiding values, to create an environment that supports ethically sound behavior, and to
instill a sense of shared accountability among employees’. Senior managers who dismiss ethics ‘run the
risk of personal and corporate liability in today’s increasingly tough legal environment’ (Lynn Paine (1994),
‘Managing for organizational integrity’, Harvard Business Review, March–April). Businesses that integrate
ethics into their strategy can enjoy the following benefits: fostering employee morale; boosting brand
reputation; encouraging loyalty in customers and employees; and improving the bottom line.
Ethics are also important in developing a set of corporate ethical values, or ideology (the way in which a
corporation actually does business). This set of values is not necessarily the same as business ethics.
Business ethics has been understood as a form of applied ethics or professional ethics that deals with
ethical principles and moral or ethical problems in the context of a business environment. They typically
deal with policies and practices relating to all aspects of business conduct, including governance, insider
trading, bribery and a range of other issues. Business ethics are central to the conduct of individuals and
entire organisations. These ethics are influenced by both national and corporate cultures, by the legal
system, and by businesses, professional organisations and individuals. Of course, conversion of this
understanding to what actually happens on the ground can still vary tremendously. There is undoubtedly
a real concern about behaviour being ethically sound, and the general public is increasingly critical of
failures in this arena. Examples of clear failures can be seen in Real World 1.5 .
business ethics
This has been understood as a form of applied ethics or professional ethics that
deals with ethical principles and moral or ethical problems in the context of a
business environment. They typically deal with policies and practices relating to
all aspects of business conduct, including governance, insider trading, bribery and
a range of other issues. Business ethics are central to the conduct of individuals
and entire organisations. These ethics are influenced by both national and
corporate cultures, by the legal system, and by businesses, professional
organisations and individuals.
The CEO of Sirtex, the cancer drug developer, pleaded guilty after being charged by ASIC for
insider trading. He sold off millions of dollars’ worth of his shares just before a plunge in share
price, caused by a profit downgrade.
Source: Samantha Bailey, ‘Former Sirtex CEO Gilman Wong pleads guilty to insider trading’, The Australian Business Review, 3 July 2019.
The European competition regulators fined Google euros 1.49bn ($2.4bn) for anti-competitive
behaviour, by ‘limiting how some websites could display ads sold by its rivals’. Google had ‘abused
the dominance of its search engine to limit competition in the niche market of selling text ads on
search results that appear on third-party websites’. This is the third large fine imposed on the
business.
Source: Sam Schechner and Valentina Pop, ‘Google fined for stifling competition’, The Australian Business Review, 21 March 2019.
The Financial Services Royal Commission, which commenced work in 2018, revealed a range of
unethical practices, a small sample of which are provided below.
Allianz was reported as having ‘a toxic culture where management is more concerned about
what it can get away with than doing the right thing’ and ‘compliance officers are regarded as
“hysterical” for raising concerns’.
Source: Michael Roddan and Ben Butler, ‘Cavalier Allianz dismissed “hysterical” compliance concerns’, The Australian Business Review, 19 September 2018.
Suncorp ‘decided to ignore a watchdog investigation into its dodgy advertising and push ahead
with new misleading ads after working out that the cost of a tiny fine paled in comparison to the
millions it could earn in insurance premiums’. AAMI was found to have advertised that ‘it would
completely replace destroyed homes, no matter the cost’, even after being told by ASIC that
this was ‘misleading and deceptive’.
Source: Michael Roddan and Ben Butler, ‘Royal Commission: Suncorp kept misleading ads campaign’, The Australian Business Review, 21 September 2018.
Freedom Insurance came in for a huge amount of criticism, with a key example being the
treatment of a 26-year-old with Downs syndrome, whose father ‘was rebuffed several times in
his attempt to get his son’s policy cancelled’, with some apparently callous comments being
made by a ‘retention’ agent.
Source: Michael Roddan and Elizabeth Redman, ‘Freedom Insurance used every trick to trap customers’, The Australian Business Review, 13 September 2018.
‘Commonwealth Bank denied the claim of an insurance customer who suffered a heart attack
by using out-of-date medical definitions, and then misled the Financial Ombudsman Service by
covering up advice it had received from a doctor when the customer complained.’
Source: Elizabeth Redman and Michael Roddan, ‘Banking royal commission: CBA rejected heart attack claims, misled ombudsman’, The Australian Business
ASIC ‘agreed to a potential record $3 million settlement with Westpac, after the bank admitted
breaching responsible lending laws by failing to properly assess the ability of borrowers to
repay loans’.
Source: Michael Roddan, ‘Westpac hit with record $35m fine for irresponsible lending’, The Australian Business Review, 5 September 2018.
Activity 1.7
Identify and discuss any recent cases where you think behaviour has been unethical.
Several of the failures identified in Real World 1.5 relate to banking and financial services. Many
observers have been both disappointed and shocked by the findings of the Royal Commission. In the
interim report issued in September 2018, the banks were found to ‘have gone to the edge of what is
permitted, and too often beyond that limit (as a result of) greed —the pursuit of short-term profit at the
expense of basic standards of honesty’ (Royal Commission, 2018). The report added that ‘pursuit of profit
has trumped consideration of how the profit is made’ (Royal Commission, 2018). The final report provided
a range of detailed recommendations, including reference to the roles of the Australian Prudential
Regulation Authority (APRA) and ASIC.
Of course, identifying the kind of issues that have occurred is only one part of the problem. How they
have arisen, what underlying ethical and cultural issues exist, and just what role the regulators have
taken, are all questions that need to be addressed in a lot more detail, as does the significant further
question regarding the appropriate punishment for the various sins. Real World 1.6 provides some
examples of comments made on these particular points.
Real world 1.6
Comments on the interim royal commission report
Source: Elizabeth Redman, ‘Breaches that led to key findings’, The Australian Business Review, 29 September 2018.
David Uren concluded that ‘the culture and incentives in the organisation’ underpinned the
conduct. Even so, the report is highly critical of the regulators, pointing out that the misconduct
uncovered ‘is already against the law, so passing new laws would simply add further regulatory
complexity’. Relations between the regulators and banks were described as ‘too cosy’. Other
comments related to the tiny amounts of money recovered by infringement notices, and the small
number of times things have gone to court.
Source: David Uren, ‘Enforcement trumps transparency with focus on regulators’, The Australian Business Review, 29 September 2018.
Judith Sloan, in an article on the release of the interim report, saw ‘the incompetence and idleness
of the regulators stand out as a major part of the problem’. She points out that the report notes:
‘Banks decided when and how laws would be obeyed.’ She argues that ASIC rarely takes matters
to court, but resorts to ‘the lame remedies of infringement notices or unenforceable undertakings’.
She notes that ‘the Australian Prudential Regulation Authority has never taken a matter to court.’
Source: Judith Sloan, ‘It’s time to speak truly ... and carry a big stick’, The Australian, 29 September 2018.
Real World 1.5 provides some extreme illustrations of poor behaviour, but there are many other
examples of breakdowns or failures that range from minor moral misjudgements through sloppiness in the
way business is transacted, and general sharp practice, to plain fraud. Also, thinking back to the section
on stakeholder theory, Freeman’s ‘new story’ clearly has not reached parts of the business community
(and possibly the entire community). Do we accept that this is reality, or try to do something more
positive?
Clearly the issues that have been raised through the Royal Commission on Financial Services are
complex. Some of them are largely cultural, some are legally oriented, while others are compliance-
related. At the end of the day, however, it is difficult to deny that many have roots in behaviour that simply
cannot be described as ethical. As we move into an era of greater social awareness, ethical behaviour will
almost certainly become an even more important part of business practice, although there will no doubt
always be a few people who try to get away with unethical behaviour. The Royal Commission will
probably advance ethical behaviour by forcing a major sector of the economy to face some unpalatable
facts. Changes in compliance, costs of misdemeanours, changes in culture, and a bit more soul-
searching should surely improve things.
In fact, in spite of the disappointment found by the Royal Commission, the impact of ethical
considerations is now well recognised. There have been substantial improvements in corporate
governance—the system by which corporations are directed and controlled—and compliance and other
regulatory requirements are more rigorous. Many superannuation funds now have investment categories
with names such as ‘ethically based investments’, which enable investors to choose investments with a
sound ethical (or green) underpinning. Consumers seem to be increasingly turning to businesses or
industries which engage in ethical trading, such as Fairtrade coffee.
In the course of this text we shall see that accountants play a very important role in compliance and
certain ethical issues. Increasingly, as community expectations change, so will compliance needs. For
example, the increased emphasis in recent years on sustainability has led to substantially expanded
reports, which are discussed in Chapter 7 . The ideas of Freeman regarding stakeholder theory’s ‘new
story’ are likely to lead to a range of new measurement systems over the next few decades.
Eva Tsahuridu, in a regular piece on ethics in InTheBlack (‘How do you stop bad apples?’, May 2015),
asked how we might move from a compliance-based approach to one which focuses on shared values
and benefit creation. The article suggests that we need to develop a positive ethical organisation, in which
doing the right thing is the normal thing to do. Such an organisation will require attention to:
There is considerable overlap between the ideas covered in the section on stakeholder theory and this
one on ethics. The use of the term ‘values-driven’ is increasingly common. Accounting has led the field in
terms of measurement. It remains the principal discipline for measurement. However, many of the ideas
raised in this chapter are difficult to measure. Considerable work remains to be done.
Concept check 16
Which of the following factors have contributed to the changing business and reporting
environment we live in?
A. Advances in technology
B. Deregulation of utility providers (e.g. electricity, water)
C. Breakdown of political barriers
D. None of the above
E. The first three.
Concept check 17
Which of the following is NOT a response of the accounting profession to the changing
environment being faced by today’s business?
A. Accounting standards that meet the unique needs of a particular country
B. Increased clarity of financial reports
C. Harmonisation of accounting rules across countries and continents
D. Greater transparency in financial reporting
E. Greater comparability in financial reporting.
How useful is accounting information?
LO 8 Explain why accounting information is generally considered to be useful, and why you need to
know the basics of accounting
No one would seriously claim that accounting information fully meets all of the needs of each of the
various user groups. Accounting is still a developing subject, and we still have much to learn about user
needs and the ways in which these needs should be met. Nevertheless, the information contained in
accounting reports should help users make decisions relating to the business. The information should
reduce uncertainty about the financial position and performance of the business. It should help to answer
questions concerning the availability of funds to pay owners a return, to repay loans, to reward employees
and so on.
While we cannot be sure just how useful accounting information actually is to users, there is little doubt
that accounting is perceived as being useful. Several studies have attempted to rank the importance of
accounting information in relation to other sources of information. Generally, these studies have found
that accounting information is ranked more highly than other sources of information. The impact on share
prices of accounting information is one area where some clear evidence can be seen to support these
views. Real World 1.7 provides information on a research report on decision usefulness in financial
reporting, prepared for the CPA Australia, followed by examples of the impact on share prices of
announcements regarding current or anticipated profits. Typically, there is no close substitute for the
information provided by the financial statements. Thus, if users cannot glean the required information
from the financial statements, it is often unavailable to them. Other sources of information concerning the
financial health of a business are normally much less useful.
CPA Australia has produced a further two reports dealing with particular aspects of decision
usefulness.
A useful summary of the issues can be found in the July 2018 edition of INTHEBLACK in an article
by Tony Kaye entitled ‘Is this the end of accounting? Bringing financial statements to account.’
Source: Perry Williams, ‘Caltex share dive on profit warning’, The Australian Business Review, 21 June 2019.
Apple reduced its quarterly revenue forecast for the first time in more than 15 years with the result
that shares price dropped by more than 7% in a single day.
Source: Robert McMillan and Tripp Mickle, ‘Apple makes rare cut to sales forecast as China demand dips’, The Wall Street Journal, 3 January 2019.
In October 2018, shares in online retailer Kogan.com plunged 33% after it revealed that its profit
margins were being squeezed by rival online retailers such as Amazon.
Source: Samantha Bailey, ‘Kogan.com plunges 33pc as online retailer laments foreign rivals “avoiding GST” ’, The Australian Business Review, 29 October 2018.
Activity 1.8
What other sources of information might, say, an investment analyst use in an attempt to gain an
impression of the financial position and performance of a business? What kind of information might be
gleaned from these sources?
Such decisions can have a profound effect on all those connected with the business. It is important,
therefore, that all of those who intend to work in a business should have a fairly clear idea of certain
important aspects of accounting and finance. These aspects include:
Many, perhaps most, students have a career goal of being a manager within a business—perhaps a
personnel manager, a production manager, a marketing manager or an IT manager. If you are one of
these students, an understanding of accounting and finance is very important. When you become a
manager, even a junior one, it is almost certain that you will have to use financial reports to help you to
carry out your role. It is equally certain that it is largely on the basis of financial information and reports
that your performance as a manager will be judged.
As part of your management role, it is likely that you will be expected to help in forward planning for the
business. This will often involve the preparation of projected financial statements and the setting of
financial targets. If you do not understand what the financial statements really mean and the extent to
which the financial information is reliable, you will find yourself at a distinct disadvantage to others who
know their way around the system. Along with other managers, you will also be expected to help decide
how the limited resources available to the business should be allocated between competing options. This
will require an ability to evaluate the costs and benefits of the different options available. Once again, an
understanding of accounting and finance is important to carrying out this management task.
This is not to say that you cannot be an effective and successful personnel, production, marketing or IT
manager unless you are also a qualified accountant. It does mean, however, that you need to become a
bit ‘streetwise’ in accounting and finance if you are to succeed. This book should give you that street
wisdom.
Concept check 18
Which of the following statements is true?
A. Well-prepared financial statements will meet all of the needs of most, but not of all
user groups.
B. Accounting information is useful only to those trained in accounting.
C. The ability to understand financial statements is important and even critical for many
non-accounting managers in business.
D. All of the above.
E. None of the above.
Concept check 19
Financial statements and accounting information can provide information to aid which of the
following decisions?
A. Whether or not to buy shares in a company
B. Whether or not to provide credit to a business
C. Whether to invest in a particular project
D. Whether to buy product or services from a company
E. All of the above.
Summary
In this chapter we have achieved the following objectives in the way shown.
Explain the nature and role of accounting Distinguished two distinct roles—a stewardship role and a
decision-usefulness role
Identified the role as the provision of economic information
to assist in decision-making
Explained accounting as a service function, with particular
emphasis on quantitative characteristics
Explained accounting as an information system concerned
with the collection, analysis and communication of economic
information
List the main groups that use the accounting reports of a business entity, Identified the following groups:
and summarise the different uses that can be made of accounting —owners
information
—managers
—lenders
—suppliers
—investment analysts
—customers
—competitors
—government
—community representatives
Compare and contrast financial and management accounting Identified differences as follows:
Identify the main purpose of a business (while recognising a range of Identified wealth enhancement as the main objective of a
other influences), and explain the traditional risk–return relationship business
Discussed a range of other secondary objectives that may
influence the way in which a business is run
Explained the need to retain a balance between risk and
return
Provide an overview of the main financial reports prepared by a business Illustrated the need for, and development of, the statement
of cash flows, the statement of financial position, and the
statement of financial performance (profit and loss account)
Identified the typical management accounting reports
prepared
Outline the main types of business ownership, describe the way in which Identified and outlined the main kinds of business ownership
a business is typically organised and managed, and explain the —sole proprietorship
importance of accounting in a business context
—partnership
—limited company
Identify ways in which business and accounting have been changing, Identified the ways in which business has become
together with some current issues confronting businesses and their increasingly complex and turbulent
associated reporting, including current thinking on ethics in business Explained how the internationalisation of business has led to
a harmonisation of accounting rules
Identified areas of concern and current activity in
accounting, as a result of the greater complexity
Outlined the importance of ethics in business
Explain why accounting information is generally considered to be useful, Explained that accounting is central to all businesses, and
and why you need to know the basics of accounting that a basic knowledge is essential if you are to fulfil a
managerial role in a business
References
Australian Accounting Standards Board (AASB) (2019), Conceptual Framework for Financial Reporting
(AASB, Melbourne), https://www.aasb.gov.au/Pronouncements/Conceptual-framework.aspx
External Reporting Centre for Excellence (2014), A Guide to Understanding the Financial Reports of Not-
forprofit Entities (CPA, Melbourne), https://www.cpaaustralia.com.au/~/media/corporate/allfiles/
document/professional-resources/reporting/not-for-profit-guide.pdf.
Jude Lau, David Hardidge, Siva Sivanantham and Dean Han (2019), A Guide to Understanding Annual
Reports (CPA, Melbourne), https://www.cpaaustralia.com.au/~/media/corporate/allfiles/
document/professional-resources/reporting/guide-to-understanding-annual-reporting.pdf?
la=en.
Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry
(2018), Interim Report of the Financial Services Royal Commission into Misconduct in the Banking,
Superannuation and Financial Services Industry, Volume 1 (Royal Commission into Misconduct in the
Banking, Superannuation and Financial Services Industry, Canberra).
Discussion questions
Easy
1.1 LO 1 What is the purpose of producing accounting information?
1.3 LO 5 Identify the similarities and differences between the three major external financial reports (statement of financial position,
statement of financial performance, statement of cash flows).
1.4 LO 6 Distinguish between ‘accounting entities’ and ‘legal entities’ as business structures.
1.6 LO 8 ‘Understandability’ is identified in the text as a key characteristic of accounting information. By whom should the financial
reports be readily understood?
1.9 LO How are annual budgets linked to the long-term plans of an organisation?
3/4/6
Intermediate
1.10 LO ‘Relevance’ and ‘faithful representation’ represent two key qualitative characteristics of accounting information. What do these
1 two terms mean in an accounting context? Are they in conflict?
1.11 LO As an owner of a small business, what are three key financial attributes of the business you would wish to assess when you
2 review financial reports?
1.12 LO Reconcile financial accounting with management accounting. Your textbook clearly distinguishes between them. What are the
3 similarities?
1.13 LO What is meant by the ‘risk–return’ relationship? Provide a non-accounting example of the trade-off between risk and return.
4
1.15 LO In relation to recent corporate crashes, what have been the main lessons in relation to the accounting process and corporate
7 governance (recording and reporting procedures)?
1.16 LO Accounting is said to perform a ‘decision-usefulness role’ as well as an ‘accountability (stewardship) role’. Distinguish between
5/6 these two roles and provide an example of each.
1.17 LO Control in accounting is linked to timely comparison between actual and budget figures. What are the implications of this
6 relationship for:
a. the budgeting process?
b. the financial reporting process?
Challenging
1.18 LO 1 Financial accounting statements tend to reflect past events. In view of this, how can they help a user make a decision when
decisions, by their very nature, can only be made about future actions?
1.19 LO However a business is organised, it must meet the needs or demands of various stakeholders.
2/6
1.20 LO 4 The global financial crisis showed us that risk is bad. Do you agree?
1.21 LO 5 ‘The statement of financial performance reflects the financial performance for the period, and explains the changes in the
statement of financial position.’ Do you agree or disagree with this statement? Why?
1.22 LO 7 It has been suggested that the global financial crisis might have been avoided if we had used cash-based accounting.
Discuss.
1.23 LO 8 Which financial information would be useful if you were running the sales department of a large business? Can you think of
any non-financial information that you might want to have?
1.24 LO If you were to consider starting a business, what information would you be seeking before commencing?
1/8
1.25 LO Do you purchase any goods that might be categorised as Fairtrade? Why/why not? To what extent might your decision be
4/7 influenced by your own particular circumstances?
1.26 LO Do you think, from your own experience, that the ideas of stakeholder theory, as compared with the traditional search for
5/7/8 profit, are gaining much ground, and if so in which areas and ways?
1.27 LO What kind of information might you collect if you thought that you needed to figure out how to create value, not just for
7/8 investors, but for customers, suppliers, employees and communities?
1.28 LO 7 What do you consider are ethical considerations that might occur in data mining and privacy?
1.29 LO 8 What impact do you think that the corporate culture has on improving behaviour in business?
Chapter 1 Case study
Background case
Given the general nature of our introductory chapter, this case has a range of objectives:
1. To get you thinking about the way in which you make decisions that involve the use of resources.
2. To specifically consider whether you are interested in a career in business, and whether you are
interested in starting a business of your own.
3. To consider your attitude to ‘inclusivity’, and what kind of stakeholders you regard as legitimate.
Linked to this, it would be useful to get you to try to articulate any preconceived notions as to what
you consider good or bad about business, and the way you conceive it being organised and run.
4. To consider the importance of people skills, particularly teamwork and good communication, in
business.
5. To appreciate the importance of accounting and finance in decision-making.
You should note that this case is not expected to be assessed; rather, it is hoped that you will think about
how the questions relate to you, compare ideas with your classmates, and learn from your answers. It is
longer than usual in this book, but this is primarily due to the fact that there are no practical stand-alone
exercises in this chapter.
A: Decision-making
In the ‘Accounting and You’, you were made to think about the kind of decisions you will need to make in
your life, typically increasing in complexity as you progress. Some decisions you have already made.
1. You are enrolled on a program of studies for a reason, which involves you in a cost. Why did you
choose the particular institution and program?
2. How important was the cost in your decision-making?
3. Do you have a clear idea as to how the cost is to be covered?
4. Do you need to get a job to partially fund the program?
5. Do you have an expectation of future benefits arising from studying and completing this program?
6. How many of these benefits are you able to quantify? How confident are you about these figures?
What assumptions are you making? What judgements are involved?
B: A business career
1. Have you considered starting a business? If so, what kind of business is it? What kind of
information would you seek before commencing?
2. Who might you want to work with, and in what capacity? Why?
3. How important is making money to you? Is wealth enhancement likely to be the principal objective
of a) you and your business, or b) most commercial undertakings? If your answer to either of these
is no, what do you think are the primary objectives?
4. If you are managing a business, or running your own business, what assumptions will you make
regarding the objectives of your staff, your suppliers and your customers? How might these
assumptions affect your own decision-making or the ideology of the business itself?
Activity 1.1
Probably not—however, each piece of information should aim to do so insofar as possible.
Activity 1.2
It would be very useful if accounting reports could be understood by everyone. This, however, is
unrealistic, as complex financial events and transactions cannot normally be expressed in simple terms. It
is probably best that we regard accounting reports in the same way that we regard a report written in a
foreign language. To understand either of these, we need to have had some preparation. When producing
accounting reports, it is normally assumed that the user not only has a reasonable knowledge of business
and accounting, but is also prepared to invest some time in studying the reports.
Activity 1.3
Your answer may be along the following lines:
Customers Whether to take further motor policies with PI. This might involve an assessment of PI’s ability to continue in business and to
meet their needs, particularly in respect of any insurance claims made.
Competitors How best to compete against PI or, perhaps, whether to leave the market on the grounds that it is not possible to compete
profitably with PI. This might involve competitors using PI’s performance in various aspects as a benchmark when evaluating
their own performance. They might also try to assess PI’s financial strength and identify significant changes that may signal
PI’s future actions (e.g. raising funds as a prelude to market expansion).
Employees Whether to continue working for PI and, if so, whether to demand higher rewards for doing so. The future plans, profits and
financial strength of the business are likely to be of particular interest when making these decisions.
Government Whether PI should pay tax and, if so, how much, whether it complies with agreed pricing policies, whether financial support is
needed, and so on. In making these decisions, an assessment of PI’s profits, sales revenues and financial strength would be
made.
Community Whether to allow PI to expand its premises and/or whether to provide economic support for the business. PI’s ability to
continue to provide employment for the community, the extent to which it is likely to use community resources, and its likely
willingness to help fund environmental improvements are likely to be considered when arriving at such decisions.
Investment Whether to advise clients to invest in PI. This would involve an assessment of the likely risks and future returns associated
with PI.
Suppliers Whether to continue to supply PI and, if so, whether to supply on credit. This would involve an assessment of PI’s ability to
pay for any goods and services supplied.
Lenders Whether to lend money to PI and/or whether to require repayment of any existing loans. PI’s ability to pay the interest and to
repay the principal sum would be important factors in such decisions.
Managers Whether the performance of the business needs to be improved. Performance to date would be compared with earlier plans
or some other benchmark to decide whether action needs to be taken. Managers may also wish to decide whether there
should be a change in PI’s future direction. This would involve looking at PI’s ability to perform and at the opportunities
available to it.
Owners Whether to invest more in PI, or to sell all, or part, of the investment currently held. This would involve an assessment of the
likely risks and returns associated with PI. Owners may also be involved with decisions on rewarding senior managers. The
financial performance of the business would normally be considered when making such a decision.
Although this answer covers many of the key points, you may have identified other decisions and/or other
factors to be taken into account by each group.
Activity 1.4
We thought of two points:
Managers will, at times, be interested in receiving an historical overview of business operations of the
sort provided to other users.
Other users would be interested in receiving information relating to the future, such as the planned
level of profits, and non-financial information, such as the state of the sales order book and the extent
of product innovations.
Activity 1.5
A government savings account is normally a very safe investment. Even if a government is in financial
difficulties, it can always print more money to repay investors. Returns from this form of investment,
however, are normally very low. Investing in a lottery ticket runs a very high risk of losing the whole
amount invested. This is because the probability of winning is normally very low. However, a winning
ticket can produce enormous returns.
Thus, the government savings account should be placed towards the far left of the risk–return line and the
lottery ticket towards the far right.
Activity 1.6
Statement of cash flows for day 3 $
1290
Sales 390.00
Profit 52.50
Cash 690.00
Activity 1.7
Starting suggestions include: Ezubo; VW; Wells Fargo; Rio Tinto; and Pearls Agrotech Corporation.
Activity 1.8
Other sources of information available include:
These sources can provide information on various aspects of the business, such as new products or
services being offered, management changes, new contracts offered or awarded, the competitive
environment within which the business operates, the impact of new technology, changes in legislation,
changes in interest rates and future levels of inflation. However, the various sources of information
identified are not really substitutes for accounting reports. Rather, they are best used in conjunction with
the reports in order to obtain a clearer picture of the financial health of a business.
Chapter 2 Measuring and reporting financial position
Learning objectives
When you have completed your study of this chapter, you should be able to:
LO 1 Explain the nature and purpose of the statement of financial position (balance sheet)
and its component parts
LO 2 Explain the accounting equation, and use it to build up a statement of financial
position at the end of a period
LO 3 Classify assets and claims
LO 4 Apply the different possible formats for the statement of financial position
LO 5 Identify the main factors that influence the content and values in a statement of
financial position
LO 6 Explain the main ways in which the statement of financial position can be useful for
users of accounting information
LO 7 Identify the main deficiencies or limitations in the statement of financial position.
The next five chapters essentially deal with the area known as financial
accounting. In this chapter we examine the first of the major financial
reports—that which is concerned with establishing financial position. The
statement of financial position, traditionally labelled the ‘balance sheet’,
represents the assets of an entity and the claims against those assets at a
given point in time. The interests in, or claims against, the assets are
divided into external (liability) and internal (owners’) interests. We will see
how the statement is made up and how the report is prepared. We will also
consider the basis on which accounts are included, measured and
reported. Finally, its usefulness in decision-making will be considered and
possible deficiencies highlighted.
The purpose of the statement of financial position is to set out the financial position of a business at a
particular point in time. It is also referred to as a ‘balance sheet’. Both terms have been used in recent
years. However, the current recommendation is that the term ‘statement of financial position’ be used.
This statement represents a summary of information provided in the accounts, and is effectively a listing
of the balances in all of the detailed accounts—this is where the term ‘balance sheet’ comes from. The
statement of financial position sets out the assets of the business on the one hand, and the claims against
it on the other. Before looking at the statement in more detail, we need to be clear what these terms
mean.
Assets
An asset , for accounting purposes, is essentially a resource controlled by the entity as a result of past
events. To qualify as an asset for inclusion in the statement of financial position, however, a resource
must possess the following characteristics:
It must be a present economic resource. This type of resource confers a right that gives the
potential to receive economic benefits in the future. The right is usually acquired through legal
ownership or through a contractual agreement (e.g. leasing equipment). This right must entitle the
business to receive economic benefits that are not equally available to others. To illustrate this point
let us consider the right to use what economists refer to as ‘public goods’, such as the road system,
GPS satellites or official statistics. Although these resources may provide economic benefits to the
business, others can receive the same benefits at no greater cost. The right to benefit from public
goods is not, therefore, an economic resource of the business.
Potential benefits flowing from an economic resource can take various forms depending on how the
resource is used. Examples include: cash generated by using the resource to produce goods or
services; cash received from the proceeds of its sale; the value received when it is exchanged for
another economic resource; the value received when it is used to satisfy debts incurred by the
business; or cash generated from renting or leasing it.
Note that an economic resource need only have the potential to generate benefits. These benefits
need not be certain or even likely. Where, however, there is a very low probability that economic
benefits will flow, the information is unlikely to be relevant to users. The resource may not, therefore,
be included as an asset in the statement of financial position. Thus, an obsolete piece of equipment
that can be sold for scrap would still be considered an asset, whereas an obsolete piece of equipment
that could not be sold for scrap would not be regarded as an asset.
The economic resource must be under the control of the business. The business must have the
right to decide how the resource will be used and be entitled to any benefits that flow. Again, control is
usually acquired through legal ownership or through contractual agreement (e.g. leasing equipment).
The transaction, or other event, establishing control must have occurred in the past. This
means that the business will already exercise control over the resource. Thus, if a business agrees to
purchase a piece of machinery at some future date, this does not make the item one of its assets at
this point in time.
The economic resource must be capable of measurement in monetary terms. Unless the
resource can be measured in monetary terms with a reasonable degree of certainty, it will not be
recognised as an asset on the statement of financial position. For example, customer loyalty may be
valuable to the business but impossible to quantify. Similarly, the title of a magazine (e.g. New Idea or
Wheels) that was created by its publisher. While it may be extremely valuable to the publishing
business, its value cannot be measured with reasonable certainty. It will not, therefore, appear as an
asset in the statement of financial position. This is because any valuation produced is likely to have
little relevance to user needs.
asset
Note that all of the characteristics identified must exist if a resource is to qualify for recognition. This will
strictly limit the resources that are regarded as an asset for inclusion in the statement of financial position.
Once included, an asset will continue to be recognised until the economic benefits are exhausted or the
business disposes of it.
Figure 2.1 summarises the above discussion in the form of a decision chart.
We can see that these conditions will strictly limit the kind of items that may be referred to as ‘assets’ in
the statement of financial position. Certainly not all resources exploited by a business will be assets of the
business for accounting purposes. Some, like the roads system or the magazine title Wheels, may well be
assets in a broader sense, but not for accounting purposes. Once an asset has been acquired by a
business, it will continue to be considered an asset until the benefits are exhausted or the business
disposes of it in some way.
Examples of items that often appear as assets in a business statement of financial position include:
freehold premises; machinery and equipment; fixtures and fittings; patents and trademarks; accounts
receivable; investments; cash; and inventories.
Note that an asset does not have to be a physical item—it may also be a non-physical right to certain
benefits. Assets that have a real, physical substance are referred to as tangible assets (e.g. inventory,
plant and equipment). Assets that have no physical substance but still represent potential benefits are
referred to as intangible assets (e.g. copyright, trademark, patent, franchise, goodwill). Leases now
need to be shown as an asset, other than for short-term operating leases, with a corresponding liability
being shown.
tangible assets
Those assets that have a physical substance (e.g. plant and machinery, motor
vehicles).
intangible assets
An obligation on the part of the business to provide cash or some other economic
resource to an outside party.
liabilities
owners’ equity
The residual interest in the assets of the entity after deducting all its liabilities.
equity/capital
Liabilities
Liabilities represent the claims of individuals and organisations, apart from those of the owner(s). They
involve a present obligation to transfer economic resources (usually cash) as a result of past transactions
or events. Liabilities normally arise when individuals, or organisations, supply goods and services, or lend
money, to the business. Examples include accounts payable (creditors), bank overdrafts, personal loans,
mortgages and provisions (estimates) for warranty, long-service leave, holiday pay and taxation. In order
to be recognised as a liability, the same kinds of recognition criteria that apply to assets also apply, which
means it must meet the definition and result in relevant and faithfully represented information.
Most liabilities represent legal claims by external parties against the entity for satisfaction in cash (e.g.
bills or accounts payable) or for the provision of goods and services (e.g. subscriptions received in
advance). Another type of liability is generally classified as provisions. Provisions are estimated
liabilities, for which there is rather less certainty regarding the amount or timing. Provisions typically
include income tax, long-service leave, warranties, etc.
provisions
An estimated liability for which there is greater uncertainty regarding the amount
or the timing of the amount than for a normal liability.
In certain instances, the situation arises in which a potential liability exists that might arise on the
occurrence of a particular event. This is known as a contingent liability . It will become a liability
contingent on that event happening. This situation does not satisfy the definition of a liability, so will not be
included in the statement of financial position. For limited companies, such contingent liabilities will
normally be included in the annual report as a note.
contingent liability
A potential liability that might arise by the occurrence of one or more uncertain
future events. It will become a liability contingent on that event happening.
Activity 2.1
Indicate which of the following items could appear as an asset or a liability on the statement of financial
position of business A. Explain your reasoning in each case.
The equity section of the statement of financial position is broadly the same irrespective of the type of
business concerned. We shall see in Chapter 4 that with limited companies the total equity figure must
be analysed according to how each part of it first arose. For example, companies must make a distinction
between the part of it that arose from retained earnings (or profits) and the part that arose from the
owners putting in cash to start up the business, usually by buying shares in the company.
Once a claim from the owners or outsiders has been incurred by a business, it will remain as an obligation
until it is settled.
Concept check 1
The statement of financial position:
A. Is prepared at a particular point in time
B. Is also referred to as a balanced sheet
C. Consists of assets, reliabilities and equity
D. All of the above are true
E. None of the above is true.
Concept check 2
Which of the following is a main characteristic of an asset?
A. Confirmed future economic benefit
B. Exists from a future transaction or event
C. The business has an exclusive right to control the economic resource
D. Cannot be reliably measured in monetary terms
E. All of the above are key asset characteristics.
Concept check 3
A potential liability exists that might arise on the occurrence of a particular event is known
as:
A. A provision
B. A creditor
C. A contingent liability
D. A debt
E. All of the above.
The accounting equation
LO 2 Explain the accounting equation, and use it to build up a statement of financial position at the
end of a period
Now that the meanings of the terms ‘assets’, ‘liabilities’ and ‘owners’ equity’ have been established, we
can go on to discuss the relationship between them. It is quite simple and straightforward: if a business
wishes to acquire assets it will have to raise the necessary funds from somewhere. It may raise the funds
from the owner(s) or from other outside parties, or from both. The relationship is demonstrated by the new
business outlined in Example 2.1 .
EXAMPLE
2.1
Jerry and Co. deposits $20,000 in a bank account on 1 March to commence business. Let us
assume that the cash of (i) $6,000 is supplied by the owner, and (ii) $14,000 is supplied by the
bank, an outside party. The effect of this transaction is to increase the assets on the left-hand side
of the accounting equation, specifically cash at bank by $20,000. Raising the funds (capital) this
way will give rise to a claim on the business by both (i) the owner (capital), and (ii) the bank, an
outside party (liability) of $14,000. There is an equal increase of $20,000 on the right-hand side of
the accounting equation. The equation relates only to the business entity. Jerry and Co.’s owners’
personal assets and debts are not part of the business, and therefore are excluded from the
equation because of the business entity equation.
If a statement of financial position of Jerry and Co. is prepared following the above transactions,
the assets and claims of the business will appear as follows:
Assets $ Claims $
Liability—loan 14,000
We have chosen a two-sided, traditional-style statement for our example. This is primarily because
this links easily with the formal recording process, which will be outlined in Accounting and You,
later in the chapter (page 57). At a later stage, we will discuss other formats that are in more
common use for published reports.
We can see from the statement that has been prepared that the total claims are the same as the
total assets. Thus:
Assets=Owners' equity+Liabilities
The equation shown above—often referred to as the ‘accounting equation’—will always hold true.
Whatever changes may occur to the business’s assets or the claims against it, compensating
changes elsewhere will ensure that the statement of financial position always ‘balances’ (i.e. both
sides agree). For example, consider some further possible transactions for Jerry and Co. Assume
that, after the $20,000 had been deposited in the bank, the following transactions took place:
3 March Purchased inventory (stock-in-trade, goods to be sold) on one month’s credit for $3,000. (This means that the
inventories were bought on 3 March, but payment will not be made until 3 April.)
6 March Owner introduced another $4,000 into the business bank account.
A statement of financial position may be drawn up after each day in which transactions have taken
place. In this way, the effect of each transaction on the assets and the claims against them can be
seen. The statement of financial position as at 2 March will be as follows:
Assets $ Claims $
As you can see, the effect of purchasing a motor vehicle is to decrease the balance at the bank by
$5,000 and to introduce a new asset—a motor vehicle—onto the statement. The motor vehicle is
recorded initially at its cost of $5,000. The total assets of $20,000 are still equal to the liabilities of
$14,000 plus equity of $6,000. The total assets remain unchanged; only the ‘mix’ of assets has
changed. The claims against the business remain the same, as there has been no change in the
funding arrangements for the business.
The statement of financial position as at 3 March, following the purchase of inventory, will be as
follows:
Assets $ Claims $
The effect of purchasing inventory has been to introduce another new asset (inventory) to the
statement of financial position. In addition, the fact that the goods have not yet been paid for
means that the claims against the business have been increased by the $3,000 owed to the
supplier, which is referred to as ‘accounts payable’ on the statement of financial position. Accounts
payable is also known as ‘payables’ or ‘creditors’. Jerry and Co.’s equity in the business remains
unchanged at $6,000, because the assets and liabilities increased by equal amounts of $3,000
withy the purchase of inventory. The accounting equation is still in balance, with $23,000 in total
assets and $23,000 of liabilities and equity.
We will use the statement of financial position drawn up for Jerry and Co. as at 6 March in the
solution to Activity 2.2 (page 52). The statement of financial position was as follows:
Assets $ Claims $
Let us assume that, on 7 March, the business managed to sell all of its inventory for $5,000 and
received a cheque immediately from the customer for this amount. The statement of financial
position on 7 March, after this transaction has taken place, will be as follows:
Assets $ Claims $
We can see that the inventory of $3,000 has now disappeared from the statement of financial
position, but the cash at bank has increased by the selling price of the inventory, that is $5,000.
The net effect has, therefore, been to increase assets by $2,000 (i.e. $5,000 – $3,000). This
increase represents the net increase in wealth (profit) which has arisen from trading. Also note that
the owners’ equity in the business has increased by $2,000 in line with the increase in assets. This
increase in owners’ equity reflects the fact that increases in wealth as a result of trading or other
operations will be to the benefit of the owner and will increase his or her stake in the business.
Activity 2.2
Try drawing up a statement of financial position for Jerry and Co. as at 4 March and as at 6 March.
Example 2.1 illustrates the point made earlier that the accounting equation
(owners’ equity+liabilities=assets) will always hold true because the equation is based on the fact that if a
business wishes to acquire assets it must raise funds equal to the cost of those assets. These funds must
be provided by the owners (owners’ equity) or other outside parties (liabilities), or both. Hence, the total
cost of assets acquired should always equal the total owners’ equity (capital) plus liabilities.
It is worth pointing out that a business would not draw up a statement of financial position after each day
of transactions, as shown in Example 2.1 . Such an approach is likely to be impractical given even a
relatively small number of transactions each day. A statement of financial position for a business is
usually prepared at the end of a defined reporting period. Determining the length of the reporting period
involves weighing up the costs of producing the information against its perceived benefits for decision-
making purposes. In practice, the reporting period varies between businesses, and could be monthly,
quarterly, half-yearly or annually. For external reporting purposes, an annual reporting cycle is the norm
(although certain large companies report more frequently than this). However, for internal reporting
purposes, many businesses produce monthly financial reports.
Assets $ Claims $
As we can see, the inventory of $3,000 will disappear from the statement of financial position, but the
cash at bank will rise by only $1,000. This will mean a net reduction in assets of $2,000. This reduction
will be reflected in a reduction in the equity of the owner(s).
We can see that any decrease in wealth (loss) arising from trading or other transactions will lead to a
reduction in the owners’ stake in the business. If the business wished to maintain the level of assets as at
6 March, it would have to obtain further funds from the owner(s) or outside parties, or both.
What we have just seen means that—assuming that the owner(s) makes no injections or withdrawals of
equity during the period—the accounting equation can be extended as follows:
Assets at the end of the period=Owners’ equity at the beginning +Profit (or
−Loss)+Liabilities at the end of the period
Any funds introduced by the owner(s), or withdrawn by the owner(s) for living expenses or other reasons,
will further extend the accounting equation as follows:
Assets at the end of the period=Owners’ equity at the beginning +Profit (or−Loss)
±Other owners’ equity changes+Liabilities at the end of the period
These additions and withdrawals are typically shown separately on the statement of financial position, as
is the profit figure for the period. Thus, if we assume that the above business sold the inventory for
$5,000, as in the earlier example, and further assume that the owner withdrew $1,500 of the profit, the
owners’ equity would appear as follows on the statement of financial position:
Owners’ equity $
12,000
Less drawings 1,500
Jerry and Co.’s closing equity balance is $10,500, consisting of the $10,000 the owner invested to start
the business plus $2,000 profit, representing the excess of income of $5,000 over expenses of $3,000 for
the period, less the $1,500 drawings. If the drawings were in cash, then the balance of cash would
decrease by $1,500 in the statement of financial position.
It is highly unlikely that a statement of financial position will be required on a daily basis, but rather at the
end of a specified period, typically at the end of a month or a year. The same approach could theoretically
be used to build up a statement of financial position at the end of a period. Self-assessment Question
2.1 requires you to try to do this.
SELF-ASSESSMENT QUESTION
2.1
The statement of financial position of a business at the start of a week is as follows:
Assets $ Claims $
269,000 269,000
1. Sold inventory for $11,000 cash. This inventory had cost $8,000.
2. Sold inventory for $23,000 on credit. This inventory had cost $17,000.
3. Received cash from accounts receivable totalling $18,000.
4. The owners of the business contributed $100,000 of their own money, which was placed in
a business bank account.
5. The owners contributed a second-hand motor vehicle at the start of the business, valued at
$10,000 to be used in the business. No cash is involved in this transaction.
6. Bought inventory on credit for $14,000.
7. Paid accounts payable of $13,000.
8. Paid wages of $2,000.
Show the statement of financial position after all these transactions have been reflected.
An alternative to the system of pluses and minuses is a worksheet approach. Table 2.1 provides an
illustration of how a worksheet can achieve the same result. It uses the content of Example 2.1 . It
should be noted that the drawings figure is effectively a negative figure in the owners’ equity section of the
statement of financial position.
Cash Inventory Motor vehicle Accounts payable Loan Owners’ contribution Retained profit Drawings
*
Owners’ equity account balance $10,500 (i.e. 10,000+2,000−1,500).
In Chapter 1 we indicated that in this book we will not be focusing on the collection of
accounting information or the actual preparation of financial reports. We have, for purposes of
illustration and understanding, explained the nature of the accounting equation by use of a system
of pluses and minuses. In practice, accounting systems are based on a system of recording known
as double-entry book-keeping. Most systems are now computerised, but are essentially still based
on double-entry book-keeping principles.
With double-entry book-keeping every item that requires recording is effectively done via a system
of individual accounts. Every item in the statement of financial position has its own account, in
which entries are made.
Historically, these accounts were typically held in a book known as a ‘ledger’; hence, the
commonly used reference to ‘ledger accounts’. The form of a ledger account is essentially T-
shaped; hence, the alternative name of ‘T accounts’. An example is set out below. This represents
the recording in the cash account of Jerry and Co. up to 4 March.
20,000 20,000
Basically, for assets, entries made on the debit side increase the amount in an asset account,
while a credit represents a reduction in the particular asset account. The date enables events to be
tracked. The detail represents the other account that needs to be entered, given the dual aspect
convention.
For liability accounts, the increases are recorded on the credit side and the decreases on the debit
side. When it comes to ledger accounts, this leads to the dual-aspect convention becoming ‘for
every debit there must be a credit’; hence, double-entry book-keeping. This means that the double
entry to the first debit entry in the cash account for 1 March would be a credit to an account set up
to keep track of the owners’ equity, as shown below.
Periodically, and certainly when a statement of financial position is needed, it will be necessary to
summarise the position of every account, which leads to a balancing of individual accounts. This is
shown in the ‘Cash’ account used above. Note that ‘c/f’ stands for ‘carried forward’, and ‘b/f’ stands
for ‘brought forward’. All that has happened in this case is that the two sides have been totalled
(clearly $20,000 on the debit side and $7,000 on the credit side), which means that there is
$13,000 left.
This approach means that during a period all changes in the assets, liabilities and equities are
recorded, and at the end of the period balanced, which should leave the balance sheet equation in
balance.
At this stage, the important point for you to recognise is that the statement of financial position is
simply a summary of the account balances that are maintained in the individual ledger accounts;
hence, the title of ‘balance sheet’, which is the traditional title for the statement of financial position.
So why might it be useful for you to know this? Several reasons spring to mind.
Many experienced business people still use (or refer to) the traditional terminology. Knowing
the double-entry system will enable you to have a more productive dialogue with your
accountant or chief financial officer.
There are examples where figures are represented using debits and credits (e.g. bank
statements). For example, you may find a credit balance on your bank account. What does this
mean? It seems to be contrary to what is said above. In fact, the bank statement sent to the
customer is prepared from the bank’s viewpoint. If you have cash in the bank, the bank would
show this as a liability (credit) in its accounts. In the customer’s own ledger accounts, cash in
hand would be shown as a debit.
In practice, of course, manual ledger systems are rare, with most systems using computerised
systems such as MYOB. Many of these still use traditional terminology, and a broad
understanding of the systems might be useful. For example, many computer systems still refer
to the ‘sales ledger’ or ‘debtors ledger’, which is simply the place where detailed individual
records relating to customers are kept.
The situation gets a bit more complicated when we consider the income statement, but the
principles remain valid.
Concept check 4
Which of the following is false?
A. Debits and credits are the accountant’s method of pluses and minuses.
B. A debit to an asset account is an increase to the account.
C. A credit to a liability account will increase the account balance.
D. A debit to an equity account will increase the account balance.
E. None of the above. All are true.
Concept check 5
Which of the following is NOT a possible representation of the accounting equation?
A. Owners’ equity+Liabilities=Assets
B. Assets=Liabilities+Owners’ equity
C. Assets−Liabilities=Owners’ equity
D. Assets−Owners’ equity=Liabilities
E. All of the above are valid representations of the accounting equation.
Reflection 2.1
Your friend Lucas, a young entrepreneur, heard you were enrolled into an accounting course. He
has some questions about what value the balance sheet has. He is a bit of a gourmet chef, and
has plans to open a high-class restaurant. He has managed to lease premises and bought the
necessary equipment, funded by a loan from his parents. He plans to do most of the cooking, but
is recruiting a small team of employees, all of whom are to be paid a wage. He is trying to think
through just what kind of business transactions he needs to plan for. He has asked you for your
thoughts on just what these transactions might be. (He is worried about forgetting something and
the impact that this might have on the success of the business.) He is particularly concerned about
just what his balance sheet might look like after the first six months.
Provide him with some guidance.
The classification of assets and claims
LO 3 Classify assets and claims
Current assets are basically assets that are held for the short term. They include cash and other
assets that are expected to be consumed or converted to cash, usually within the next 12 months or
within the operating cycle .
current assets
Assets that are not held on a continuing basis. They include cash and other
assets which are expected to be consumed or converted to cash, usually within
the next 12 months or within the operating cycle.
operating cycle
Normally represents the time between the acquisition of the assets and their
ultimate realisation in cash or cash equivalents.
To be more precise, current assets are assets that meet any of the following conditions:
they are held for sale or consumption during the business’s normal operating cycle
they are expected to be sold within a year after the date of the relevant statement of financial position
they are held principally for trading, and/or
they are cash, or near-cash (such as easily marketable, short-term investments).
The operating cycle normally represents the time between the acquisition of the assets (e.g. raw materials
or finished goods) and their ultimate realisation in cash or cash equivalents. Current assets are normally
held as part of the day-to-day trading activities of the business. The most common current assets are
inventory (stock), accounts receivable (trade debtors), prepayments and cash itself: these are all
interrelated and circulate in a business, as shown in Figure 2.2 . It is worth making the point here that
most sales made by most businesses are made on credit. This is to say that the goods pass, or the
service is rendered, to the customer at one point but the customer pays later. Retail sales are the only
significant exception to this general practice. We can see that cash can be used to purchase inventory,
which is then sold on credit. When the customers pay, the business receives an injection of cash. For
purely service businesses, the situation is similar, except that inventories are not involved.
Inventories may be sold on credit to customers. When the customers pay, the accounts receivable will be
converted into cash, which can then be used to purchase more inventories, and so the cycle begins
again.
Non-current assets (also known as ‘fixed assets’) are simply assets that do not meet the definition of
current assets. They tend to be held for long-term operations, so they are typically held for generating
wealth rather than resale (although they may be sold when the business has no further use for them).
They can be seen as the tools of the business. Non-current assets may be either tangible or intangible.
Tangible non-current assets are normally categorised under a heading of ‘property, plant and equipment’.
This rather broad term includes items such as land and buildings, motor vehicles, and fixtures and fittings.
non-current assets
Assets held with the intention of being used to generate wealth rather than being
held for resale. They can be seen as the tools of the business, and are normally
held by the business on a continuing basis.
Intangible assets are of increasing importance in today’s business environment. The role of data and
information, the importance of staff and associated teams, the use of technology in an effective way, and
intellectual property all have the potential to impact seriously on the success of a business. It is clear that
while commerce has typically attached value to physical assets, and intangibles can be difficult to identify
and measure, intangible assets are of major (and growing) importance to businesses. Real World 2.1
provides some discussion of recent articles on this.
Included under the umbrella of intangibles are ‘software code, data, trade secrets, branding,
domain names, and ... the skills and knowledge of the workforce’. The empires of Google and
Facebook are created ‘from and with data’, not by generating actual content. Uber owns no
vehicles, Alibaba doesn’t actually hold stock, and Airbnb has no real estate. ‘Not every business
asset has to be tangible. Entire business models can be created from and operate through
intangibles.’
Source: Yohan Ramasundra, ‘How you tap intangible assets may decide your future growth’, The Australian Business Review, 13 February 2018.
‘Today the most valuable assets are more likely to be stored in the cloud than in a warehouse.’
There has been a shift in Western economies ‘from making things to providing information and
services’. While hard to define, it has been estimated that intangibles ‘accounted for 84% of the
value of S & P 500 firms’.
Source: The Economist, ‘Insurers struggle to come to grips with intangible assets’, The Australian, 27 August 2018.
It is important to appreciate that the classification of an asset may vary (i.e. between current and non-
current) according to the nature of the business being carried out. This is because the purpose for which
a particular type of business holds a certain asset may vary. For example, a motor-vehicle manufacturer
normally holds its motor vehicles for resale, and would therefore classify them as inventory. On the other
hand, a business that uses motor vehicles for transport would classify them as non-current assets.
Assets should be classified as non-current when they do not satisfy any of the criteria for being classified
as current.
The accounting standard relating to the presentation of financial statements also permits assets to be
classified using the order of liquidity (i.e. the ability to turn the asset into cash), where appropriate. The
vast majority of businesses use the current/non-current basis.
Activity 2.3
a. The assets of Kunalun and Co., a large metalworking business, are shown below. Classify each of
the following accounts as either (i) current or (ii) non-current assets for the preparation of a
statement of financial position.
cash at bank fixtures and fittings office equipment
short-term investments
b. Can you identify which sort of businesses may prefer to use the liquidity basis rather than the
current/non-current basis for classifying assets?
Classifying claims
As we have already seen, claims are normally classified into equity (owners’ claim) and liabilities (claims
of outsiders). Liabilities are further classified as either current or non-current.
Current liabilities are basically amounts due for settlement in the short term. To be more precise, they
are liabilities that meet any of the following conditions:
current liabilities
Amounts due for repayment to outside parties within 12 months of the statement
of financial position date, or within the operating cycle.
they are expected to be settled within the business’s normal operating cycle
they exist principally as a result of trading
they are due to be settled within a year after the date of the relevant statement of financial position,
and/or
there is no right to defer settlement beyond a year after the date of the relevant statement of financial
position.
Non-current liabilities represent amounts due that do not meet the definition of current liabilities and
so represent longer-term liabilities.
non-current liabilities
Those amounts due to other parties which are not liable for repayment within the
next 12 months after the statement of financial position date.
Current Non-current
Unlike the case for assets, the purpose for which the liabilities are held is not an issue—only the period
for which the liability is outstanding is important. Thus, a long-term liability will turn into a current liability
when the settlement date comes within 12 months or one operating cycle of the statement of financial
position date. For example, borrowings to be repaid 18 months after the date of a particular statement of
financial position will appear as a non-current liability, but will appear as a current liability in the statement
of financial position in the following year.
This classification of liabilities between current and non-current helps to highlight those financial
obligations that must shortly be met. Users can compare the amount of current liabilities with the amount
of current assets (i.e. the assets that are cash or will turn into cash within the normal operating cycle).
This comparison should indicate whether a business can cover its maturing obligations.
The classification of liabilities between current and non-current should also help to indicate how long-term
finance is raised. If a business relies on long-term borrowings to finance the business, the financial risks
associated with the business will increase. This is because these borrowings will bring a commitment to
make periodic interest payments and capital repayments. The business may be forced to stop trading if
this commitment is not fulfilled. Thus, when raising long-term finance, a business must try to strike the
right balance between non-current liabilities and owners’ equity. We shall consider this issue in more
detail in Chapter 14 .
However, for most businesses it is useful, or required (as in the case of companies), to provide three
separate categories:
1. owners’ equity
2. reserves:
a. retained profits
b. other reserves.
Table 2.2 shows how equity typically appears for the three types of business structure.
Partner B
(etc.)
Partner B
(etc.)
Other Seldom found other than A number are possible, with revaluation being A variety, to be discussed in detail in
reserves revaluation reserve probably the most common later chapters
Concept check 6
Which of the following is NOT a current asset?
A. Cash
B. Equipment
C. Inventory
D. Accounts receivable
E. Debtors.
Concept check 7
Which of the following statements is true?
A. Non-current assets must be tangible.
B. Non-current assets are generally held for sale to customers.
C. Current liabilities are amounts due for settlement within a year or two.
D. Revenue received in advance can be either a current or a non-current liability.
E. Accounts payable are generally classified as a non-current liability.
Concept check 8
Which of the following is NOT a component of owners’ equity?
A. Share capital
B. Retained earnings
C. Contributed capital
D. Revaluation reserve
E. None of the above. All are components of owners’ equity.
Formats for statements of financial position
LO 4 Apply the different possible formats for the statement of financial position
Now that the classification of assets, liabilities and owners’ equity has been completed, it is time to
consider the format of the statement of financial position. Although there is an almost infinite number of
ways of presenting the same information, there are, in practice, two basic choices.
Horizontal format
So far in the chapter we have used the traditional horizontal format (also referred to as the ‘T account
format’) based on the ledger accounting system outlined earlier in Accounting and You (page 57). Figure
2.3 provides an overview of this perspective.
The equation for the horizontal form of statement of financial position layout.
The style we adopted with Jerry and Co. in Example 2.1 is in line with this approach. A more
comprehensive example of this style is shown in Example 2.2 .
EXAMPLE
2.2
Illustration of horizontal statement of financial position.
Brie Manufacturing
Statement of financial position
as at 31 December 2021
Note that within each category of asset (current and non-current), the items are listed with the most liquid
(starting with cash) first, going down to the least liquid. This is standard practice, which is followed
irrespective of the format used. Liquidity generally relates to cash or closeness to cash. Note also that this
approach is not used in all countries. For example, in the United Kingdom the order is typically reversed:
the list goes from the least liquid to the most liquid. Overall content is basically the same; only the order
changes.
entity approach
The focus of the entity approach is on the entire entity, whereas that of the proprietary approach is on the
proprietary interest. The only difference is that the two layouts will be arranged slightly differently, as
shown below.
It should be clear that the entity approach simply rearranges the horizontal layout in a vertical format. The
proprietary approach requires some readjustment, as can be seen in Example 2.3 , which shows the
information provided in Example 2.2 from a vertical, proprietary perspective.
EXAMPLE
2.3
Vertical statement of financial position using proprietary approach
Brie Manufacturing
Statement of financial position
as at 31 December 2021
$ $
Current assets
Inventory 92,000
212,000
Non-current assets
Motor vehicles 76,000
Property 180,000
376,000
Less liabilities
Current liabilities
Non-current liabilities
Loan 200,000
Owners’ equity
256,000
We can see that when using the proprietary approach the total liabilities are deducted from the total
assets. This derives a figure for net assets, which is equal to equity. Using this format, the basic
accounting equation is rearranged so that:
Assets−Liabilities=Equity
This rearranged equation highlights the fact that equity represents the residual interest of the owner(s)
after deducting all of the liabilities of the business.
In terms of published statements of financial position in Australia, the most commonly presented is the
vertical format based on the entity equation. Irrespective of the format, or the equation, all statements of
financial position contain the same information.
Activity 2.4
The following information relates to the Simonson Engineering Company as at 30 September 2020:
Inventory 180,000
A business normally prepares a statement of financial position as at the close of business on the last day
of its accounting year. In Australia and New Zealand, businesses are free to choose their accounting
year, but most businesses select an accounting year ending 30 June to coincide with the taxation year.
When making a decision on which year-end date to choose, commercial convenience is often a deciding
factor. Thus, a business operating in the retail trade may choose to have a year-end date early in the
calendar year (e.g. 31 January) because trade tends to be slack during that period and more staff time is
available to help with the tasks of preparing the annual accounting statements (e.g. checking inventory).
Since trade is slack, it is also a time when the amount of inventory held by the business is likely to be
lower than it is at other times of the year. Thus, the statement of financial position, although showing a fair
view of what it purports to show, may not show the more typical position of the business over the year.
Concept check 9
Which of the following is NOT a valid format for the statement of financial position?
A. Horizontal
B. Vertical—entity approach
C. Narrative
D. Parallel—proprietary approach
E. All of the above are valid formats.
Concept check 10
Which layout of the statement of financial position focuses on the owners?
A. Horizontal
B. Vertical—entity approach
C. Narrative
D. Vertical—proprietary approach
E. All of the above.
Concept check 11
Which of the following statements is false?
A. The statement of financial position is prepared for a specified period in time.
B. A company could choose 14 February as its year-end for accounting purposes.
C. Many companies in Australia choose 30 June as their accounting year-end.
D. Commercial convenience should be a factor in choosing a year-end.
E. A balance sheet can be likened to a snapshot or financial position ‘selfie’.
Factors influencing the form and content of the
financial reports
LO 5 Identify the main factors that influence the content and values in a statement of financial position
The two most significant influences on the accounts included in the statement of financial position and the
financial measures assigned to those accounts are:
1. traditional accounting conventions and doctrines that have underpinned accounting practice for
decades
2. continued development of professional and statutory accounting standards.
In Chapters 2 and 3 we focus on the first of these, but will deal with the second in more detail in the
later chapters on limited companies. Our aim in Chapters 2 and 3 is to provide a broadly based
understanding of the statement of financial position and income statement without the additional
complications involved in larger-scale businesses, which are subject to much more rigorous regulation
and control in terms of their financial reporting. The notion of a reporting entity is relevant here, and
provides a rationale for our approach.
Essentially a reporting entity is one which has a range of external users who use the financial
statements to make decisions. Just which decisions users wish to make, and exactly what information
they think they need, is not known precisely by the reporting entity. Consequently, the aim is to provide
general-purpose information that will be of use to a variety of users. These general-purpose reports are
subject to increasing amounts of regulation through accounting standards, legislation, stock exchange
requirements and a variety of other bodies. In Chapters 2 and 3 we focus on the basic accounting
principles which apply to all organisations. In Chapters 4 and 5 we will deal with the major area of
reporting entities—namely, companies—at which stage we shall consider the development of accounting
standards and their application.
reporting entity
conventions
Rules that have been devised over time in order to deal with practical problems
experienced by preparers and users of financial reports.
The convention which holds that, for accounting purposes, the business and its
owner(s) are treated as quite separate and distinct.
Historic cost convention
The historic cost convention holds that the value of assets shown on the statement of financial
position should be based on their historic cost (i.e. acquisition cost). The use of historic cost means that
problems of measurement reliability are minimised, as the amount paid for a particular asset is usually a
matter of demonstrable fact. Reliance on opinion is avoided, or at least reduced, which should enhance
the credibility of the information in the eyes of users. A key problem, however, is that the information
provided may not be relevant to user needs. Even quite early in the life of some assets, historic costs may
become outdated compared to current market values. This can be misleading when assessing current
financial position.
The accounting convention that holds that assets should be recorded at their
historic (acquisition) cost.
Many argue that recording assets at their current value would provide a more realistic view of financial
position and would be relevant for a wide range of decisions. A system of measurement based on current
value does, however, bring its own problems. The term ‘current value’ can be defined in different ways. It
can be defined broadly as either the current replacement cost or the current realisable value (selling
price) of an asset. These two types of valuation may result in quite different figures being produced to
represent the current value of an item. Furthermore, the broad terms ‘replacement cost’ and ‘realisable
value’ can be defined in different ways. We must therefore be clear about what kind of current value
accounting we wish to use.
Activity 2.5 illustrates some of the problems associated with current value accounting.
Activity 2.5
Can you think of two ways in which current values might be defined? Using your two definitions, consider
the following.
Plumber and Co. has some motor vans that are used by staff when visiting customers’ premises to carry
out work. It is now the last day of the business’s reporting period. If it were decided to show the vans on
the statement of financial position at a current value (rather than a figure based on their historic cost), how
might the business arrive at a suitable value, and how reliable would this figure be?
The figures produced under a system of current value accounting may be heavily dependent on the
opinion of managers. Unless these figures are capable of some form of independent verification, there is
a danger that the financial statements will lose their credibility among users. The motor vans discussed in
Activity 2.5 are less of a problem than many types of asset. There is a ready market for motor vans,
which means that a value can be obtained by contacting a dealer. For a custom-built piece of equipment,
however, identifying a replacement cost—or, worse still, a selling price—could be very difficult.
It is argued that more reliable information is produced by reporting assets at their historic cost. Reporting
in this way reduces the need for subjective opinion, as the amount paid for a particular asset is usually a
matter of demonstrable fact. However, information based on past costs may not always be relevant to
users’ needs in terms of decisions about the allocation of scarce resources.
Despite the problems associated with current values, they are increasingly used when reporting assets in
the statement of financial position. This has led to a steady erosion of the importance of the historic cost
convention. Many businesses now prepare financial statements on a modified historic cost basis with a
growing emphasis on the use of current values. Later in the chapter we will consider in more detail the
valuation of assets in the statement of financial position.
The convention which holds that financial reports should err on the side of
caution, effectively anticipating losses and only recognising profits when they are
realised.
Those who support this approach to prudence argue that it is better to understate than to overstate
financial strength. They make the point that, by overstating financial strength, users of financial
statements may be misled into making poor decisions.
Reflection 2.2
You have recently read an article in the Financial Review that ‘CIMIC has lost $1.6 billion of value
in just two days after Hong Kong’s GMT Research claimed Australia’s biggest construction group
has used “accounting shenanigans” to inflate pre-tax profits by $1 billion over the last two years’.
In your view, what sort of poor decisions may be made as a result of overstating the financial
strength of a business? Why is the prudence convention important?
Source: Jenny Wiggins, ‘CIMIC market value drops by $1.6b on alleged “accounting shenanigans”’, The Australian Financial Review, 7 May 2019.
The bias towards the understatement of financial strength evolved in order to counteract the excessive
optimism of managers. However, just as overstatement can lead to poor decisions being made,
understatement can lead to the same. It may, for example, result in existing owners selling their business
too cheaply, lenders refusing a loan application based on a distorted picture of financial strength, and so
on.
The systematic bias towards understatement just described clashes with the need for neutrality, a
desirable element of one of the main qualitative characteristics of financial information in preparing
financial statements. Neutrality, by definition, requires that financial statements are not slanted or
weighted so as to present either a favourable or an unfavourable picture to users. To accommodate the
concept of neutrality, therefore, prudence must be interpreted and applied in a different way than
described above. Adopting a cautious approach to preparing financial statements should not be used to
justify the deliberate understatement of financial strength.
Where a business is in financial difficulties, however, non-current assets may have to be sold in order to
repay those who have enforceable claims against the business. This convention is important, because the
value of non-current assets on a liquidation basis (which is the alternative to the going concern basis) is
often low in relation to the recorded values, and an expectation of winding up would mean that anticipated
losses on sale should be fully recorded. However, where there is no expectation of liquidation, the value
of non-current assets can continue to be shown at their recorded values (i.e. based on historic cost). This
convention, therefore, supports the historic cost convention under normal circumstances.
Dual-aspect convention
The dual-aspect convention asserts that each transaction has two aspects, both of which will affect
the statement of financial position. Thus, the purchase of a car for cash results in an increase in one asset
(car) and a decrease in another (cash). The repayment of a loan results in the decrease in a liability (loan)
and the decrease in an asset (cash/bank).
dual-aspect convention
The accounting convention which holds that each financial transaction has two
aspects, and that each aspect must be recorded in the financial statements.
As we saw in Example 2.1 (page 52), recording the dual aspect of each transaction ensures that the
statement of financial position will continue to balance. The ‘dual aspect’ is reflected in the system of
double-entry book-keeping/accounting , which underpins the recording of information in the actual
accounting records.
double-entry book-keeping/accounting
The formal system of recording using ledger accounts which reflect the dual
aspect of financial transactions.
Recording the dual aspect of each transaction ensures that the statement of financial position will
continue to balance.
money measurement
The accounting convention which holds that accounting should deal with only
those items that are capable of being expressed in monetary terms.
Accounting is a developing subject, and the boundaries of financial measurement can change. In recent
years, attempts have been made to measure particular resources of a business previously excluded from
the statement of financial position. For example, we have seen ideas of valuing goodwill and brands, and
also the development of human resource accounting that attempts to measure the ‘human assets’ of the
business, and these are briefly addressed below.
The term ‘goodwill’ is often used to cover various attributes, such as the quality of the products, the skill of
employees and the relationship with customers. The term ‘product brands’ is also used to cover various
attributes, such as the brand image, the quality of the product, the trademark, and so on. Where goodwill
and product brands have been generated internally by the business, it is often difficult to determine their
cost or to measure their current market value, or even to be clear that they really exist. They are,
therefore, excluded from the statement of financial position.
When they are acquired through an ‘arm’s length transaction’, however, the problems of uncertainty about
their existence and measurement are resolved. (An arm’s length transaction is one that is undertaken
between two unconnected parties.) If goodwill is acquired when taking over another business, or if a
business acquires a particular product brand from another business, these items will be separately
identified and a price agreed for them. Under these circumstances, they can be regarded as assets (for
accounting purposes) by the business that acquires them, and included on the statement of financial
position.
To agree on a price for acquiring goodwill or product brands means that some form of valuation must take
place, and this raises the question as to how it is done. Usually, the valuation will be based on estimates
of future earnings from holding the asset—a process that is fraught with difficulties. Nevertheless, a
number of specialist businesses now exist that are prepared to take on this challenge. Real World 2.2
shows how one specialist business ranked and valued the top 10 brands in the world for 2019, and also
what valuations are associated with brands of football (soccer) clubs.
Marketing services group Kantar, part of WPP plc, produces an annual report that ranks and
values the top world brands. For 2019, the top 10 brands and their values are as follows:
2 Apple 309,527 3%
3 Google 309,000 2%
9 McDonald’s 130,368 3%
10 AT & T 108,375 2%
We can see that US technology businesses dominate the rankings. We can also see that the
valuations placed on the brands owned are quite staggering. These valuations, however, should
be viewed with some scepticism. There are significant variations in both the rankings and the
values assigned to brands between the various brand valuers.
It is interesting to compare results year-on-year. Over the past year Amazon surged by $108
billion. Other brands moved in a much smaller way. The report, which is very extensive, also lists
the brand contribution, a measure of the influence of brand alone on financial value, on a scale of 1
to 5, with 5 being the highest.
Ranking and reports are provided for a number of other countries. In Australia for 2018 the list was
headed by Commonwealth Bank, with a value of $16,412 million. The first five places were held by
banks or telcos followed by Woolworths and Coles.
Source: ‘BrandZ™ Top 100 Most Valuable Global Brands 2019’, p. 32, http://www.millwardbrown.com/brandz/rankings-and-reports/top-global-brands/2019, ©
Kantor.
In soccer, the most valuable football brands for 2019 were Real Madrid, valued at US$1,846
million, and Manchester United, valued at US$1.651 million. Six of the top 10 teams in order of
brand value came from the English Premier League, with Barcelona, Bayern Munich and Paris St
Germain being the European contingent.
Reflection 2.3
You have been running a successful restaurant on the Flinders Lane for more than 10 years and
the restaurant is often well ranked by various food guides. The Australian Financial Review
estimates the brand value of your restaurant could be worth $50,000. How useful do you think the
information is? In what kind of decisions, and how, might the information be used?
While the figures and the associated methodology and commentary is fascinating, and undoubtedly of
interest to investors, few of the values would satisfy the criteria necessary to be added into a statement of
financial position.
Human resources
Attempts have also been made to place a monetary measurement on the human resources of a business,
but without any real success. There are, however, certain limited circumstances in which human
resources are measured and reported in the statement of financial position. These circumstances
normally arise with professional sports clubs. While sports clubs cannot own players, they can own the
rights to the players’ services. Where these rights are acquired by compensating other clubs for releasing
the players from their contracts, an arm’s length transaction arises and the amounts paid provide a
reliable basis for measurement. This means that the rights to services can be regarded as an asset of the
club for accounting purposes (assuming, of course, the player will also bring benefits to the club).
Real World 2.3 describes how one leading soccer club reports its investment in players on the
statement of financial position.
Tottenham Hotspur Football Club (Spurs) has acquired several key players as a result of paying
transfer fees to other clubs. In common with most UK football clubs, Spurs reports the cost of
acquiring the rights to the players’ services on its statement of financial position. The club’s 2018
annual report shows the total cost of registering its squad of players at almost £327 million. These
costs are amortised on a straight-line basis over the period of the individual contracts. An
impairment review will be carried out if events or circumstances arise which suggest that the
carrying amount will not be recoverable. Amortisation was charged for the year of £57 million and
almost £15 million for impairment. The £326 million does not include ‘home-grown’ players such as
Harry Kane, because Spurs did not pay a transfer fee for them and so no clear-cut value can be
placed on their services.
The item of players’ registrations is shown as an intangible asset in the statement of financial
position, as it is the rights to services, not the players, that are the assets. It is shown net of
depreciation (or amortisation, as it is usually termed for intangible non-current assets). The
carrying amount at 30 June 2018 was more than £151 million and represented 12% of Spurs’ total
assets, as shown in the statement of financial position.
You need to understand that the statement of financial position aims to provide a list of assets and
liabilities that has a high degree of objectivity, so that almost anyone looking at a particular business or
individual would come to a similar conclusion, because all are following the same basic rules. Our
discussion about the value of brands, of soccer players and other ‘human’ assets was not intended to
imply that these have no value, but that it is difficult to obtain agreement about their value. When making
decisions about value, all users of accounting information have to make assumptions or judgements
about the value of the assets controlled by a business. When looking at figures in a statement of financial
position you should be trying to ascertain the underlying values, in terms of individual assets and
composite groups of assets or businesses. In your own life, you will need to make the same kind of
judgements about worth. Accounting figures can be helpful, but they simply cannot make individual
judgements in the way that you can and need to do.
The accounting convention which holds that money, which is the unit of
measurement in accounting, will not change in value over time.
Valuing assets
We saw earlier that when preparing the statement of financial position the historic cost convention is
normally applied for the reporting of assets. This point requires further explanation as, in practice, things
are a little more complex than this. Large businesses throughout much of the world adhere to the asset
valuation rules set out in International Financial Reporting Standards. (These reporting standards will be
discussed in more detail in Chapter 5 .) The key valuation rules are considered below.
Non-current assets
Non-current assets have lives that are either finite or indefinite. Those with a finite life provide benefits to
a business for a limited period of time, whereas those with an indefinite life provide benefits without a
foreseeable time limit. The distinction between the two types of non-current assets applies to both
tangible assets and intangible assets.
Initially, non-current assets are recorded at their historic cost, which will include any amounts spent on
getting them ready for use.
The amount used up, which is referred to as depreciation (or amortisation, in the case of intangible non-
current assets), must be measured for each reporting period for which the assets are held. Although we
shall leave a detailed examination of depreciation until Chapter 3 , we need to know that when an asset
has been depreciated this must be reflected in the statement of financial position.
The total depreciation that has accumulated over the period since the asset was acquired must be
deducted from its cost. This net figure (i.e. the cost of the asset less the total depreciation to date) is
referred to as the carrying amount. It is sometimes also known as net book value or written-down value.
The procedure just described is not really a contravention of the historic cost convention. It is simply
recognition of the fact that a proportion of the historic cost of the non-current asset has been allocated in
the process of generating benefits for the business.
Fair values
Initially, non-current assets of all types (tangible and intangible) are recorded at cost. Subsequently,
however, an alternative form of measurement may be allowed. Non-current assets may be recorded using
fair values, provided these values can be measured reliably. The fair value is market-based. Fair
values represent the selling price that can be obtained in an orderly transaction under current market
conditions. The use of fair values, rather than cost, provides users with more up-to-date information,
which may be more relevant to their needs. It may also place the business in a better light, as assets such
as property may have increased significantly in value over time. Increasing the statement of financial
position value of an asset does not, of course, make that asset more valuable. Perceptions of the
business may, however, be altered by such a move.
fair value
One consequence of upwardly revaluing non-current assets with finite lives is that the depreciation charge
will be increased. This is because depreciation is based on the new (increased) value of the asset.
Refer back to Example 2.2 on page 64. What would be the effect of revaluing the property to a figure
of $440,000 on the statement of financial position? The effect on the statement of financial position would
be to increase the property to $440,000, and the gain on revaluation (i.e. $440,000−$180,000=$260,000)
would be added to equity, as it is the owner(s) who will benefit from the gain. Typically, the revaluation
‘gain’ would be shown in a revaluation reserve.
Once non-current assets are revalued, the frequency of revaluation then becomes an important issue, as
assets recorded at out-of-date revaluations can mislead users. Using such figures on the statement of
financial position is the worst of both worlds. It lacks the objectivity and verifiability of historic cost; it also
lacks the realism of current values. Where fair values are used, revaluations should therefore be frequent
enough to ensure that the carrying amount of the revalued asset does not differ materially from its true fair
value at the statement of financial position date.
When an item of property, plant or equipment (a tangible asset) is revalued on the basis of fair values, all
assets within that particular group must be revalued. Thus, it is not acceptable to revalue some items of
property but not others. Although this provides some degree of consistency within a particular group of
assets, it does not prevent the statement of financial position from containing a mixture of valuations.
Intangible assets are not often revalued to fair values. This is because revaluations can be used only
where there is an active market, thereby permitting fair values to be properly determined. Such markets,
however, rarely exist for intangible assets.
Reflection 2.4
You own a property in New South Wales that you purchased 10 years ago for $500,000. You
intend to use it as a non-current asset in a new business, which you are starting up with a partner.
How would you assess the fair value of this property? How accurate can you be? How could you
convince anyone else that your estimate is reasonable?
How objective is accounting? How many instances can you identify where judgement is a key
element?
impairment
The amount of loss that must be written-off for an asset in the situation where the
carrying amount of the asset exceeds its recoverable amount.
We should bear in mind that impairment reviews involve making judgements about the appropriate value
to place on assets. Employing independent valuers to make these judgements will normally give users
greater confidence in the information reported. There is always a risk that managers will manipulate
impairment values to portray a picture that they would like users to see.
Intangible non-current assets with indefinite useful lives must be tested for impairment at the end of each
reporting period. Other non-current assets, however, must also be tested where events suggest that
impairment has taken place.
In early 2018 Wesfarmers announced ‘$1.3 billion in writedowns ... flowing from Bunnings in Britain
and the still problematic retail chain’.
Source: Eli Greenblatt, ‘Wesfarmers takes $1.3b hit as Bunnings UK bleeds’, The Australian, 6 February 2018.
In 2019 the company reported in its annual report a profit after tax of $5,510 million, after including
non-cash impairments of BUKI and Target totalling $1,323 million before tax.
Woolworths in its 2019 annual report included an impairment relating to its Big W network review
totalling $166 million.
BHP Billiton Ltd., the world’s number one miner by market value, recorded its worst-ever annual
loss as US$7.7 billion in impairment losses exacerbated by a deep slump in commodity prices.
Source: Rhiannon Hoyle, ‘BHP Billiton reports worst-ever annual loss’, The Wall Street Journal, 16 August 2016, www.wsj.com.
Reflection 2.5
Professional soccer clubs such as Tottenham Hotspur wrestle with valuation and revaluation of
players throughout their careers. How might you approach valuation of:
If a career-ending injury, or a major falling-out with the club, occurs, what do you think are the
implications for impairment and depreciation?
It is not only non-current assets that run the risk of a significant fall in value. The inventories of a business
could also suffer this fate as a result of changes in market taste, obsolescence, deterioration, damage
and so on. Where a fall in value means that the amount likely to be recovered from the sale of the
inventories will be lower than their cost, this loss must be reflected in the statement of financial position.
Thus, if the net realisable value (i.e. selling price less any selling costs) falls below the historic cost of
inventories held, the former should be used as the basis of valuation. Similarly, if the book value of
receivables is seen as being unlikely to be received, some write-down or impairment is needed. This will
be reviewed in Chapter 3 . Both of these reflect, once again, the influence of the prudence convention
on the statement of financial position. The published financial statements of large businesses will normally
show the basis on which inventories are valued (as can be seen in Real World 2.5 ).
Real World 2.5 provides examples of how certain non-current assets are valued in the major
telecommunications company, Telstra.
Telstra
Property, plant and equipment
a. Acquisition
Property, plant and equipment, including construction in progress, is recorded at cost less
accumulated depreciation and impairment. Cost includes the purchase price and costs
directly attributable to bringing the asset to the location and condition necessary for its
intended use. We capitalise borrowing costs that are directly attributable to the acquisition,
construction or production of a qualifying asset. All other borrowing costs are recognised as
an expense in our income statement when incurred.
b. Depreciation
Items of property, plant and equipment, including buildings and leasehold property but
excluding freehold land, are depreciated on a straight-line basis in the income statement
over their estimated useful lives. We start depreciating assets when they are installed and
ready for use.
c. Impairment assessment
All non-current tangible assets are reviewed for impairment whenever events or changes in
circumstances indicate that the carrying amounts may not be recoverable. For our
impairment assessment we identify cash generating units (CGUs), i.e. the smallest groups
of asset that generate cash inflows that are largely independent of cash inflows from other
assets or groups of assets.
Intangible assets
a. Goodwill
Goodwill acquired in a business combination is measured at cost. Cost represents the
excess of what we pay for the business combination over the fair value of the identifiable
net assets acquired at the date of acquisition. Goodwill is not amortised but is tested for
impairment on an annual basis or when an indication of impairment arises. Goodwill amount
arising on acquisition of joint ventures or associated entities constitutes part of the cost of
the investment.
b. Internally generated intangible assets
Internally generated intangible assets include mainly IT development costs incurred in
design, build and testing of new or improved IT products and systems. Research costs are
expensed when incurred.
Capitalised development costs include:
external direct costs of materials and services consumed
payroll and payroll-related costs for employees (including contractors) directly
associated with the project
borrowing costs that are directly attributable to the qualifying assets.
Internally generated intangible assets have a finite life and are amortised on a straight-line
basis over their useful lives.
c. Acquired intangible assets
We acquire other intangible assets either as part of a business combination or through a
separate acquisition. Intangible assets acquired in a business combination are recorded at
their fair value at the date of acquisition and recognised separately from goodwill. Intangible
assets acquired through a specific acquisition are recorded at cost.
d. Amortisation
The weighted average amortisation periods of our identifiable intangible assets are as
follows:
EXPECTED BENEFIT (YEARS) AS AT 30 JUNE
Software assets 8 8
Licences 14 14
Other intangibles 10 10
Concept check 12
Which of the following statements is true?
A. GAAP, or generally accepted accounting principles, are accounting rules developed
by the AASB (Australian Accounting Standards Board).
B. The entity or business entity convention provides for a clear alliance of the business
and its owners.
C. The historic cost convention values assets at their cost on the date of acquisition.
D. Current values provide more reliable amounts for asset valuation.
E. The prudence convention is rarely applied in actual practice.
Concept check 13
The money measurement convention:
A. Requires expression in monetary terms with reasonable reliability for all balance
sheet resources
B. Precludes a proprietor from recording the goodwill that he or she has with regular
customers
C. Will result in the balance sheet understating the value of the business
D. None of the above
E. All of the above.
Usefulness of the statement of financial position
LO 6 Explain the main ways in which the statement of financial position can be useful for users of
accounting information
The statement of financial position is the oldest of the three main financial statements, and many
businesses prepare one on a regular basis, even though they may not be subject to regulations requiring
it to be produced. This suggests that it is regarded as providing useful information. There are various
ways in which the statement of financial position may help users, including the following:
It provides insights about how the business is financed and how its funds are deployed. The
statement of financial position shows how much finance is contributed by the owners and how much is
contributed by outside lenders. It also shows the different kinds of assets acquired and how much is
invested in each kind. The relative proportion of total finance contributed by the owners and outsiders
can be calculated to see whether the business depends heavily on outside financing. Heavy borrowing
can incur a commitment to large interest payments and large capital repayments at regular intervals.
Such legally enforceable obligations can be a real burden as they have to be paid irrespective of the
financial position of the business. Funds raised from the owners of the business, on the other hand, do
not impose such obligations on it.
It provides insights into the liquidity of the business. This is the ability of the business to meet its
short-term obligations (current liabilities) from its liquid (cash and near-cash) assets. Liquidity is
particularly important because business failures occur when the business cannot meet its maturing
obligations, for whatever reason.
It can provide a basis for assessing the value of the business. Since the statement of financial
position lists, and places a value on, the various assets and claims, it can provide a starting point for
assessing the value of the business. It is, however, severely limited in the extent to which it can do
this. We have seen earlier that accounting rules may result in assets being shown at their historic cost,
and that the restrictive definition of assets may exclude certain business resources from the statement
of financial position. Ultimately, the value of a business will be based on its ability to generate wealth
in the future. Because of this, assets need to be valued on the basis of their wealth-generating
potential. Also, other business resources that do not meet the restrictive definition of assets, such as
brand values, need to be similarly valued and included.
It provides insights into the ‘mix’ of assets held by the business. The relationship between
current assets and non-current assets is important. Businesses with too much of their funds tied up in
non-current assets could be vulnerable to financial failure, because non-current assets are seldom
easy to turn into cash to meet short-term obligations. Converting many non-current assets into cash
may well lead to substantial losses for the business, because such assets are not always worth on the
open market what the business paid to acquire them or what they are worth to the business. For
example, a specialised piece of equipment may have great value to one business, yet little to another.
It can help users in assessing performance. The effectiveness of a business in generating wealth
can usefully be assessed against the amount of investment that was involved. Thus, the relationship
between profit earned during a period and the value of the net assets invested can be helpful to many
users, particularly owners and managers.
The interpretation of the statement of financial position will be considered in more detail in Chapter 8 .
Activity 2.6
Consider the following statement of financial position of a manufacturing business:
$ $
Current assets
Inventory 192,000
416,000
Non-current assets
644,000
Current liabilities
168,000
Non-current liabilities
Loan 640,000
Owners’ equity
296,000
252,000
Total liabilities and owners’ equity 1,060,000
What does this statement tell you about the financial position of the business?
Concept check 14
The statement of financial position helps users by:
A. Providing insights about how the business is financed and how its funds are
deployed
B. Informing as to the liquidity of the business
C. Providing a basis for valuation of the business
D. Providing insights into the ‘mix’ of assets held by the business
E. All of the above.
Concept check 15
For which of the following will the balance sheet be LEAST useful?
A. Providing insights on how the business is financed and how its funds are deployed
B. Informing as to the liquidity of the business
C. Providing a basis for valuation of the business
D. Providing insights into the ‘mix’ of assets held by the business
E. None of the above. Very useful for all.
SELF-ASSESSMENT QUESTION
2.2
Your friends, three young business entrepreneurs, each gave you the statements of financial
position of their businesses. They each have concerns, one regarding his liquidity, one about her
level of debt, and, more generally, whether they are using their assets in the best way. Explain to
them how the statement of financial position can be used to assess (a) liquidity, (b) solvency
(ability to meet financial obligations), and (c) the asset mix of the businesses.
Activity 2.7
The statement of financial position has been likened to a financial photograph or snapshot of a business
at a point in time. If you think about the problems you have had with particular photos you have taken,
these will provide some useful insights into potential deficiencies in statements of financial position. For
example, when looking at a group photograph you have taken, you may have noted that:
How can these problems with taking a group photograph relate to the possible deficiencies of a statement
of financial position in presenting the financial position at a point in time?
Thinking along these lines enables us to identify some of the deficiencies or limitations that a statement of
financial position has in presenting the financial position of an entity at a point in time. The statement of
financial position represents the end product of the interpretation and application, by management,
accountants and auditors, of the statutory and professional rules and principles of accounting and
financial reporting. In interpreting and applying this body of knowledge, at least two situations may cause
deficiencies in individual statements of the financial position of a given entity at a point in time.
First, within this body of knowledge itself there are potential conflicts that may lead to such deficiencies.
While this introductory text on accounting does not set out to review accounting theory in detail, a few
examples may illustrate the possible conflicts. We stated earlier that an underlying assumption was a
‘stable monetary unit’: the economic reality is that since money is a good in its own right, subject to supply
and demand fluctuations, it cannot be used accurately as a measuring unit for comparisons over time.
Therefore, when accountants add building costs in 2000 to alteration costs in 2020, the aggregate makes
no more sense than adding together Australian and US dollars without making some translation
adjustment. That is, Australian dollars in 2000 do not have the same purchasing power significance as
Australian dollars in 2020, so they cannot be added meaningfully.
We also noted in Chapter 1 that the financial information presented in the reports should be both
relevant and faithfully represented, yet these two qualities are often in conflict. Relevant information
(useful in decision-making) is not always entirely faithfully representative (reliable), and if you wait for
reliable information, it may not always be particularly relevant. What you paid for some equipment in 2005
can be reliably measured (external invoice and receipt), but this may not be relevant in 2020 when you
have to decide whether to retain or dispose of the equipment. In 2020 you may want to know the value of
that asset in use (the present value of future cash flows attributable to that asset) or its value in exchange
(the estimated selling price less costs to sell). While these two current values are useful for decision-
making, as measures they may not be reliable as they are subject to estimation error or personal bias.
Second, the accounting principles and rules of the accounting body of knowledge allow management
individuals considerable discretion when it comes to deciding how to record transactions. Many of these
choices will be specifically discussed in Chapter 3 on the statement of financial performance, so you
may find it useful to review this section again after having read Chapter 3 . These choices include:
The accountant nevertheless has a wide range of accounting methods or techniques for recording
transactions in many areas related to the statement of financial position. In accounting for accounts
receivable and bad debts, bad debts can be recognised when realised, or anticipated using a percentage
of credit sales or based on the age of the debt. With inventory, the inventory on hand at the end of the
period can be measured by different methods (first in, first out; last in, first out; weighted average;
standard cost). With plant and equipment, various depreciation methods are acceptable (straight-line;
units of production; reducing balance; sum of the years’ digits). These few examples again highlight
implications for the account balances in the statement of financial position.
Reflection 2.6
If you were to develop your own business you are likely to do so partly for financial reasons, but
also for reasons to do with factors such as flexibility, job satisfaction and so on. What kind of
factors might you include in your own personal list of assets or benefits associated with running
your own business, which would not normally be included in the business balance sheet, and how
important are these likely to be to you? Does this list reduce the importance of the balance sheet?
Concept check 16
The usefulness of the statement of financial position will be limited by:
A. Inflation
B. Naïve users
C. Poor estimations by the accountant
D. Poor choice of accounting policy
E. All of the above.
Summary
In this chapter we have achieved the following objectives in the way shown.
Explain the nature and purpose of the statement of Identified the purpose as being to set out the financial position of a business
financial position (balance sheet) and its component parts at a particular point of time
Explained that the statement included assets and claims, which consisted of
external liabilities and owners’ equity
Identified and analysed the nature of assets
Identified and analysed the nature of liabilities
Identified and analysed the nature of owners’ equity
Used the accounting equation to illustrate the build-up of a statement of
financial position, covering a range of transactions, including trading
transactions
Explain the accounting equation, and use it to build up a Explained the accounting equation
statement of financial position at the end of a period Illustrated by use of a practical example
Worked through an additional activity to enable us to prepare a statement of
financial position after a series of transactions
Classify assets and claims Identified the most common classification of assets being based on the
timing of receipts of economic benefits (e.g. current, non-current)
Identified the current/non-current classification as being appropriate for
liabilities
Explained the difference between the various components of equity
Apply the different possible formats for the statement of Illustrated the main format of the statement of financial position
financial position Examined the following formats:
—horizontal (T account)
—vertical (narrative)
—entity: A=L+OE
Identify the main factors that influence the content and Identified and analysed the following factors:
values in a statement of financial position
conventional accounting practice
business entity
historic cost
prudence/conservatism
going concern
dual aspect
money measurement, including consideration of goodwill and brands and
human resources
stable monetary unit
valuation of assets
Explain the main ways in which the statement of financial Identified the ways in which the statement of financial position can provide
position can be useful for users of accounting information useful insights into:
Identify the main deficiencies or limitations in the Explained that the deficiencies of the statement of financial position in
statement of financial position portraying financial position largely relate to:
General
Easy
2.1 LO What are the main characteristics of assets and liabilities from an accounting perspective? Is this consistent with a non-
1 accounting definition?
2.2 LO What is the primary measure used for asset valuation on the statement of financial position? What is the source of this measure
5 and the justification for its use?
2.4 LO What sort of account would be included in the intangible asset category?
3
Intermediate
2.5 LO Provide examples of valuable resources of a business that will not be included as assets on the statement of financial
1/5/7 position. Why does this occur?
2.7 LO 3 Describe the basis used to determine whether an asset is classified as current or non-current. Is the same basis used for the
classification of liabilities?
2.8 LO 2 Why is the statement of financial position also called a ‘balance sheet’?
2.9 LO 4 Do you think the format of the statement of financial position will affect users’ understanding of the statement?
2.11 LO 5 The prudence convention has significantly influenced financial transactions recording and reporting.
2.12 LO 6 What other financial measures besides historical cost might be used for asset valuation?
Challenging
2.13 LO ‘Human capital’ and ‘intellectual property’ are of significant value in many organisations. Provide arguments for and against
1/5 their inclusion on the statement of financial position.
2.14 LO Does the use of some sort of ‘current cost’ for statement of financial position valuation increase the usefulness of the
1/2/5 statement? Does it cause problems?
2.15 LO An accountant prepared a statement of financial position for a business using the horizontal layout. In this statement, the
1/2/5 capital of the owner was shown next to the liabilities. This confused the owner, who argued: ‘My capital is my major asset and
so should be shown as an asset on the statement of financial position.’ How would you explain this misunderstanding to the
owner?
2.16 LO ‘The statement of financial position shows how much a business is worth.’ Do you agree with this statement? Discuss.
5/6/7
2.17 LO 2 Refer to Accounting and You. Do you consider that knowledge of how accounting systems work is necessary for managers?
Can you think of ways in which this knowledge might be useful to you, assuming that you are operating as a manager in a
business, not as an accountant?
Application exercises
Easy
2.1a LO 2 Would the following accounts be classified as assets? If not, how would they be classified?
1. Accounts receivable
2. Accumulated depreciation
3. Investments purchased
4. Advance to employees
5. Prepaid insurance
6. Supplies used
2.1b LO 3 Would the following accounts be classified as liabilities? If not, how would they be classified?
1. Accounts payable
3. Loan guarantee
2.2 LO 2 For each of the following transactions identify the effect on the balance sheet equation.
A. The owner, ‘Bill’, contributes cash to the business, ‘Bills Electrical Services’
B. The business purchases supplies on credit
E. Cash payment for rent of storage shed for the next 6 months
F. Cash payment at the end of the month for electricity used during the month
2.3 LO 2/4 The following is a list of assets and claims of a manufacturing business at a particular point in time:
a. Prepare a statement of financial position in the standard vertical format incorporating these figures.
(Hint: There is a missing figure which needs to be deduced and inserted.)
b. Discuss the significant features revealed by this financial report.
Intermediate
2.4 LO Complete the table of assets below by classifying each account in terms of being:
2/3
current
non-current: investments
non-current: property, plant and equipment
non-current: intangibles
Account Classification
Cash at bank
Patent
Equipment
Prepayment
Land
Goodwill
Accounts receivable
Shares in Telstra
Accumulated depreciation—equipment
Inventories
Leasehold improvements
Interest prepaid
Government bonds
2.5 LO 2 You are provided with the following statement of financial position at the start of the week and the seven transactions for the
week.
Complete the table to show how each transaction affected the accounts together with the balances at the end of the period.
$ 1234567
Assets
Cash 3,000
Inventory 7,000
93,000
Liabilities
33,000
Capital 60,000
93,000
2.6 LO 2/4 On 1 March 2020 Joe Conday started a new business. During March he carried out the following transactions:
2. Purchased fixtures and fittings for $6,000 cash, and inventory valued at $8,000 on credit.
4. Purchased a car for $7,000 cash and withdrew $200 for own use.
5. Purchased another car costing $9,000. The car purchased on 4 March was given in part exchange at a value of $6,500. The
balance of purchase price for the new car was paid in cash.
6. Conday won $2,000 in a lottery and paid the amount into the business bank account. He also repaid $1,000 of the loan.
a. Prepare a statement of financial position for the business at the end of each day using the horizontal format.
b. Show how the statement of financial position you have prepared as at 6 March 2020 would be presented in the vertical format.
Challenging
2.7 LO 2 Cohen has the following assets and liabilities at year-end:
Property 150,000
Equipment 126,000
Inventory 80,000
During the year, the business made a profit of $110,000 and the owner injected $50,000 into the business. The owner’s equity at the
beginning of the year was $240,000.
2.9 LO You are presented with the following statement of financial position which is an incorrect draft. Assuming the accounts and
2/4 amounts are correct, prepare the statement of financial position again, making the necessary corrections.
$ $
Current assets
Non-current assets
Inventory 15,000
Current liabilities
Non-current liabilities
Owner’s equity
2.10 LO An entrepreneur has been working on a fintech business, a business which incorporates technology and finance. She has the
5 following questions.
1. She has read something about the value of a brand in this sort of business and wonders whether it can be included in the
balance sheet.
2. She is working with a small team of high-performing technical people. She is aware of the fact that this group of people,
working together very well, gives the business some real competitive advantage, and she is wondering how she might
give this a value in the business balance sheet. She feels that this is an intangible asset with value.
3. She is also aware that the world’s most highly valued brands are typically tech businesses and wonders why this is.
4. She has managed to acquire some small premises, with the help of a small inheritance which covered the deposit. The
rest of the cost is covered by a mortgage loan, secured on the premises. She has heard that valuation can be at ‘fair
value’, and wonders just what that means for her business.
5. She heard the value of the premises can be subject to impairment, and wonders what impairment means.
2.11 LO Assume that several years down the track the fintech business in Application Exercise 2.10 is successful, and the entrepreneur
6/7 is considering acquiring a small business that owns some patents related to the blockchain. Her financial adviser has managed
to obtain the balance sheet of the small business, but has advised her not to use the balance sheet to estimate the business’s
purchase price.
Try to summarise what the balance sheet tells her and what it doesn’t tell her. Explain why there might be a difference between
a business’s market value and the value of the net assets in the balance sheet. Identify briefly, what the limitations of the
balance sheet are, and why they are so difficult to overcome.
Chapter 2 Case study
This phenomenon raises a number of interesting questions, including the extent to which the traditional
financial statements continue to be relevant to investors’ decisions with these tech blue-chips. For
example, although Twitter reported a loss of $79 million before its IPO (initial public offering), this did not
prevent frenzied investors from buying its shares in 2013. Twitter even continued to report losses in the
next four years. Microsoft purchased LinkedIn in 2016 when there was no sign of profit in the acquiree’s
income statement. Does this mean that the income statements for digital firms are meaningless as a
basis on which investors should make decisions?
This seems to be not only true for the income statement, but also balance sheet. NYU Stern Professor
Baruch Lev (2016) claimed that the current financial accounting model could not capture the underlying
value creator for digital firms: increasing return to scale on intangible investments. That is, ‘the
fundamental idea behind the success of digital companies (the increasing returns to scale) goes against a
basic tenet of financial accounting (assets depreciate with use)’.
The proportion of physical assets is much less than the traditional firms.
A lot of internally generated intangibles—such as brands, organisational strategy, peer and supplier
networks, customer and social relationships—are not allowed to be recognised as assets. This makes
the balance sheet of digital firms an artefact of regulatory compliance, with little or no utility to
investors.
In contrast to the depreciation of physical assets in traditional firms, the intangible investments in
digital firms increase its value as more people use them.
For digital firms, their investments into research and development are just like the investments of the
traditional firms in factory and plants. However, the current accounting standards require the majority
of the investments to be treated as expenses instead of assets.
The most important asset of digital firms is usually the human capital, which is not reported in the
balance sheet according to the conventional accounting standards.
Sources: Baruch Lev and Feng Gu (2016), The End of Accounting and the Path Forward for Investors and Managers (Wiley, New Jersey).
Vijay Govindarajan, Shivaram Rajgopal and Anup Srivastava, ‘Why financial statements do not work for digital companies’, Harvard Business Review, 26 February 2018.
Questions
1. Why do you think investors would purchase shares of digital firms that make losses?
2. Do you agree that financial statements for digital companies are less relevant to stakeholders’
decision-making? If so, why?
3. Why do you think the intangible investments in digital firms (e.g. Facebook) increase their value
when more people use them?
4. Why do the current accounting standards not allow items such as brands, organisational strategy,
peer and supplier networks, customer and social relationships, and human capital to be recognised
in the balance sheet?
5. What might be the problems if these items were allowed to be recognised in the balance sheet?
What solutions can you offer?
Activity 2.1
Your answer should be along the following lines:
a. Under normal circumstances, a business would expect a customer to pay the amount owed. Such
an amount is, therefore, typically shown as an asset under the heading ‘debtors’, also referred to
as ‘accounts receivable’ or simply ‘receivables’. However, in this particular case the customer is
unable to pay. Hence, the item cannot provide future benefits, and the $1,000 owing would not be
regarded as an asset. Debts that are not paid are referred to as ‘bad debts’.
b. The purchase of the licence would meet all of the conditions set out in the chapter, and would,
therefore, be regarded as an asset.
c. The hiring of a new marketing director would not be considered to be the acquisition of an asset.
One argument against its classification as an asset is that the organisation does not have exclusive
rights of control over the director. Nevertheless, it may have an exclusive right to the services that
the director provides. Perhaps a stronger argument is that the value of the director cannot be
measured in monetary terms with any degree of reliability.
d. The machine would be considered an asset even though it is not yet paid for. Once the
organisation has agreed to purchase it and has accepted it, the machine is legally owned by the
organisation even though payment is still outstanding. (The amount outstanding would be shown
as a claim.)
e. This would appear as a liability known as ‘accounts payable’. Goods have been received but not
paid for, so the amount as yet unpaid will appear as a liability.
f. The advance payments relating to subscriptions will be shown as a liability until such time as the
magazines have been delivered and the contract completed.
g. A guarantee does not constitute a liability. It will only become a liability should the manager default.
h. This is more problematic, but it would probably be included as a liability if the business recognised
that there was a high probability that the legal action would succeed and that the estimated figure
was seen as a reasonable estimate.
Activity 2.2
The statement of financial position as at 4 March, following the repayment of part of the loan, will be as
follows:
Assets $ Claims $
The repayment of $2,000 of the loan will result in a decrease in the balance at the bank of $2,000 and a
decrease in the loan claim against the business by the same amount.
Assets $ Claims $
The introduction of more funds by the owner will result in an increase in the capital of $4,000 and an
increase in the cash at bank by the same amount.
Activity 2.3
a. Your answer should be as follows:
Non-current assets Current assets
Computer equipment
b. Financial institutions such as banks and insurance companies frequently select the liquidity
approach to classifying assets to provide more relevant and faithfully represented information to
the report users. The nature of their business is largely linked to matching available funds with
external claims over time, and so classifying both assets and liabilities on a liquidity basis provides
valuable insights into the entity’s ability to service such claims.
Activity 2.4
The statement of financial position you prepare should be set out as follows:
$ $
Current assets
Inventory 180,000
378,000
Non-current assets
Current liabilities
176,000
Non-current liabilities
Loan 204,000
Capital
542,000
482,000
how much would have to be paid to buy vans of a similar type and condition (current replacement
cost)
how much a motor van dealer would pay for the vans were the business to sell them (current
realisable value).
Both options will normally rely on opinion, and so a range of possible values could be produced for each.
For example, both the cost to replace the vans and the proceeds of selling them are likely to vary from
one dealer to another. Moreover, the range of values for each option could be significantly different from
one option to the other. (The selling prices of the vans are likely to be lower than the amount required to
replace them.) Thus, any value finally decided upon could arouse some debate.
Activity 2.6
The statement of financial position provides an insight into the ‘mix’ of assets held. Thus, it can be seen
that, in percentage terms, approximately 60% of assets held are in the form of non-current assets, and
that freehold premises comprise more than half of the non-current assets held. Current assets held are
largely in the form of inventory (approximately 46% of current assets) and accounts receivable
(approximately 42% of current assets).
The statement of financial position also provides an insight into the liquidity of the business. The current
assets are $416,000, and can be viewed as representing cash or near-cash assets held, compared to
$168,000 in current liabilities. In this case it appears that the business could be overly liquid, as the
current assets exceed the current liabilities by a large amount. Liquidity is very important in order to
maintain the capacity of the business to pay debts.
The statement of financial position gives an indication of the financial structure of the business. In the
statement provided, it can be seen that the owner is providing $252,000 and long-term lenders are
providing $640,000. This means that outsiders contribute, in percentage terms, more than 71% of the
total long-term finance required, and the business is therefore heavily reliant on outside sources of
finance. The business is under pressure to make profits which are at least sufficient to pay interest and to
make capital repayments when they fall due.
Activity 2.7
In a very real sense, some of the simple issues observed here with taking a group photograph are similar
to the problems accountants have in taking a financial photograph of business resources and claims
against those resources. For example:
While the statement of financial position is a measure of the resources and the claims against the
resources at a point in time, some valuable resources, or claims against those resources, may have
been left out. For resources to be included as assets, they must satisfy the asset definition and
recognition tests. Valuable business resources, such as employees, will not pass such tests, and
therefore will not appear on the statement of financial position. Similarly, legally enforceable claims
may not appear on the statement of financial position where contracts are deemed to be of an
executory nature (unperformed on either side), such as construction contracts.
There may be incomplete transactions where the outcome is unknown at balance date, and so the
statement of financial position measure does not accurately reflect the ultimate situation. Will research
expenditure lead to valuable future resources? Or what about the extent of future warranty or legal
claims against the products or services provided by the entity?
There may be assets in the statement of financial position that ultimately will not lead to future
economic benefits, such as the uncollectable accounts receivable balance or spare parts for
equipment that will never be used, or liabilities that will not have to be satisfied, such as excessive
provisions for future possible claims.
The actual measures used for assets and liabilities are varied and can distort the picture. For assets
we can readily observe the use of: initial purchase price; replacement price; selling price; and the net
present value of future cash flows expected to be generated by the asset. The aggregation of such
varied measures has the potential to yield meaningless totals.
The statement of financial position is largely prepared for a single set of viewers: the equity investors
or owners. The content of the statement of financial position is, therefore, potentially biased in favour
of a select interest group, rather than a more diversified group who may be interested in more than the
economic nuts and bolts. They may also be concerned with social and environmental performance, for
example.
Being a static report at a point in time, the statement of financial position cannot cope with any
complex interaction of transactions and events involving the entity and its social, economic, legal and
political environments.
Several important potential limitations of the statement of financial position have already been identified in
the analogy with a snapshot (photograph). However, the following are also often cited as deficiencies of
the statement of financial position at a point in time:
Learning objectives
When you have completed your study of this chapter, you should be able to:
In Chapter 2 we examined the nature and purpose of the statement of financial position. We saw that
this statement was concerned with setting out the financial position of a business at a particular moment
in time. However, most users need more than just the information on the amount of wealth held by a
business at one moment in time. Most businesses exist for the primary purpose of generating wealth, or
profit, and so the profit generated during a specific period is the primary concern of many users of
financial reports. Although the amount of profit generated is of particular interest to the owners of a
business, other stakeholder groups, such as managers, employees and suppliers, will also have an
interest in the profit-making ability of the business. The purpose of the statement of financial performance
(usually called the income statement) is to measure and report how much profit (financial progress or
wealth) the business has generated over a period. It also helps users to gain some impression of how that
profit was made. As with the statement of financial position, the principles are the same irrespective of
whether the income statement is for a sole proprietorship business, a partnership or a limited company.
Profit (or loss) is the difference between the increases in owners’ equity (capital), known as income, and
the decreases in owners’ equity, known as expenses. Note that changes in equity due to additional
contributions from the owner(s), or withdrawals in the form of drawings or distributions, will not form part
of the profit calculation. The measurement of profit (or loss) for the period requires the calculation of the
total income of the business generated during a particular period less the expenses incurred for that
period. Income reflects the wealth generated from business activities, with expenses reflecting any
offsetting reductions in wealth generated.
Income is defined as the increases in economic benefits through the inflow of assets (e.g. cash or
amounts owed to a business by accounts receivable) or the reduction in liabilities, which will increase
equity (other than those relating to owners’ equity contributions) for the particular reporting period. Income
is comprised of both operating ‘revenues’ and ‘other gains/losses’. Revenues represent the gross
inflows of future economic benefits gained from the different categories of operating activities (e.g. cash
from sales). Other gains represent the net inflows from the non-operating activities; for example, the
gain on sale of investments, or the gain on foreign currency transactions. Different forms of business
enterprise will generate different forms of revenue. Some examples of the different forms that revenue
can take are as follows:
sales of goods (e.g. of a manufacturer)
fees for services (e.g. of a solicitor)
subscriptions (e.g. of a club)
interest received (e.g. of an investment fund).
income
Increases in economic benefits for the accounting period in the form of inflows of
assets or decreases in liabilities that result in increases in equity, other than those
relating to ownership contributions.
revenues
Increases in the owners’ claim as a result of operations.
other gains
Gains from non-operating activities.
It is quite possible for a business to have more than one source of income.
Activity 3.1
The following represent different forms of business enterprise:
1. accountancy practice
2. squash club
3. bus company
4. newspaper
5. finance company
6. songwriter
7. retailer
8. magazine publisher
Can you identify the main source(s) of revenue for each type of business enterprise?
Reflection 3.1
Have you any idea what proportion of total revenues the gate receipts of a major soccer club are,
say for Arsenal, Manchester United or Juventus? Examine the annual reports of a major sporting
club, summarise the major revenue types, and then discuss your findings. Does the diversity
surprise you?
Then put yourself in the position of a dairy farmer in South Gippsland, milking 200 cows a day, who
is struggling because of the price of milk. What possible options can you think of that will enable
the farmer to diversify revenue sources?
The total expenses relating to each period must also be identified. Expense is really the opposite of
revenue. An expense represents the outflow of assets (or increase in liabilities) incurred in the process of
carrying on a business and generating income. The nature of the business will again determine the type
of expenses incurred. Examples of some of the more common types of expense are:
the cost of buying goods which are subsequently sold—known as ‘cost of sales’ or ‘cost of goods sold’
salaries and wages
rent and rates
motor vehicle running expenses
insurances
printing and stationery
heat and light, and
telephone and postage.
expense
A measure of the outflow of assets (or increase in liabilities) incurred as a result of
generating revenues.
The income statement for a period simply shows the total income generated during a particular period
(revenues and other gains), from which is deducted the total of the expenses incurred in generating that
income. The difference between the total income and the total expenses will represent either profit (if
income exceeds expenses) or loss (if expenses exceed income). Thus, we have:
reporting period
The particular period for which the accounting information is prepared.
The two major statements—the statement of financial position and the income statement—should not be
viewed as substitutes for each other, but rather as performing different functions. The statement of
financial position of a business is a report at a single point in time and is effectively a ‘snapshot’ of the
stock of wealth held by the business. The income statement, on the other hand, is concerned with the
generation of wealth over a period of time. The two statements are nevertheless closely related.
The income statement can be viewed as linking the statement of financial position at the beginning of the
period with that at the end of the period. At the start of a new reporting period, the statement of financial
position shows the opening wealth position of the business. After an appropriate period, an income
statement is prepared to show the wealth generated over that period. A statement of financial position is
then also prepared to reveal the new wealth position at the end of the period. This statement will reflect
the changes in wealth that have occurred since the previous statement of financial position was drawn up.
Thus, at the commencement of the business, a financial position statement will be produced to reveal the
opening financial position:
Abeg=OEbeg+Lbeg
where
Abeg=assets at the beginning of the periodOEbeg=owners' equity (capital) at the beginning of the period, and
At the end of an appropriate period, an income statement will be prepared to show the wealth generated
over the period:
where
Iperiod=the income for the period, andEperiod=the expenses for the period
At the end of the period, a revised statement of financial position will be prepared to incorporate the
changes in wealth that have occurred since the beginning financial position statement was drawn up. This
will include adjustments to capital, reflecting the amount of profit for the period and any other owners’
changes disclosed. This means that the accounting equation can be extended as follows:
where
Assetsend = the assets at the end of the periodOther OEadj = other adjustments to equity (i.e. injections and drawings or d
In theory, it would be possible to calculate profit and loss for the period by making all adjustments for
income and expenses through the equity section of the statement of financial position (the capital
account), as was done in the solution to Self-assessment Question 2.1 . However, this would be
rather cumbersome with even a small business. A better solution is to have an ‘appendix’ to the owners’
equity (capital) account in the form of an income statement. By deducting expenses from the income for
the period, the profit (loss) can be derived for adjustment to the capital account. This figure represents the
net effect of operating and other activities for the period. Providing this ‘appendix’ means that a detailed
and more informative view of financial performance is presented to users.
net assets
The difference between assets and external liabilities.
Concept check 1
The statement of financial performance:
A. Is prepared at a particular point in time
B. Is more important than the balance sheet
C. Consists of revenues and expenses
D. All of the above are true
E. None of the above is true.
Concept check 2
Which of the following would NOT normally be an expense?
A. Cost of goods sold
B. Interest received
C. Salaries and wages
D. Utilities
E. Rates.
Concept check 3
Which of the following is true?
A. Drawings are a typical deduction in the determination of profit.
B. The profit equation could be restated as ‘Expenses=Revenues−Profit’.
C. Income is earned with increases in economic benefits through the outflow of assets.
D. All of the above are true.
E. None of the first three is true.
The format of the income statement
LO 2 Understand the layout of a typical statement of financial performance, and describe its
component parts
The format of the income statement will vary according to both the entity structure (e.g. non-profit entity,
sole proprietorship, partnership, company) and the nature of its operations (e.g. manufacturing, retail,
service). To illustrate an income statement, let us consider the case of a retail business (i.e. a business
that buys goods in their completed state and resells them).
Example 3.1 sets out a typical layout for the income statement of a retail business.
EXAMPLE
3.1
BETTER-PRICE STORES
Income statement
for the year ended 31 October 2020
Insurance (1,000)
A clear understanding of the key terms used in this statement is important, and these are explained
below.
Key terms
Gross profit
The first part of the income statement is concerned with calculating the gross profit for the period. We
can see that revenue, which arises from selling the goods, is the first item to appear. Deducted from this
item is the cost of sales (also called ‘cost of goods sold’) during the period. This gives the gross profit,
which represents the profit from buying and selling goods, without taking into account any other revenues
or expenses associated with the business.
gross profit
The difference between the revenues from sales and the cost of those sales.
Operating profit
From the gross profit, operating expenses (overheads) that have been incurred in operating the business
(salaries and wages, rent and rates, etc.) are deducted. The resulting figure is known as the operating
profit for the reporting period. This represents the wealth generated during the period from the normal
activities of the business. It does not take account of any income that the business may have from
activities that are not included in its normal operations. Better-Price Stores in Example 3.1 is a retailer,
so the interest on some spare cash that the business has invested is not part of its operating profit. Costs
of financing the business are also ignored in the calculation of the operating profit. Operating profit is
often called ‘earnings before interest and tax’(EBIT).
operating profit
The increase in wealth for a period that is generated from normal operations.
Profit for the period
Having established the operating profit, we add any non-operating income (such as interest income) and
deduct any non-operating expenses, including interest expense and income tax expense, to arrive at the
profit for the period . This is the income that is attributable to the owner(s) of the business, and will be
added to the equity figure in the statement of financial position. As can be seen, profit for the period is a
residual: that is, the amount remaining after deducting all expenses incurred in generating the sales
revenue for the period and taking account of non-operating income.
Cost of sales
The cost of sales (or ‘cost of goods sold’) figure for a period can be identified in different ways. In
some businesses, the cost of sales amount for each individual sale is identified at the time of the
transaction. Each item of sales revenue is closely matched with the relevant cost of that sale, and so
identifying the cost of sales figure for inclusion in the income statement is not a problem. Many large
retailers (e.g. supermarkets) have point-of-sale (checkout) devices that not only record each sale but also
simultaneously pick up the cost of the goods that are the subject of the particular sale. Other businesses
that sell a relatively small number of high-value items (e.g. an engineering business that produces
custom-made equipment) also tend to match sales revenue with the cost of the goods sold, at the time of
the sale. However, some businesses (e.g. small retailers) do not usually find it practical to match each
sale to a particular cost of sales figure as the reporting period progresses. Instead, therefore, they identify
the cost of sales figure at the end of the reporting period.
cost of sales
The cost attributable to the sales revenues.
To understand how this is done, we need to remember that the cost of sales figure represents the cost of
goods that were sold by the business during the period rather than the cost of goods that were bought by
that business during the period. Part of the goods bought during a particular period may remain in the
business, as inventories, at the reporting period end. These will normally be sold in the next period. To
derive the cost of sales for a period, we need to know the amount of opening and closing inventories for
the period and the cost of goods bought during the period. Example 3.2 illustrates how the cost of
sales is derived.
EXAMPLE
3.2
Better-Price Stores, which we considered in Example 3.1 , began the reporting period with
unsold inventories of $40,000 and during that year bought inventories at a cost of $289,000. At the
end of the year, unsold inventories of $75,000 were still held by the business.
The opening inventories at the beginning of the year plus the goods bought during the year will
represent the total goods available for resale. Thus:
The closing inventories will represent that portion of the total goods available for resale that
remains unsold at the end of the period. Thus, the cost of goods actually sold during the period
must be the total goods available for resale less the inventories remaining at the end of the period.
That is:
These calculations are sometimes shown on the face of the income statement as in Example 3.3 .
EXAMPLE
3.3
$
Cost of sales:
Opening inventories 40,000
(254,000)
This is just an expanded version of the first section of the income statement for Better-Price Stores, as set
out in Example 3.1 . We have simply included the additional information concerning inventories
balances and purchases for the year in Example 3.2 .
Classifying expenses
The classifications for the revenue and expense items—as with the classifications of various assets and
claims in the statement of financial position—are often a matter of judgement by those who design the
accounting system. Thus, the income statement set out in Example 3.1 (page 102) could have
included the insurance expense with the telephone and postage expense under a single heading—say,
‘general expenses’. Such decisions are normally based on how useful a particular classification will be to
users. This will usually mean that expense items of material size will be shown separately. For
businesses that trade as limited companies, however, there are rules that dictate the classification of
various items appearing in the financial statements for external reporting purposes. In this case, and in
general, expenses are normally classified under four headings:
1. cost of sales
2. selling and distribution
3. administration and general, and
4. financial.
You should note that this classification applies only to external reporting. More detail would be required by
managers in their day-to-day operations, and managerial reports would provide as much detail as was
needed.
Activity 3.2
The following information relates to the activities of H & S Retailers for the year ended 30 April 2021:
Sales 389,600
Insurance 3,000
Prepare an income statement for the year ended 30 April 2021. (Hint: Not all items listed should appear
on this statement.)
Concept check 4
Which firm would typically show gross profit on their income statement?
A. An accountancy practice
B. A legal practice
C. A motor vehicle repairer
D. All of the above
E. None of the above.
Concept check 5
It is common for an income statement to be prepared:
A. Annually
B. Quarterly
C. Monthly
D. All of the above
E. None of the above.
Profit measurement and the recognition of revenues
and expenses
Recognising revenue
The amount to which a business is entitled for providing goods or services to a customer should be
recognised as revenue. In many instances the recognition of revenues is fairly straightforward, but in
others the determination as to when revenue should be recognised is more problematic.
As a general rule, it should be recognised as soon as control of the goods or services is transferred to the
customer. At this point, the business has satisfied its performance obligations towards the customer.
Control of a good or service (i.e. an asset) refers to the ability to direct the use of, and obtain substantially
all of the remaining benefits from, the asset. In order to help determine the point at which control passes,
there are important indicators, such as when:
If we try to apply these ideas to, say, a self-service store, where sales are for cash, the above indicators
suggest that revenue can normally be recognised when the customer checks out. However, revenue
recognition is not always so straightforward. By way of illustration, let us suppose that a manufacturer
produces and sells a standard product on credit, which is transported to customers using the
manufacturer’s delivery vans. There are several points in the production/selling cycle at which revenue
might be recognised:
The point at which revenue is recognised can have a significant impact on the total revenues reported for
a particular reporting period. This, in turn, could have a significant effect on profit. If the sales transaction
straddled the end of a reporting period, the choice made between the three possible times for recognising
the revenue could determine whether it is included as revenue of an earlier reporting period or a later one.
Reflection 3.2
Some businesses do not fit the above revenue recognition criteria, and different criteria are used. If
you were in the timber plantation business how do you think that revenue should be recognised?
And what if you were running a gold mine?
Although revenue for providing services is often recognised before the cash is received, there are
occasions when it is the other way around. Situations may arise where an entity has received benefits
(normally cash) in advance—that is, before providing all of the related goods and services. For example,
customers often pay a deposit in advance, or pay for goods or services for a specified future time period
(e.g. subscriptions, insurance premiums and service fees are regularly paid in advance). For such
transactions the income recognition criteria are not fully satisfied, and the reporting entity receiving such
advances should classify the advance receipts as a liability (known as ‘deferred revenue’) in the
statement of financial position. They represent an obligation to provide the customer, member or client
with goods or services (or a refund where goods or services are not provided) at some time in the future.
It is important to note that the approach in this section (known as ‘accruals accounting’) recognises
income on the basis that it has been earned irrespective of whether the cash receipt is in arrears or
advance. For accounting purposes, income is deemed to be earned when it is realised.
The customer enjoys the benefits as the business performs its obligations. This can occur with
service contracts, such as where an accounting firm undertakes employee payroll services for a large
business, or the provision of electricity or gas.
The business creates, or improves, an asset held by the customer. This can occur with building
contracts, such as where a builder undertakes the refurbishment of a shop owned by a retailer.
The business creates an asset with no alternative use and the customer has agreed to pay for
work carried out. This can apply to special orders, such as where an engineering business produces
specially-designed equipment for a manufacturer.
Where control is transferred over time, the total revenue will be spread across the reporting periods
covered by the contract. In other words, part of the total contract price will be treated as revenue in each
reporting period. To determine the appropriate revenue for each period, some method of measuring
progress towards transferring the goods or services is needed.
Various methods are available. Some are based on outputs, such as particular ‘milestones’ reached in
completing the contract, or the number of units produced or delivered. Others are based on inputs, such
as resources consumed by the contract, or hours expended by labour or by machines. Methods based on
output often provide a direct measure of the value of goods or services transferred to customers. Methods
based on input are less likely to do so. Where methods based on output are unreliable, or unavailable,
however, methods based on input may be chosen. There is no single correct method: it depends on the
particular circumstances.
Particular issues arise in the context of long-term contracts and services. These are dealt with in more
detail below.
Long-term contracts
Some contracts, both for goods and services, can last for more than one reporting period. If the business
providing the goods or service were to wait until the contract was completely fulfilled before recognising
revenue, the income statement could give a misleading impression of the wealth generated in the various
reporting periods covered by the contract. This is a particular problem for businesses that undertake
major long-term contracts, where a single contract could represent a large proportion of their total
activities.
Construction contracts often extend over a long period of time. Suppose that a customer enters into a
contract with a builder to have a new factory built that will take three years to complete. In such a
situation, it is possible to recognise revenue before the factory is completed, provided that the building
work can be broken down into a number of stages and each stage can be measured reliably. Let us
assume that building the factory could be broken down into the following stages:
Stage 1: clearing and levelling the land and putting in the foundations
Stage 2: building the walls
Stage 3: putting on the roof
Stage 4: putting in the windows and completing all of the interior work.
Each stage can be awarded a separate ‘staging’ price, with the total for all the stages being equal to the
total contract price for the factory. This means that, as each stage is completed, the builder can recognise
the price for that stage as revenue and bill the customer accordingly. This is provided that the outcome of
the contract as a whole can be estimated reliably.
If the builder were to wait until the factory was completed before recognising revenue, the income
statement covering the final year of the contract would recognise all of the revenue on the contract, and
the income statements for each preceding year would recognise no revenue. This would give a
misleading impression, as it would not reflect the work done during each period.
Services
There are certain kinds of services that may take years to complete. One example is where a consultancy
business installs a new computer system for the government. Under these circumstances, if the contract
can be broken down into stages, and each stage can be reliably measured, a similar approach to that
used for long-term construction contracts can be adopted. This will allow revenue to be recognised at
each stage of completion.
In some cases, a continuous service may be provided to a customer. For example, a telecommunications
business may provide open access to the internet for subscribers. Here, the benefits from providing the
service are usually assumed to arise evenly over time and so revenue is recognised evenly over the
subscription period.
Where it is not possible to break down a service into particular stages of completion, or to assume that
benefits from providing the service accrue evenly over time, revenue will not usually be recognised until
the service is fully completed. The work done by a solicitor on a house purchase for a client would
normally be one such example.
When a service is provided, there will usually be a timing difference between the recognition of revenue
and the receipt of cash. Revenue for providing services is often recognised before the cash is received,
as with the sale of goods on credit. However, there are occasions when it is the other way around, usually
because the business demands payment before providing the service. Examples include: rent received
from letting premises; telephone line rental charges; vehicle licences or TV subscription fees; and
subscriptions received for the membership of clubs.
Real World 3.1 provides an illustration of the difficulties and importance of determining exactly when a
sale should be recognised for income purposes.
Real world 3.1
The Hewlett Packard/Autonomy takeover
Hewlett-Packard (HP) bought British software company Autonomy for US$11 billion in 2011. HP
subsequently argued that Autonomy included too much revenue upfront in deals selling both
software and continuing services to clients, and sued Autonomy. The issue surrounds the question
as to when is a sale a sale? The problems identified earlier in this section on revenue recognition
can be seen to be real issues in mainstream corporations.
The issue seems to be based on just how the rules relating to revenue recognition are applied.
Standard practice in this particular industry seems to be that a proportion is recognised upfront,
with the balance being spread over the life of the service contract. Each company can determine
the appropriate split for them, which then needs to be applied consistently over time. Obviously,
HP was unhappy with the split determined by Autonomy.
HP wrote down the value of the Autonomy deal by US$8.8 billion in 2012, blaming US$5.5 million
on ‘accounting improprieties’. It referred the case to the US Securities and Exchange Commission
and the British Serious Fraud Squad.
In 2015 HP unveiled the details of its fraud case against Mike Leach, the founder of Autonomy.
Essentially, it boils down to the claim that Autonomy fraudulently inflated the revenues. As Juliette
Garside recounted in The Guardian: ‘Its purpose was to ensure that the Autonomy group’s
financial performance ... appeared to be that of a rapidly growing pure software company.’
HP’s allegations are based on Autonomy’s practices of recognising sales to resellers rather than to
the ultimate customer, and allegations of disclosure failures relating to sales of low-margin (even
loss-making) computer hardware to support its more lucrative software business.
In October 2015, Mike Lynch counter-claimed against Hewlett-Packard for more than US$160
million, for trashing his reputation and hampering his venture capital fundraising efforts.
The UK Serious Fraud Squad closed its criminal investigation in January 2015 without bringing
charges. Probes by the Securities Exchange Commission and the FBI continued.
Questions have been raised as to why, if there was jiggery-pokery at Autonomy, it went unnoticed
for so long by so many.
In September 2016, The Guardian reported that British firm Micro Focus would take on the
remaining software assets from HP’s 2011 acquisition.
In the same year US federal prosecutors brought charges against Sushovan Hussain, the former
chief financial officer of Autonomy. He pleaded not guilty, but early in 2018 Reuters reported that
he had been convicted ‘of wire fraud and other crimes related to claims by the government that he
inflated the firm’s value before its sale to Hewlett Packard’. He was sent to prison for five years.
In late 2018 the Department of Justice filed criminal charges against Mike Lynch. The charges
carry a potential maximum penalty of 20 years.
The BBC reported: ‘Mr Lynch and Mr Hussain, both British citizens, are also facing a civil case in
London, as HP sues them for damages.’ Part of the defence was that HP had ‘botched’ the
acquisition, and claims were made that the due diligence was limited.
Sources: Andrew Peaple, ‘Accounting for Autonomy’, The Australian, 23 November 2012.
Arik Hesseldahl, ‘HP sues former Autonomy execs, seeking $5 billion in damages’, Recode, 31 March 2015, http://recode.net.
Arik Hesseldahl, ‘HP’s $5.5 billion fraud lawsuit against former Autonomy executive is now public’, Recode, 5 May 2015, http://recode.net.
Christopher Williams, ‘Autonomy founder Mike Lynch sues HP for $160m over fraud claims’, The Telegraph, 1 October 2015, http://www.telegraph.co.uk.
Juliette Garside, ‘Hewlett-Packard unveils details of $5bn Autonomy fraud case’, The Guardian, 5 May 2015.
Angela Monaghan, ‘Hewlett-Packard offloads last Autonomy assets in software deal’, The Guardian, 8 September 2016.
Dan Levine, ‘U.S. jury convicts former Autonomy executive of fraud over HP deal’, Reuters, 1 May 2018.
Jasper Jolly, ‘HP briefly scrutinised Autonomy finances before 8bn buyout, court told’, The Guardian, 28 March 2019, https://www.theguardian.com.
Jasper Jolly, ‘UK entrepreneur to face charges in US over Hewlett-Packard takeover’, The Guardian, 30 November 2018, https://www.theguardian.com.
2. How might the issue regarding the principles of revenue recognition in this case have been
addressed and possibly avoided?
Reflection 3.3
Assume that you are a shareholder in Hewlett Packard, what are your thoughts on the question
raised above: why, if there was jiggery-pokery at Autonomy, did it go unnoticed for so long by so
many? Should this have been at least commented on by the auditors?
Is this a case of ‘buyer beware’? Was appropriate due diligence done before the acquisition?
Real World 3.2 provides some examples of the way in which revenue is recognised in practice.
Real world 3.2
Revenue recognition
Boral
‘Sales revenue is revenue earned from the provision of products or services, net of returns,
discounts and allowances.
‘Revenue from the sale of goods is recognised at the point in time the customer obtains control of
the goods, which is typically at the time of delivery to the customer.
‘Revenue from contracting businesses is included in sale of goods and is recognised progressively
over the period of time the performance obligation is fulfilled and the customer obtains the control
of the goods being provided in the contract, with the Group having a right to payment for
performance to date. The Group predominantly uses the output method, which typically matches
delivery to the customer, to determine the amount of revenue to recognise in a given period.
‘Revenue from the rendering of services is allocated across each service or performance
obligation based on their stand-alone selling price, and recognised as the service or performance
obligation is performed. ...
‘Revenue from the sale of land is recognised at the point in time the customer obtains control of
the land and is measured at the transaction price agreed under the contract.’
Recognition of expenses
Having considered the recognition of revenue, let us now turn to the recognition of expenses. The
matching convention provides guidance on this. This convention states that expenses should be
matched to the revenue that they helped generate. In other words, the expenses associated with a
particular item of revenue must be taken into account in the same reporting period as that in which the
item of revenue is included. Applying this convention often means that an expense reported in the income
statement for a period may not be the same as the cash paid for that item during the period. Accruals
accounting clearly also applies to recognition of expenses.
matching convention
The accounting convention which holds that, in measuring income, expenses
should be matched to the revenues they helped generate in the same accounting
period as those revenues were realised.
1. the cash payments are the same as the expenses incurred (benefits used up or consumed)
2. the cash payments are less than the expenses incurred, or
3. the cash payments exceed the expenses incurred.
The first possibility poses no problems, as the expense that is recognised on an accrual basis is the same
as the cash paid. However, with the other possibilities, the expense recognised on an accrual basis is not
the same as the cash paid. We will review these two in more detail.
Remember that for the accrual method of recognising expenses, the expense is recognised when it is
incurred (i.e. the economic benefits are used up).
EXAMPLE
3.4
Domestic Ltd, a retailer, sells household electrical appliances. It pays its sales staff a commission
of 2% of sales revenue generated. Total sales revenue for past year amounted to $300,000. This
will mean that the commission to be paid in respect of the sales for the year will be $6,000.
However, by the end of the year, the amount of sales commission that had actually been paid to
staff was only $5,000. If the business reported just the amount paid, it would mean that the income
statement would not reflect the full expense for the year. This would contravene the matching
convention, because not all of the expenses associated with the revenue of the year would have
been matched in the income statement. Also, the justification for the commission is clear, and it is
measurable with accuracy. So the adjustment needed is as follows:
Sales commission expense in the income statement will include the amount paid plus the
amount outstanding (i.e. $6,000=$5,000+$1,000).
The amount outstanding ($1,000) represents an outstanding liability at the end of the year and
will be included under the heading accrued expenses , or ‘accruals’, in the statement of
financial position. As this item will have to be paid within 12 months of the year-end, it will be
treated as a current liability.
The cash will already have reduced to reflect the commission paid ($5,000) during the period.
accrued expenses
Expenses that are outstanding at the end of the accounting period.
This illustrates the main points of Example 3.4 . We can see that the sales commission expense
of $6,000 (which appears in the income statement) is made up of a cash element of $5,000 and an
accrued element of $1,000. The cash element appears in the statement of cash flows, and the
accrued element will appear as a year-end liability in the statement of financial position.
When the outstanding sales commission is paid (probably in the next quarter):
EXAMPLE
3.5
Domestic Ltd has reached the end of its reporting period and has paid for electricity for only the
first three quarters of the year (amounting to $1,900). This is simply because the electricity
company has only just sent out bills for the quarter that ends on the same date as Domestic Ltd’s
year-end. The amount of Domestic Ltd’s bill for this last quarter is $500. In this situation, the
amount of the electricity expense outstanding is dealt with as follows:
Electricity expense in the income statement will include the amount paid, plus the amount of the
bill for the last quarter (i.e. $1,900+$500=$2,400) in order to cover the whole year.
The amount of the outstanding bill ($500) represents a liability at the end of the year, and so
will be included under the heading ‘accruals’ or ‘accrued expenses’ in the statement of financial
position. This item would normally have to be paid within 12 months of the year-end, and will,
therefore, be treated as a current liability.
The cash will already have been reduced to reflect the amount ($1,900) paid for electricity
during the period.
This treatment will mean that the correct figure for the electricity expense for the year will be
included in the income statement. It will also have the effect of showing that, at the end of the
reporting period, Domestic Ltd owed the amount of the last quarter’s electricity bill. Dealing with the
outstanding amount in this way reflects the dual aspect of the item and will ensure that the
accounting equation is maintained.
Domestic Ltd may wish to draw up its income statement before it is able to discover how much it owes for
the last quarter’s electricity. In this case it is quite normal to make a reasonable estimate of the amount of
the bill, and to use this estimated amount as described above. The accrual will then be paid in the
following year, reducing both cash (an asset) and the accrual (liability).
Examples of other expenses for a retailer that cannot be linked directly to sales revenue, and for which
matching will therefore be done on a time basis, include rent and rates, insurance, interest payments and
licence fees.
EXAMPLE
3.6
Domestic Ltd pays rent for its premises quarterly in advance (on 1 January, 1 April, 1 July and 1
October). On the last day of the accounting year (31 December), it pays the next quarter’s rent to
the following 31 March ($3,000), which is a day earlier than required. This means that a total of five
quarters’ rent has been paid during the year. If the business reported the cash paid in the income
statement, this would be more than the full expense for the year. This treatment would also
contravene the matching convention and the transaction recognition criterion, because a higher
figure than the expenses associated with the income of the year would appear in the income
statement.
Reduce cash to reflect the full amount of the rent paid during the year (i.e. 5×$3,000=$15,000).
Show the rent for four quarters as the appropriate expense in the income statement (i.e. 4×
$3,000=$12,000).
Show the quarter’s rent paid in advance ($3,000) as a prepaid expense under assets in the
statement of financial position. It is an asset because it represents future economic benefits in
terms of the right to use the rented premises for the first three months of the next year. Please
note that this example ignores GST, which would apply to commercial rentals. The prepaid
expense will appear as a current asset in the statement of financial position, under the heading
‘prepaid expenses’ or ‘prepayments’.
prepaid expenses
Expenses that have been paid in advance at the end of the reporting
period.
In the next period, this prepayment will cease to be an asset and become an expense in the
income statement of that period when the three months’ usage expires. This is because the rent
prepaid relates to that period, and will be ‘used up’ during it.
In practice, the treatment of accruals and prepayments will be subject to the materiality convention in
accounting. This convention states that, where the amounts involved are immaterial (insignificant), we
should consider only what is expedient. This may mean that an item will be treated as an expense in the
period in which it is paid, rather than being strictly matched to the income to which it relates. For example,
a business may find that, at the end of an accounting period, there is a bill of $5 owing for stationery used
during the year. The time and effort involved in recording this as an accrual would have little effect on the
measurement of profit or financial position for a business of any size, and so it would be ignored when
preparing the income statement for the period. Presumably the bill would be paid in the following period
and therefore it would be treated as an expense of that period.
materiality convention
The convention that says items need to be separately disclosed if they will be
seen as important (material) by users. Items not deemed to be important enough
to justify separate disclosure can be grouped together.
Activity 3.3
A business commences on 1 January. During the course of the first six months the following transactions
occurred.
1. Sales of $200,000 were made, of which 80% were paid in cash by the end of the period.
2. Rent of $21,000 was paid, covering the period to the end of July.
3. Insurance, amounting to $2,000, was paid for the year.
4. Loan interest of $5,000 was paid, covering the first five months of the year.
5. Electricity bills, amounting to $800, were received and paid for during the period ending on 30
April. No other bills were received by the end of the six months.
6. A number of subscriptions covering the entire year were received, amounting to $2,000.
Show how these transactions will appear in the income statement for the first six months of business, and
on the statement of financial position as at 30 June.
These points are reflected in the accruals convention of accounting, which asserts that profit is the
excess of revenue over expenses for a period, not the excess of cash receipts over cash payments.
Leading on from this, the approach to accounting that is based on the accruals convention is frequently
referred to as accruals accounting . The statement of financial position and the income statement are
both prepared on the basis of accruals accounting.
accruals convention
A convention that asserts that profit is the excess of revenue over expenses for a
period, not the excess of cash received over cash paid.
accruals accounting
The system of accounting that adheres to the accruals convention. This system is
followed in preparing the statement of financial position and the income
statement.
Interestingly, until recently many public-sector organisations have continued using cash-based accounting
systems, where cash receipts are compared with cash outgoings. There is considerable pressure for
change.
Concept check 6
Revenue is generally recognised when:
A. An order is placed by a customer (e.g. you book your flight to Hong Kong)
B. Payment is made
C. The good is delivered or service provided (e.g. on the day of your flight)
D. Any of the above
E. At the date when the income statement is prepared.
Concept check 7
Criteria considered when recognising revenue include:
A. That it is likely the business will be paid
B. That the amount of revenue can be determined
C. That ownership and control pass to the buyer
D. All of the above
E. Some but not all of the above.
Concept check 8
Which of the following businesses will have the least problems with revenue recognition?
A. A fast food restaurant
B. An airline
C. An accountant
D. A winery
E. A toothpaste manufacturer.
Profit measurement and the calculation of
depreciation
LO 4 Explain the concept of depreciation and its impact on the financial statements
The expense of depreciation , which appeared in the income statement for Better-Price Stores, is an
example of a deferred expense, where the cash is paid in advance of the expense being recognised.
Non-current assets (normally with the exception of freehold land) do not have a perpetual existence. They
are eventually used up in the process of generating income for the business. This ‘using up’ may relate to
physical deterioration (as with a motor vehicle). It may, however, be linked to obsolescence (as with some
IT software that is no longer useful) or the mere passage of time (as with a purchased patent, which has a
limited period of validity).
depreciation
A measure of that portion of the cost (less residual value) of a fixed asset that has
been expensed during an accounting period.
In essence, depreciation is an attempt to measure that portion of the cost (or fair value) of a non-current
asset that has been depleted in generating the revenue recognised during a particular period.
Depreciation tends to be relevant to both tangible non-current assets (property, plant and equipment) and
intangible non-current assets (e.g. a licence to operate a mobile phone business). We should be clear
that the principle is the same for both of these types of non-current asset.
Some non-current assets could have perpetual useful lives. These might include land and acquired
goodwill. These assets are typically not depreciated.
In the case of intangibles, we usually refer to the expense as amortisation , rather than ‘depreciation’.
In the interests of brevity, however, we shall use the word ‘depreciation’ for both tangibles and intangibles.
amortisation
The writing down of an asset—usually an intangible asset—as its benefit is used
up; the equivalent of the depreciation for a non-current asset.
In effect, depreciation is a cost allocation process, as the appropriate portion of cost that has been used
up can only be an estimate. Management estimates how much of the economic benefits of the related
asset have been used up during the period. The depreciation charge (the measure of the economic
benefits used up) is considered to be an expense of the period to which it relates.
Calculating depreciation
To calculate a depreciation expense for a period, four factors have to be considered:
EXAMPLE
3.7
Dalton Engineering Ltd purchased a new car for its marketing director. The invoice received from
the car supplier revealed the following:
$ $
Petrol 30
Registration 500
Plates 200
2,090
26,090
$ $
Plates 200
1,560
25,560
These costs include the delivery costs and plates as they are an integral part of the asset.
Improvements (alloy wheels and sunroof) are also regarded as part of the total cost of the car. The
petrol costs and registration, however, represent a cost of operating the asset rather than a part of
the total cost of acquiring the asset and making it ready for use, so these amounts will be charged
as an expense in the period incurred (although part of the cost of the registration may be regarded
as a prepaid expense if the period of the registration goes beyond the end of the current financial
year). The trade-in figure shown is part-payment of the total amount outstanding, and is not
relevant to a consideration of the total cost.
The fair value of an asset was defined in Chapter 2 as the exchange value that could be obtained in an
arm’s length transaction. Revaluations upwards from cost only occur if the fair value can be measured
reliably. They are quite common with regard to certain types of assets (e.g. buildings), but are rare with
regard to intangible non-current assets. Where fair values have been used, the depreciation expense
should be based on those fair values, rather than on the historic costs.
residual value
The expected value at the end of the useful life of a non-current asset.
Depreciation method
Once the amount to be depreciated (i.e. the cost or fair value of the asset less any residual value) has
been estimated, the business must select a method of allocating this depreciable amount between the
reporting periods covering the asset’s useful life. There are various ways in which this can be done. The
two most common methods are:
Straight-line depreciation simply allocates the amount to be depreciated evenly over the useful life of
the asset. In other words, there is an equal depreciation expense for each year that the asset is held.
Example 3.8 illustrates how this works.
straight-line depreciation
A method of accounting for depreciation that allocates the amount to be
depreciated evenly over the useful life of the asset.
EXAMPLE
3.8
Consider the following information:
To calculate the depreciation expense for each year, the total amount to be depreciated must be
calculated. This will be the total cost less the estimated residual value: $40,000−$1,024=$38,976.
Having done this, the annual depreciation charge can be derived by dividing the amount to be
depreciated by the estimated useful life of the asset of four years. The calculation is, therefore:
$38,976/4 = $9,744
Thus, the annual depreciation expense which appears in the income statement in relation to this
asset will be $9,744 for each of the four years of the asset’s life.
The amount of depreciation relating to the asset will be accumulated for as long as the asset
continues to be owned by the business or until the accumulated depreciation amounts to the cost
(or fair value) less the residual value. This accumulated depreciation figure will increase each year
as a result of the annual depreciation expense in the income statement. This accumulated amount
will be deducted from the cost (or fair value) of the asset on the statement of financial position.
Thus, for example, at the end of the second year the accumulated depreciation will be
$9,744×2=$19,488 and the asset details will appear on the statement of financial position as
follows:
$ $
20,512
The balance of $20,512 shown in Example 3.8 is referred to as the written-down value or net
book value or carrying amount of the asset. It represents that portion of the cost (or fair value) of
the asset which has still to be written off (or allocated against future income generated from using the
asset). This figure does not represent the current market value, which may be quite different. The only
point at which the carrying amount is intended to equal the market value of the asset is immediately
before it is to be disposed of. Thus, in Example 3.8 , at the end of the four-year life of the machine, the
carrying amount would be $1,024—its estimated disposal value. Disclosure of the two component parts of
the written-down value is generally considered to provide useful information as compared with disclosure
of just a single figure.
written-down value
The cost or fair value of an asset less the accumulated amount written off as
depreciation to date.
carrying amount
The net book value shown in the statement of financial position at a point of time.
The straight-line method derives its name from the fact that the written-down value of the asset at the end
of each year, when graphed against time, will result in a straight line, as shown in Figure 3.3 .
Figure 3.3 Graph of written-down value against time using the straight-line depreciation method
The figure shows that the written-down value of the asset declines by a constant amount each year. This
is because the straight-line depreciation method provides a constant depreciation charge each year. The
result, when plotted on a graph, is a straight line.
accelerated depreciation
An approach to the calculation of depreciation expense that results in depreciation
expenses being higher in the early years of an asset’s life than in later years.
reducing-balance method
A method of depreciation in which a fixed percentage is applied to the written-
down value of the asset.
Deriving the fixed percentage to be applied requires the use of the following formula:
P=(1−RCn)×100%
where
p=the depreciation percentagen=the useful life of the assets (in years)R=the residual value of the assetC=
The fixed percentage rate will be given in all examples used in this text.
To illustrate this method, let us take the same information used in Example 3.8 , but this time use a
fixed percentage (60%) of the written-down value to determine the annual depreciation charge. The
calculations are shown in Example 3.9 .
EXAMPLE
3.9
$
We can see that the pattern of depreciation is quite different between the two methods. If we plot the
written-down value of the asset derived by using the reducing-balance method against time, the result will
be as shown in Figure 3.4 .
Figure 3.4 Graph of written-down value against time using the reducing-balance depreciation
method
The figure shows that, under the reducing-balance depreciation method, the written-down value of an
asset falls by a larger amount in the earlier years than in the later years. This is because the depreciation
charge is based on a fixed-rate percentage of the written-down value.
Other methods are clearly available. One interesting method is ‘use of units of production based
depreciation’—the depreciation expense allocated to each period reflects the portion of the asset’s total
available capacity that has been ‘used up’ in the current period (e.g. kilometres travelled, units produced,
hours of operation). Under this method, the useful life of the asset changes from ‘time’ to ‘output’.
At this point it is probably useful to consider the impact that the use of the different depreciation methods
has on profit. Let us assume that the machine used in the previous two examples was owned by a
business that made a profit before depreciation of $20,000 for each of the four years in which the asset
was held. The impact on profit is shown below.
STRAIGHT-LINE METHOD
$ $ $
38,976 41,024
REDUCING-BALANCE METHOD
$ $ $
38,976 41,024
The above calculations reveal that the straight-line method of depreciation results in a constant profit
figure over the four-year period. This is because both the profit before depreciation and the depreciation
charge are constant over the period. The reducing-balance method, however, results in a changing profit
figure over time. In the first year a net loss is reported, and thereafter a rising profit is reported.
Although the pattern of profit over the individual periods will be quite different, depending on the
depreciation method used, the total profit for the four-year period will remain the same. This is because
the two methods of depreciation will allocate the same amount of total depreciation over the four-year
period. It is only the amount allocated between years that will differ.
In practice, the use of different depreciation methods may not have such a dramatic effect on profits as
suggested above. This is because businesses typically have more than one depreciating non-current
asset. Where a business replaces some of its assets each year, the total depreciation charge calculated
under the reducing-balance method (or the units of production approach mentioned above) will reflect a
range of charges (from high through to low), as assets will be at different points in the replacement cycle.
This could mean that the total depreciation charge under these methods may not significantly differ from
the total depreciation charge that would be derived under the straight-line method.
There is an International Financial Reporting Standard (or International Accounting Standard) to deal with
the depreciation of property, plant and equipment. As we shall see in Chapter 5 , the purpose of
accounting standards is to narrow areas of accounting difference and to try to ensure that information
provided to users is transparent and comparable. The relevant standard endorses the view that the
depreciation method chosen should reflect the pattern of economic benefits provided, but does not
specify particular methods to be used. It states that the useful life, depreciation method and residual
values of non-current assets should be reviewed at least annually, and adjustments made where
appropriate. For intangible non-current assets with finite lives, there is a separate standard containing
broadly similar rules. It does state, however, that the straight-line method must be chosen where the
pattern of consumption of economic benefits is not clear.
Figure 3.5 provides an overview of the depreciation process related to non-current assets.
Where an asset is to be replaced, the depreciation expense in the income statement will not ensure that
liquid funds are set aside specifically for this purpose. Although the depreciation expense will reduce
profit, and therefore reduce the amount that the owners may decide to withdraw, the amounts retained
within the business as a result may be invested in ways that are unrelated to the replacement of the
asset.
Making different judgements on these matters will produce a different pattern of depreciation expense
over the life of the asset and, therefore, a different pattern of reported profits. However, any under- or
over-estimations made in this context will be adjusted for in the final year of an asset’s life (as a gain or
loss on disposal), so the total depreciation charge (and total profit) over the asset’s life will not be affected
by estimation errors.
Activity 3.4
Sally Dalton (Packaging) Ltd bought a machine for $40,000. At the end of its useful life of four years, the
amount received on sale was $4,000. When the asset was bought, the business received two estimates
of the likely residual value of the asset, which were: (a) $8,000 and (b) zero.
Show the pattern of annual depreciation expenses over the four years, and the total depreciation
expenses for the asset under each of the two estimates. The straight-line method should be used to
calculate the annual depreciation expenses.
The final adjustment for under-depreciation of an asset is often referred to as ‘loss (or deficit) on sale of
non-current asset’, as the amount actually received is less than the residual value. Similarly, the
adjustment for over-depreciation is often referred to as ‘profit (or surplus) on sale of non-current asset’.
These final adjustments are normally made as an addition to the expense (or a reduction in the expense)
for depreciation in the reporting period of disposal of the asset.
Reflection 3.4
You are part of the management team of a small regional airline. The team is considering its
depreciation policy regarding its fleet of aircraft. What factors might influence its decision?
Concept check 9
Depreciation can be caused by which of the following?
A. The passage of time
B. The physical deterioration of an asset
C. Obsolescence
D. A decision by management to replace an asset
E. All of the above.
Concept check 10
The calculation of depreciation expense requires knowledge of:
A. The current fair value of the asset
B. The useful life of the asset and its residual value at the end of its useful life
C. The depreciation method to be used
D. All of the above
E. Some of the above.
Profit measurement and the valuation of inventory
LO 5 Identify the main issues relating to inventory in the context of the income statement and the
statement of financial position
As with non-current assets, inventory represents another example of a deferred expense, where the
payment for the inventory precedes the recognition of the expense. The valuation of inventory and its
impact on profit measurement raise the following issues:
What is inventory?
What is the cost of inventory?
What is the basis for transferring the inventory cost to cost of sales?
What is the net realisable value of inventory?
What is inventory?
Inventory for accounting purposes consists of finished goods (e.g. merchandise for a retailer), raw
materials (e.g. inputs to the manufacturing process—metal, paint, timber), stores or supplies (e.g.
consumables—paper, cleaning liquid), and work-in-progress (e.g. partly finished goods of a
manufacturer).
cost of purchase—which would include the purchase price, government taxes and duties, and freight-
inwards costs
costs of conversion—which would largely concern goods being manufactured, including both costs
that can be readily or physically traced to the product and others that cannot be obviously traced to the
product (these latter costs are referred to as ‘indirect costs’ or ‘overheads’), and
other costs incurred to bring the inventories to their present location and condition—which could
include things such as storage, security and display.
The ‘cost of inventory’ for profit measurement implies that any costs included in inventory will be deferred
as an asset (inventory), and not recognised as an expense until the inventory is sold (cost of goods sold)
or written down (inventory write-down). Costs that are not included in inventory will be recognised
immediately as expenses.
To calculate the cost of inventories, an assumption must be made about the physical flow of inventories
through the business. This assumption need not have anything to do with how inventories actually flow
through the business; it is concerned only with providing useful measures of performance and position.
1. first in, first out (FIFO) —the earliest inventories held are the first to be used
2. last in, first out (LIFO) —the latest inventories held are the first to be used
3. weighted average cost (AVCO) —inventories entering the business lose their separate identity
and go into a ‘pool’; any issues with inventories then reflect the average cost of the inventories that
are held.
During a period of changing prices, the choice of assumption used in costing inventories can be
important. Example 3.10 provides a simple illustration of how each assumption is applied, and the
effect of each on financial performance and position.
Let us now use this information to calculate the cost of goods sold and the closing inventory figures for
the business. The example shows that purchases of 14,000 tonnes were made, that 9,000 tonnes were
used up and sold, and 5,000 tonnes remained as closing inventory. The question is, what value do we put
on the 9,000 tonnes which were sold, and what value on the closing inventory?
EXAMPLE
3.10
A business supplying coal to factories has the following transactions during a period.
14,000
6 Sold 9,000
NO. OF COST OF SALES COST PER NO. OF CLOSING INVENTORY COST PER
TONNES TONNE TOTAL TONNES TONNE TOTAL
$ $ $ $ $
2 5,000 11 55,000
3 3,000 12 36,000 5,000 12 60,000
NO. OF COST OF SALES COST PER NO. OF CLOSING INVENTORY COST PER
TONNES TONNE TOTAL TONNES TONNES TOTAL
$ $ $ $
1 – – 1,000 10 10,000
$ $
2 5,000 11 55,000
3 8,000 12 96,000
14,000 161,000
NO. OF COST OF SALES COST PER TOTAL NO. OF CLOSING INVENTORY COST TOTAL
TONNES TONNE TONNES PER TONNE
$ $ $ $
Activity 3.5
Suppose that the 9,000 tonnes of inventory (coal) were sold for $15 per tonne.
a. Calculate the gross profit for the period under each of the three methods.
b. How is the financial position affected by each method when prices are rising?
c. Assume that prices are falling rather than rising. How would the financial performance and position
differ under the various inventory valuation methods?
It is important to recognise that the different inventory cost allocation methods will affect only the reported
profit between years. The figure derived for closing inventory will be carried forward and matched with
sales in a later period. Thus, if the cheaper purchases of inventory are matched to sales in the current
period, it will mean that the dearer purchases will be matched to sales in a later period. Over the life of the
business, therefore, the total profit will be the same whichever cost allocation method has been used.
In reviewing the different cost allocation methods, we have used a very simple method under which all
inventory purchases occur before any sales arise. In reality, the sales and purchases will be interspersed
over the period. This leads us to consider briefly the two main inventory recording systems:
Accounts
The implication of the perpetual inventory system for cost allocation is that for the LIFO and average
approaches the appropriate costing is determined progressively over time and not at the end of the
period.
(+) Purchases x
= Cost of sales x
The closing inventory is found by a physical stocktake. All the other figures will be collected in the course
of the year, and used alongside the physical stocktake to calculate the cost of sales. Under this system it
is not directly possible to determine stock losses, as the assumption is that stock not on hand must have
been sold (i.e. is in cost of sales).
Reflection 3.5
You are managing a sports shop. Are you happy to operate using the periodic approach to
inventory? Why/why not?
There is an International Financial Reporting Standard that deals with inventories. It states that, when
preparing financial statements for external reporting, the cost of inventories should normally be
determined using either FIFO or AVCO. The standard also requires the ‘lower of cost and net realisable
value’ rule to be used, and so endorses the application of the prudence convention. The LIFO assumption
is not acceptable for external reporting.
Inventory valuation provides a further example of the judgement required to derive the figures for
inclusion in the financial statements. The main areas are: the choice of cost method (FIFO, LIFO, AVCO);
deciding which items should be included in the cost of inventory (particularly for work-in-progress and the
finished goods of a manufacturing business); and deriving the net realisable value figures for inventory
held.
Inventory valuation and depreciation provide two examples of where the consistency convention
should be applied. This convention holds that when a particular method of accounting is selected to deal
with a transaction, this method should be applied consistently over time. Thus, it would not be usual to
switch from, say, FIFO to AVCO between periods. The purpose of this convention is to try to ensure that
users can make valid comparisons between periods. Where changes of this type do occur, appropriate
disclosures regarding the reasons and effects are required.
consistency convention
The accounting convention which holds that when a particular method of
accounting is selected to deal with a transaction, this method should be applied
consistently over time.
One final point before leaving this topic. Costing inventories using FIFO, LIFO or AVCO applies to items
that are interchangeable. Where they are not, as would be the case with custom-made items, the specific
cost of the individual items must be used.
Concept check 11
Which of the following would NOT be included as a cost of inventory?
A. Delivery cost (e.g. freight outward)
B. Purchase cost
C. Import taxes
D. Shipping costs (e.g. freight inward)
E. None of the above. All are costs of inventory.
Concept check 12
Which of the following statements is NOT an inventory flow assumption?
A. FIDO
B. LIFO
C. Weighted average cost
D. All of the above
E. None of the above.
Concept check 13
Fickle Company wishes to change their inventory flow assumption. Which accounting
convention or principle limits their ability to do so?
A. Historical cost
B. Matching
C. Prudence
D. Consistency
E. Conservatism.
Profit measurement and the problem of bad and
doubtful debts
LO 6 Identify the main issues regarding receivables in terms of revenue and expense recognition, and
explain their impact on the income statement and the statement of financial position
However, with this type of sale, there is always that risk that the customer will not pay the amount due.
When it is reasonably certain that the customer will not pay, the debt is considered to be ‘bad’, and this
must be taken into account when preparing the financial statements. If the bad debt were not taken into
account, the effect would be to overstate the assets (receivables) on the statement of financial position
and the profit in the income statement, as the sale (which has been recognised) will not result in any
future benefits arising.
Real World 3.3 provides evidence as to the size of the problem in the United Kingdom.
In the United Kingdom, SMEs (small- and medium-sized organisations) wrote off £5.8 billion in
2016 as bad debts. There were more than a million such companies.
According to a YouGov poll of senior SME decision-makers, carried out for insurer Direct Line,
almost one in five (19%) had cancelled an average £31,330 of unpaid bills, while almost one in 10
(9%) had stopped pursuing debts in excess of £100,000.
Direct Line for Business head Nick Breton said: ‘With more than one million SMEs based across
the UK, these enterprises really do make up the backbone of the British economy. All of these
debts add up—and with nearly 7,000 companies estimated to have entered liquidation in the first
half of 2016 alone, the potentially disastrous knock-on effects of writing off monies owed are clear.’
1. Overall, 82% of SMEs currently have outstanding balances, with each firm owed an
average £62,957.
2. 40% of respondents do not even know the full value of monies owed them.
3. 29% said they were highly unlikely to receive monies owed because key trading partners
had become insolvent.
4. 17% had given up on debts because they suspected the purchaser would not have
sufficient funds to cover them.
5. Almost two-thirds (65%) said that they were unsure about the function and purpose of the
form used in the UK to initiate a civil claim in the UK court system.
The poll’s findings chime with other, recent research in the field, including a Bibby Financial
Services (BFS) report of early August, which showed that 27% of UK SMEs had written off bad
debts in the preceding 12 months.
According to BFS, that equates to 1.4 million SMEs suffering from bad-debt problems over the past
year—with transport and construction emerging as the worst-affected sectors.
BFS Global chief executive David Postings said that bad debt was a ‘chronic problem’ for SMEs
that could lead to ‘staff cuts, delayed investment plans and—at worst—insolvency’.
Source: Extracts from The Treasurer, Association of Corporate Treasures 2017, ‘UK SMEs write off £5.8bn of bad debt: Poll shows small firms are walking away
from bad debt in droves, with almost one in 10 scrapping bills worth more than £100,000’, https://www.treasurers.org/uk-smes-write-%C2%A358bn-bad-debt.
We shall find that similar issues arise elsewhere in the world (see Real Worlds 6.1 , Real Worlds
13.5 and Real Worlds 13.6 ).
To provide a more realistic picture of financial performance and financial position, any bad debts must
be written off. This will involve:
increasing expenses (by creating an expense known as ‘bad debts written off’, or simply ‘bad debts’),
and
reducing accounts receivable (debtors)
bad debts
Amounts owed to a business that are considered to be irrecoverable.
The matching convention requires that, where possible, the bad debt be written off in the same period as
that of the sale that gave rise to the debt. Note that when a debt is bad, the accounting response is not
simply to cancel the original sale. If we did this, the income statement would not be so informative.
Reporting the bad debts as an expense can be extremely useful in evaluating management performance,
particularly credit-granting policies.
At the end of the accounting period it may not be possible to identify, with reasonable certainty, all of the
bad debts that have been incurred during the period. It may be that some debts are unlikely to be
collected, but only at some later point in time will the true position become clear. Such uncertainty does
not mean that when preparing the financial reports we should ignore the possibility that some of the
accounts receivable outstanding will eventually prove to be bad. It would not be prudent to do so, nor
would it comply with the need to match expenses to the period in which the associated sale is recognised.
As a result, the business will normally try to identify all of those debts that at the end of the period can be
classified as ‘doubtful’ (i.e. they may eventually prove to be bad). The determination of doubtful debts is
normally achieved either on the basis of the credit sales or by analysing the balances outstanding from
accounts receivable.
With a credit sales approach, a given percentage based on past experience and current expectations is
often applied to the credit sales figure (or, probably more commonly, to the balance of accounts
receivable) to determine the doubtful debts expense. Analysis of the balances outstanding in accounts
receivable may involve making an account-by-account analysis of individual accounts receivable, or
categorising the total ‘accounts receivable outstanding’ balance in terms of how long the amounts have
been outstanding. This will be dealt with in more detail in Chapter 13 .
Analysis using either the percentage of credit sales or the aged listing of accounts receivable will
determine the amount of the accounts receivable balance that is not expected to be received. This will be
recorded as:
an expense labelled ‘doubtful debts expense’ to be included in the income statement, and
a deduction from the accounts receivable account labelled ‘allowance for doubtful debts’ to be
included in the statement of financial position.
By recognising doubtful debts we take full account, in the appropriate accounting period, of those
accounts receivable for which there is a risk of non-payment. This accounting treatment of doubtful debts
will occur in addition to the treatment of bad debts described earlier. Example 3.11 illustrates the
reporting of bad and doubtful debts.
EXAMPLE
3.11
Boston Enterprises has accounts receivable of $350,000 at the end of the accounting year to 30
June 2020. Investigation of these accounts receivable reveals that $10,000 is likely to prove
irrecoverable, and that recovery of a further $30,000 is doubtful.
BOSTON ENTERPRISES
Income statement (extracts)
for the year ended 30 June 2020
$
*
Accounts receivable 340,000
310,000
*
(i.e. $350,000−$10,000)
The allowance for doubtful debts is, of course, an estimate and it is quite likely that the actual
amount of debts that ultimately prove to be bad will be different from the estimate. Any difference
will normally be adjusted in the following year’s accounts.
Activity 3.6
Clayton Conglomerates had debts outstanding at the end of the accounting year to 30 June 2020 of
$870,000. You believed that $40,000 of those debts were irrecoverable, and that a further $60,000 were
doubtful. In the subsequent period, it was found that an over-estimate had been made and that only a
further $45,000 of debts actually proved to be bad.
Show the relevant extracts in the income statement for both 2020 and 2021 to report the bad debts
written off and the allowance for doubtful debts. Also show the relevant statement of financial position
extract as at 30 June 2020.
Bad and doubtful debts represent a further area where judgement is required for deriving expenses
figures for a particular period. Judgement is often required to derive a figure for bad debts incurred during
a period. Views may differ over whether or not a debt is irrecoverable. The decision whether or not to
write off a bad debt will affect the expenses for the period and, hence, the reported profit.
The implications of this for accounting for bad and doubtful debts are:
in calculating the bad and doubtful debts expense, consideration will be given to the amount expected
to be recovered—this is essentially the same as what has already been discussed under the
traditional approach
the name of the bad and doubtful debts expense may be changed to ‘impairment loss’ on accounts
receivable
the reduction in receivables, typically called ‘allowance for doubtful debts’, may be changed to
‘allowance for impairment loss’, and
the asset (accounts receivable) will be said to be recorded on the basis of unimpaired cost; that is, it
will be recorded on the basis of cost that has not been written down for impairment.
Depreciation
‘Depreciation is calculated to expense the cost of items of property, plant and equipment
(excluding freehold land) less their estimated residual values on a straight-line basis over their
estimated useful lives.’
‘Depreciation rates and methods, useful lives and residual values are reviewed at each balance
sheet date. When changes are made, adjustments are reflected prospectively in current and future
years only.’
For each class of assets the following depreciation and amortisation rates are used: buildings 1–
10%; mineral reserves and licences 1–5%; plant and equipment 5–33.3%.
Receivables
‘Trade and other receivables are initially recognised at fair value plus any directly attributable
transaction costs. Subsequent to initial measurement they are measured at amortisation cost less
any provisions for expected impairment losses or actual impairment losses. …
‘The Group has considered the collectability and recoverability of trade receivables. An allowance
for doubtful debts has been made for the estimated irrecoverable trade receivable amounts arising
from the past rendering of services, determined by reference to past default experience along with
an expected impairment loss calculation which considers the past events, and exercises
judgement over the impact of current and future economic conditions when considering the
recoverability of outstanding trade receivables at the reporting date. Subsequent changes in
economic and market conditions may result in the provision for impairment losses increasing or
decreasing in future periods.’
Inventories
‘Inventories are valued at the lower of cost and net realisable value. Net realisable value
represents the estimated selling price less all estimated costs of completion and costs to be
incurred in marketing, selling and distribution.
‘For land development projects, cost includes the cost of acquisition, development and holding
costs during development. Costs incurred after completion of development are expensed as
incurred.’
Concept check 14
The primary issue with accounting for uncollectable credit sales is:
A. How much expense to recognise
B. Determining why the sale was made
C. Determining when to recognise the bad debt expense
D. Determining which accounts are ‘bad’
E. All of the above.
Concept check 15
The ‘Allowance for doubtful debts’ account is what kind of account?
A. Expense
B. Asset (i.e. contra-asset)
C. Liability
D. Revenue
E. Liability (i.e. contra-liability)
Preparing an income statement from relevant
financial information
LO 7 Prepare a simple income statement from relevant financial information
Given that this book is targeted at users of accounting information we do not expect you to be especially
proficient in preparing accounts from a list of transactions. However, this section provides an opportunity
for you to work through a small number of practical activities and exercises with the aim of reinforcing
your understanding of the basic principles. This should enable you to better understand the end products,
the final income statement and the statement of financial position.
It is suggested that you work through Activity 3.7 . Giving yourself plenty of paper to work on, set out a
statement of financial position and an income statement, and work through each transaction, noting the
impact of each transaction on the face of the statements. You will probably find it useful to record items in
two columns—a ‘+’ column and a ‘-’ column—for each item in each statement. When you have completed
this, total the items and the end result should be clear. If necessary, use the approach in the solution to
assist you with other exercises.
Activity 3.7
TT Motors is a new business that started trading on 1 January 2020. The following is a summary of
transactions that occurred during the first year of trading:
1. The owners introduced $70,000 of capital, which was paid into a bank account opened in the name
of the business.
2. Premises were rented from 1 January 2020 at an annual rental of $20,000. During the year, rent of
$25,000 was paid to the owner of the premises.
3. Rates on the premises were paid during the year as follows:
For the period 1 January 2020 to 31 March 2020—$500.
4. A delivery vehicle, bought on 1 January for $32,000, is expected to be used in the business for four
years and then sold for $16,000.
5. Wages totalling $33,500 were paid during the year. At the end of the year, the business owed $630
of wages for the last week of the year.
6. Electricity bills for the first three quarters of the year were paid, totalling $1,650. After 31 December
2020, but before the accounts had been finalised for the year, the bill for the last quarter arrived
showing a charge of $620.
7. Inventory totalling $143,000 was bought on credit.
8. Inventory totalling $12,000 was bought for cash.
9. Sales on credit totalled $152,000 (cost $74,000).
10. Cash sales totalled $35,000 (cost $16,000).
11. Receipts from accounts receivable totalled $132,000.
12. Payments to accounts payable totalled $121,000.
13. Vehicle running expenses paid totalled $9,400.
At the end of the year it was clear that an accounts receivable of $400 would not be paid.
Prepare a statement of financial position as at 31 December 2020, and an income statement for the year
to that date.
Concept check 16
The owners’ contribution of capital to open the business bank account will result in which of
the following?
A. An increase in both revenue and equity
B. An increase in revenue and a decrease in equity
C. An increase in cash and a decrease in equity
D. An increase in cash and an increase in equity
E. An increase in both cash and revenue.
Concept check 17
Inventory purchased on credit:
A. Increases the amount of assets
B. Increases the amount of liabilities
C. Increases the amount of equity
D. Some of the above
E. None of the above.
SELF-ASSESSMENT QUESTION
3.1
The following is the statement of financial position of TT Motors at the end of its first year of trading
(from Activity 3.7 ):
TT MOTORS
Statement of financial position
as at 31 December 2020
$ $
Current assets
Inventory 65,000
90,650
Non-current assets
28,000
Current liabilities
23,250
Owners’ equity
95,400
Prepaid expenses included $5,000 for rent and $300 for rates.
The income statement, like the statement of financial position, has been around for a long time, and most
major businesses seem to prepare an income statement on a frequent basis (monthly or even more
frequently). This clearly suggests that the income statement is regarded as providing useful information.
In particular, this statement should help in providing information on how effective the business has been
in generating wealth and how the profit was derived.
Since wealth generation is the primary reason for most businesses to exist, assessing how much wealth
has been created is an important issue. The income statement reveals the profit for the period, or the
‘bottom line’, as it is sometimes called. This provides a measure of the wealth created for the owners.
Gross profit and operating profit are also useful measures of wealth creation.
In addition to providing various measures of profit, the income statement provides other information
needed for a proper understanding of business performance. It reveals the level of sales revenue, and the
nature and amount of expenses incurred, which can help in understanding how profit was derived.
EXAMPLE
3.12
Consider the income statement set out below:
PATEL WHOLESALERS
Income statement
for the year ended 31 March 2021
Sales 460,500
Less
The sales figure represents an important measure of production, and can be compared with
sales figures of earlier periods and the planned sales figure for the current period to assess the
achievement of the business.
The gross profit figure can be related to the sales figure to find out the profitability of the goods
sold. The statement above shows that the gross profit is about 25% of the sales figure, or, to
put it another way, for every $1 of sales generated, the gross profit is 25¢. This level of
profitability may be compared with past periods, with planned levels of profitability, or with
comparable figures of similar businesses.
The expenses of the business may be examined and compared with past periods to evaluate
operating efficiency. Individual expenses can be related to sales to assess whether the level of
expenses is appropriate. Thus, for example, in the above statement, the salaries and wages
represent almost 10% of sales, or for every $1 of sales generated, 10¢ is absorbed by
employee costs.
Profit can also be related to sales. In the statement shown above, profit is about 8% of sales.
Thus, for every $1 of sales, the owners of the business benefit by 8¢. Whether or not this is
acceptable will again depend on making the kind of comparisons referred to earlier. Profit as a
percentage of sales can vary substantially between different types of businesses. Usually a
trade-off can be made between profitability and sales volume. Some businesses are prepared
to accept a low profit percentage in return for generating a high volume of sales. At the other
extreme, some businesses may prefer to have a high profit percentage but accept a relatively
low volume of sales. For example, a supermarket may fall into the former category, while a
trader in luxury cars may fall into the latter category.
It should be clear that profit is the difference between revenues and expenses. In assessing the adequacy
of past profit it is necessary to understand just what the nature of the revenues is, as well as the nature of
the expenses. When moving forward, any desired increases in profit require either further development of
revenues and/or continued cost control and cost reduction. Revenues and expenses may not necessarily
be closely connected. Revenues can decrease while costs can also increase. All components of the
income statement need to be continually reviewed if profitability is to be maintained or increased.
Real World 3.5 provides examples of situations where further questions might usefully be asked about
costs and cost reduction, ideas for raising future revenues and strategy generally.
Real world 3.5
Factors that might impact on revenues and expenses
Packaging billionaire Raphael Geminder raised some questions about ‘serious domestic cost
imposts, such as higher energy costs, tax rates and wage rates’. He was concerned about the
need for ‘a clearly articulated strategy on where the country was going to go on a whole bunch of
metrics’.
Source: Damon Kitney, ‘Packaging billionaire: “globally naïve” Australia must address costs’, The Australian, 23 February, 2017.
Woolworths has ‘pinpointed “impulse buying” as an important revenue source for fiscal 2019’. It
plans to work more closely with suppliers ‘to innovate around special occasions’, and ‘has
improved its metrics in the “impulse buy” category, including, measurements of outbound service
levels, store service levels, and stock in hand’.
Source: Eli Greenblat, ‘Woolies acts on impulse buys’, The Australian, 26 September 2018.
Telstra boss Andrew Penn expects consumers will be prepared to pay more for services powered
by 5G. He also anticipates that ‘5G will enable new revenue streams that do not exist today’. It will
also give cost savings ‘by reducing the cost per bit of data travelling over the network’. Additionally,
Mr Penn saw 5G as offering ‘a number of new avenues for Telstra to leverage the reach of its
networks in Australia’.
Source: Supratim Adhikari, ‘Telstra boss Andrew Penn: 5G whiz factor will be a winner’, The Australian, 6 December 2018.
New Coles CEO Steven Cain aims to ‘refresh’ the supermarket chain by stripping out $1 billion in
costs over the next four years, ‘to be reinvested in store refurbishments, an expanded and
improved online offering, and greater and more localised grocery products—all backed by a
futuristic supply chain using greater automation and robots’.
Source: Eli Greenblat, ‘Coles CEO Steven Cain’s $1bn “refresh” gambit’, The Australian, 19 June 2019.
Reflection 3.6
Do you agree with Raphael Geminder that serious domestic cost imposts are a major problem for
the economy? How might you prepare for them if you are running a small or medium-sized
enterprise?
Concept check 18
Analysis of the income statement will NOT provide:
A. Useful information
B. An indication of how profit was derived
C. An indication of the company’s financial position
D. Information about sources of revenue
E. Information about types of expenses.
Real World 3.6 shows the implications of COVID-19 for financial reporting.
A bulletin from PwC reports that the COVID-19 outbreak has had ‘devastating consequences for
communities across the globe’. It describes how containment measures ‘have affected economic
activity, which in turn has implications for financial reporting’. Included among the ‘broad
implications’ are: ‘the ability to forecast cash flows and the related going concern assessment; debt
covenants; hedging and financing; impairment of assets; onerous contracts; and recognition of
revenues’.
Source: Matt Graham, Regina Fikkers, John Dovaston, Chris Dodd, Evan Barron, Jason Perry, ‘Accounting implications of the effects of coronavirus’, PwC Straight
With most companies unlikely to be spared the ‘increased economic uncertainty and risk’ created
by COVID-19 and its containment response, KPMG has put together a checklist that looks at the
consequent ‘significant financial reporting implications’. Areas of change to be alert for include:
the potential impairment of non-financial assets, such as goodwill, intangible assets, and
property, plant and equipment
whether ‘fair values [are being] appropriately determined’
whether there is the potential to recover deferred tax assets using taxable profits
the potential impairment of lease assets
the recoverability of revenue-cycle assets
the potential effect on the capitalisation of borrowing costs
‘how have economic forecasts used to measure expected credit losses been updated’
any reassessments being made of borrowers’ and other debtors’ credit risk
any impacts on hedge accounting
the continued validity of any own use exemptions in contracts
potential changes to the terms of borrowers’ liabilities
the impact of ‘expected credit losses on trade receivables’.
Source: KPMG, ‘COVID-19 financial reporting: resource centre on the financial reporting impacts of coronavirus’, KPMG, 12 April 2020, https://home.kpmg/xx/en/
home/insights/2020/03/covid-19-financial-reporting-resource-centre.html.
Concept check 19
The ‘bottom line’ refers to:
A. Gross profit
B. Operating profit
C. Gross margin
D. Profit for the year
E. All of the above.
Activity 3.8
Chan Exporters provides the following income statement:
CHAN EXPORTERS
Income statement
for the year ending 31 May 2020
Sales 840,000
Less
Insurance (2,000)
In the previous year, sales were $640,000. The gross profit was $200,000 and the net profit was $37,000.
Analyse the performance of the business for the year to 31 May 2020 as far as the information allows.
SELF-ASSESSMENT QUESTION
3.2
The following is a draft set of simplified accounts for Pear Ltd for the year ended 30 September
2020.
PEAR LTD
Income statement
for the year ended 30 September 2020
$’000
Sales 1,456
Less expenses
Salaries (220)
Depreciation (249)
Operating profit 88
Taxation—30% (22)
PEAR LTD
Statement of financial position
as at 30 September 2020
$’000
Current assets
Cash at bank 21
Inventory 207
410
Non-current assets
Cost 1,570
Accumulated depreciation (690)
880
Current liabilities
Tax payable 22
Accounts payable 88
235
Non-current liabilities
Shareholders’ equity
755
1. Depreciation has not yet been charged on office equipment with a written-down value of
$100,000. This class of asset is depreciated at 12% per annum using the reducing-balance
method.
2. A new machine was purchased on credit for $30,000 and delivered on 29 September, but
has not been included in the financial statements.
3. A sales invoice to the value of $18,000 for September has been omitted from the accounts.
(The cost of sales is stated correctly.)
4. A dividend has been proposed of $25,000.
5. The interest expense on the loan for the second half of the year has not been included in
the accounts.
6. A general allowance for doubtful debts is to be made at the rate of 2% of accounts
receivable.
7. An invoice for electricity to the value of $2,000 for the quarter ended 30 September 2020
arrived on 4 October and has not been included in the accounts.
8. The charge for taxation will have to be amended to take into account the above information.
Prepare a revised set of financial statements for the year ended 30 September 2020,
incorporating the additional information in points 1–8.
Assessable Represents the ordinary and statutory income items that are classified as income within the Income Tax
income* Assessment Act 1997. This would include such things as salary and wages, share of partnership profits, interest,
grossed-up dividends, rent, fees for services, taxable capital gains, etc.
Allowable Generally you can claim for expenses that you incur in earning your assessable (taxable) income, but not
deductions* private, domestic or capital expenses.
Deductions might include: certain vehicle and travel expenses; gifts and donations; home office expenses; self-
education expenses; tools, equipment and other assets; and expenses incurred in earning investment income.
You should note that these will depend on your particular circumstances and the conditions under which
payment for these items was made.
Basically, a deduction is an amount that can be taken off your assessable income, thus reducing your tax
liability.
Deductions provide greater benefits to taxpayers with the higher marginal tax rates.
Tax payable This is determined by applying the applicable tax scales to the taxable income. For residents, the tax scales for
the year ended 2020 were:
$0−$18,200 nil
$18,201−$37,000 19%
$37,001−$87,000 32.5%
$87,001−$180,000 37%
$180,000+ 45%
Levies These represent additional amounts to be paid related to specific benefits received by the taxpayer—the main
one being Medicare, which is based on 2% of the taxable income, although some reductions are available in
certain cases. There is also a Temporary Budget Repair Levy, payable at a rate of 2% for taxable incomes over
$180,000. Another levy is the HELP or HECS repayment levy based on the level of the debt and the income
earned.
Tax offsets Tax offsets provide a direct reduction of the tax payable. A whole range of offsets are available, but some of the
(also known as more common ones relate to: spouse or dependent relatives; health insurance; medical expenses; seniors and
‘rebates’) pensioners; superannuation and low-income earners.
Adjusted tax The initial tax payable plus levies minus offsets.
payable
Pay as you go The tax paid on the employee’s behalf by the employer during the year. The difference between the adjusted tax
(PAYG) payable and the total paid under PAYG will give the net tax payable (or the refund due).
withholding tax
Franking When companies pay dividends out of taxed profits, the tax credit is passed on to the shareholder receiving the
credits dividend. Normally, tax has been paid on all of the profit out of which the dividend is paid. This is called ‘fully
franked’. Thus (assuming an income tax rate for companies of 30%), a fully franked dividend of $2,800 needs to
be recorded by the taxpayer as:
Assessable income:
(i.e. the dividend received is net of tax, so the gross dividend is scaled up by 100/70, 30% being the expected
income tax rate for companies).
*
These items make up the taxable income but are not actually shown on the assessment.
In arriving at the profit for the year for a business, most normal expenses would be treated as
deductions, although in some cases the ATO applies its own rules; for example, it uses its own
figures for calculating depreciation for tax purposes.
Any profits made by individuals through a sole proprietorship or a partnership will be dealt with as
part of the individual tax assessment of the owner. Profits made by a corporation will be taxed at a
rate applying to companies. At the time of writing this was 30%.
Summary
In this chapter we have achieved the following objectives in the way shown.
Explain the nature and purpose of the statement of Identified the purpose as being the measurement of the increment in
financial performance, usually referred to as an income wealth during the period
statement, and its relationship with the statement of Explained the nature of the income statement
financial position Explained the profit and loss equation
Illustrated use of the stock approach to calculate profit
Illustrated the link between the income statement and the statement of
financial position
Explain the layout of a typical statement of financial Illustrated the typical format for an income statement
performance, and describe its component parts Explained the main components of the typical income statement
Illustrated that the income statement is for a specified period
Explain the concept of depreciation and its impact on the Explained depreciation as the allocation of the cost or fair value of a tangible
financial statements asset to reflect the consumption of that asset’s economic benefits during the
period (physical deterioration, technical obsolescence, commercial
obsolescence)
straight-line
reducing-balance (accelerated)
Identify the main issues relating to inventory in the context Identified the key issues relating to inventory
of the income statement and the statement of financial Defined ‘inventory’
position Illustrated what is covered in cost of inventory
Illustrated how to arrive at cost of sales
—first in, first out (FIFO)
Identify the main issues regarding receivables in terms of Explained the problems associated with accounts receivable and bad debts,
revenue and expense recognition, and explain their impact and examined alternative recognition methods:
on the income statement and the statement of financial
position bad debts are realised in the sense that both the accounts receivable and
the amount can be established
doubtful debts relate to amounts that are not expected to be collected in
accounts receivable but are not currently uncollectable
Prepare a simple income statement from relevant financial Illustrated building up of financial statements from a list of transactions
information
Review and interpret the income statement Explained and analysed such statements by comparison with:
past performance
expectations or budget
other firms in the same industry
Discussion questions
Easy
3.1 LO What is the major connection between the statements of financial position and performance?
1/2
3.3 LO Discuss the write-down of inventory to the lower of cost and net realisable value in the context of the various accounting
5 concepts.
3.4 LO For accounting and financial reporting, what does it mean to say that an item of income or expense is ‘material’?
3
3.5 LO Provide three examples each of (a) non-operating income and (b) operating revenues. Exact classification will depend on the
2/3 individual business and the nature of its operations.
Intermediate
3.6 LO Company Xcel Ltd announces an increase of 10% in net profit for the year to $1,700,000. As a potential investor in the
1 company:
3.7 LO Discuss the provision for doubtful debts in the context of the various accounting concepts.
6
3.8 LO What evidence would suggest that income statement review and analysis is considered a useful exercise? To what end are
8 such reviews conducted?
3.12 LO Assume you are the manager of Mantra Russell Street, your accountant tells you one day that when a customer prepays for the
3 hotel booking Mantra cannot recognise revenue when the prepayment is received. Do you agree with him? Why?
Challenging
3.15 LO 3 When should income or revenue be recognised as being earned and recorded in the accounts? Provide discussion and
examples of different types of income and revenue where the recognition date is not as clear-cut as it would be for a cash sale
with immediate delivery.
3.17 LO 3 Why do you think revenue recognition for long-term contracts is challenging? Can you give an example of the stage of
completion recognition method in the real world?
3.18 LO 3 Have you heard of the term ‘earnings management’? Why do you think manages may have the motivation to conduct earning
management? What typical methods do they use for manipulation?
3.19 LO Can you identify reasons why you might feel the need to engage in tax planning?
1/2/8
3.20 LO If you were considering setting up a business, what are the taxation factors that might influence your choice of using a sole
2/8 proprietorship, a partnership or a company?
Application exercises
Easy
3.1 LO For a restaurant, provide examples of expenses that relate to the following functions.
2
Cost of sales Selling and distribution Administration and general Financial
3.2 LO a. Bert & Ernie Company begin the year with inventory of $5,000. During the year they purchase goods for $80,000 and have
3/5 sales totalling $120,000. The business makes a uniform gross profit of 30% on sales.
What is their closing inventory value for the year?
b. Mulder & Scully Company begin the year with inventory of $25,000. During the year they achieve sales totalling $120,000,
earning profit at a uniform gross profit rate of 30% on sales. Inventory at the end of the year amounted to $8,000.
What were Mulder & Scully’s purchases for the year?
3.4 LO a. It is three months before the end of the financial year, and Leo Murphy, owner and operator of Murph’s Trucking, has just
4 purchased a new truck for his cattle and hay hauling business.
Costs incurred are as indicated below:
Intermediate
3.5 LO 4 Following on from Exercise 3.4, Leo is expanding his business and has just bought another truck (see details below).
Leo has been talking to some of his trucking buddies, and has been advised that he should be using ‘km driven’ as the basis for
determining his depreciation expense. Leo estimates that he’ll get 500,000 km from the truck, at which time he’ll be able to sell
it for $10,000.
3.6 LO Joe’s profit and loss records for the year ended 30 June 2020 have been lost. However, you are able to extract the following
1/2/3 statement of financial position information, together with the owner’s contributions and drawings for the year.
Beginning End
Current assets
Non-current assets
Current liabilities
Non-current liabilities
Additional information: The owner did not make any further contributions during the year, but did withdraw cash of $12,000.
Calculate the profit made by Joe’s sole proprietorship during the year ended 30 June 2020.
3.7 LO a. Prepare an income statement for Mostyn Company for the year ended 30 June 2020, given the following account
7/8 balances. (Note: Some accounts may not be relevant.)
Cash 3,900
Depreciation—equipment 44,160
Insurance 2,600
Inventory 14,300
Loan 52,000
Sales 464,000
b. Consider the resulting statement of financial performance. Provide a review and interpretation of this statement, giving
indications of what further information is required to conduct a proper review.
c. What questions might be raised regarding the accounting treatment chosen for (1) insurance and (2) equipment repairs?
3.8 LO 5
Spratley Ltd is a builders’ merchant. On 1 September the business had 20 tonnes of sand in stock at a cost of $18 per tonne, a
total cost of $360. During the first week in September the business purchased the following amounts of sand:
2 48 $20
4 15 $24
6 10 $25
Calculate:
a. The cost of goods sold based on perpetual inventory and FIFO cost allocation.
b. The closing inventory based on periodic inventory and weighted average cost allocation.
3.9 LO 7 Calculate depreciation expense for each asset group for the year ended 30 June 2020.
Office
Asset Delivery trucks equipment Computer Building
Depreciation expense $? $? $? $?
#
The trucks were driven 24,500 km during the year.
*
The company uses an approximated reducing-balance rate of 60%. One year of depreciation has been recorded prior to the current year.
Challenging
3.10 LO Diaxon Supplies Co. has recently prepared draft financial statements for the most recent year. A profit for the year of $290,000
6 was reported. Subsequent investigation found that one item of the inventories (IXL 205) had been valued using the LIFO basis,
whereas the policy of the business is to use the FIFO basis for all inventories. The business had the following transactions
during the year for this item:
IXL 205
Units Cost/unit
After the draft financial statements were prepared, it was discovered that the net realisable value of inventories of item IXL 205
was $27,500.
Calculate the revised profit for the year after the inventories for item IXL 205 have been appropriately valued.
3.11 LO The following is the statement of financial position of WW Associates as at 31 December 2019.
7/8
WW ASSOCIATES
Statement of financial position
as at 31 December 2019
ASSETS
Current assets
Cash 16,600
Inventories 24,400
84,400
Non-current assets
Machinery 50,600
Current liabilities
37,200
Equity
97,800
The business uses the reducing-balance method of depreciation for non-current assets at the rate of 30% each year.
Prepare an income statement for the year ended 31 December 2020 and a statement of financial position as at that date.
Less expenses
Rent 15,000
Insurance 2,000
Advertising 3,000
Beginning Ending
Also, there should be depreciation of plant and equipment of $2,400, and bad and doubtful debts of $300.
While Paul is not someone who needs a huge amount of money to be content, he has realised that he
needs a certain amount of regular income to be able to survive, and also to be able to purchase the
materials needed for his preferred activities.
Recently an opportunity has arisen which looks as though it might enable him to achieve what he wants,
which is essentially a base level of income, but leaving him with enough time to devote to his main
interest. There is a small motel available for sale in a small country town, which has a reputation for being
something of an ‘arty’ town. There is already an art gallery there, together with a choir and a hall that is
used for visiting performers. The location is close to a very popular national park, with a good prospect of
high occupancy rates. As against this, occupation rates are likely to be low outside school-holiday times.
The motel is offered as a ‘walk in, walk out’ (WIWO) facility, and is fully equipped. The purchase price for
the business is $65,000. However, the buildings are not owned, but leased. The current lease expires in
three years, but there are options for at least two further five-year terms in place. The current lease costs
$50,000 per annum in rent. The motel has 15 rooms, 10 of which are double or twin rooms. There are a
further three rooms with a third single bed, and the remaining two rooms are family rooms that will take
four to five people. The motel is graded as a three-star facility, with tariffs for a double room being around
$120 per night. There is a two-bedded residence for the manager as well. A full breakfast menu is
provided at a charge as part of the motel service.
The statement that is provided by the real estate agent includes the following information:
On investigation you are given more detail relating to the operating expenses for the last year, as follows:
Interest 900
Insurance 5,200
Newsagents 1,700
Electricity 17,000
Water 1,200
Donations 1,400
Telephone 2,500
Rent 50,000
Rates 6,000
Questions
1. Advise Paul on whether or not he should proceed with the purchase.
2. Advise Paul as to whether the price is appropriate.
3. Explain why not separating the figures into those relating to personal or business aspects may
cause problems for decision-making.
4. Attempt to summarise the above information in such a way as to calculate a profit figure for the
business.
5. Summarise the aspects of the decision that relate to Paul’s artistic leanings.
6. What other factors might be worth considering by Paul in reaching a final decision?
Activity 3.1
Your answer should be along the following lines:
Activity 3.2
Your answer should be as follows:
H & S RETAILERS
Income statement
for the year ended 30 April 2021
Sales 389,600
Purchases 273,400
289,400
(277,400)
Less
The two items not included in the income statement are in fact assets (motor vans and cash) and would
appear in the statement of financial position.
Activity 3.3
1. Sales will appear in the income statement as $200,000. Cash will increase in the statement of
financial position by $160,000, with $40,000 being added to receivables.
You should note that there will be an expense to reflect the cost of sales as well.
2. The rent paid covered seven months, so the expense in the income statement for the six months
ending 30 June will be confined to $18,000, with the $3,000 extra paid being shown as a
prepayment.
3. Insurance covers the entire year. The income statement covers only the first six months, so the
expense will be half of $2,000 ($1,000), with the remaining $1,000 appearing in the balance sheet
as at 30 June as a prepayment.
4. The $5,000 loan interest paid all relates to the accounting period covering the first six months, so
all will be included in the income statement. However, the amount of interest for June is not yet
paid, so this will need to be added to the expense in the income statement (making the loan
interest for the six-month period $6,000) and to a liability in the balance sheet, accrued loan
interest ($1,000).
5. The $800 electricity bill all relates to the six-monthly accounting period, so will form part of the
electricity expense in the income statement for the period. However, May and June remain unpaid.
It will be necessary to estimate the likely expense for these two months, and add the estimated
amount to the expense in the income statement and to a liability (accrued electricity) in the
statement of financial position. Given that the expense for the first four months was $800, an
estimate of around $200 per month seems reasonable. So the expense for the period will be
$1,200 while there will also be an accrual of $400.
6. The subscriptions received cover the entire year. So not all of the amount received should appear
as revenue in the income statement. Only half should be recorded as revenue, with the other half
being shown as a liability (deferred revenue) in the statement of financial position. The deferred
revenue is a payment in advance—to the business—and this remains a liability until the
subscription is used up.
Activity 3.4
The depreciation expense, assuming estimate (a), will be $8,000 a year (i.e. ($40,000−$8,000)/4. The
depreciation expense, assuming estimate (b), will be $10,000 a year (i.e. $40,000/4). As the actual
residual value is $4,000, estimate (a) will lead to under-depreciation of $4,000 (i.e. $8,000−$4,000) over
the life of the asset, and estimate (b) will lead to over-depreciation of $4,000 (i.e. $0−$4,000). These
under- and over-estimations will be dealt with in year 4.
The pattern of depreciation and total depreciation expenses will therefore be:
Estimate
(a) (b)
$ $
Year
32,000 40,000
Activity 3.5
Your answer should be along the following lines.
The above figures reveal that FIFO will give the highest gross profit during a period of rising prices. This is
because sales are matched with the earlier (and cheaper) purchases. LIFO will give the lowest gross
profit, as sales are matched against the more recent (and dearer) purchases. The AVCO method will
normally give a figure that is between these two extremes.
The closing inventory figure in the statement of financial position will be highest with the FIFO method.
This is because the cost of goods still held will be based on the more recent (and dearer) purchases.
LIFO will give the lowest closing inventory figure, as the goods held in stock will be based on the earlier
(and cheaper) inventory purchased. Once again, the AVCO method will normally give a figure that is
between these two extremes.
When prices are falling, the position of FIFO and LIFO is reversed. FIFO will give the lowest gross profit,
as sales are matched against the earlier (and dearer) goods purchased. LIFO will give the highest gross
profit, as sales are matched against the more recent (and cheaper) goods purchased. AVCO will give a
cost of sales figure between these two extremes. The closing inventory figure in the statement of financial
position will be lowest under FIFO, as the cost of inventory will be based on the more recent (and
cheaper) stocks purchased. LIFO will provide the highest closing inventory figure, and AVCO will provide
a figure between the two extremes.
Activity 3.6
Your answer should be as follows:
CLAYTON CONGLOMERATES
Income statement (extracts)
for the year ended 30 June 2020
CLAYTON CONGLOMERATES
Income statement (extracts)
for the year ended 30 June 2021
CLAYTON CONGLOMERATES
Statement of financial position (extract)
as at 30 June 2020
$
**
Accounts receivable 830,000
Less allowance for doubtful debts 60,000
770,000
*
This figure will usually be netted off against any allowance created for doubtful debts in respect of 2021.
**
$870,000−$40,000
Activity 3.7
In an exercise like this one, where you are in effect trying to record detailed transactions directly into the
final accounts (i.e. income statement and statement of financial position), you may find it useful to list
transactions, as shown, in a two-sided format with columns for pluses and minuses. This effectively
duplicates the double-entry process that would be carried out in practice in a set of ledger accounts. In
this particular example, there are no minus transactions in the income statement, unlike the exercises at
the end of the chapter. Clearly, the end product for both statements may then need to be reformatted into
a vertical format on completion.
TT MOTORS
Statement of financial position
as at 31 December 2020
+ - Net + - Net
35,000 500
132,000 1,200
32,000
33,500
1,650
12,000
121,000
9,400
400 620
Profit 25,400
12,000 16,000
Non-current assets
TT MOTORS
Income statement
for the year ended 31 December 2020
+ - Net + - Net
16,000 35,000
*
Rent 20,000 20,000
630
620
161,600
187,000 187,000
*
An alternative approach would have been to show the $25,000 initially as an expense, and at the year-
end transfer $5,000 of this to the prepayment.
**
An alternative approach would have been to show the $1,200, and subsequently transfer $300 to the
prepayment.
Current assets
Cash 750
Prepayments 5,300
Inventory 65,000
90,650
Non-current assets
28,000
Current liabilities
Accruals 1,250
23,250
Capital/Equity
Contributed 70,000
95,400
Sales 187,000
Less expenses
Rent (20,000)
Rates (1,400)
Wages (34,130)
Electricity (2,270)
Depreciation (4,000)
Activity 3.8
Sales increased by more than 30% over the previous year, but the bottom line fell from a profit of $37,000
to a loss of $58,000. The rapid expansion of the business has clearly brought problems in its wake. In the
previous period, the business was making a gross profit of more than 31¢ for every $1 of sales made.
This reduced in the year ending 31 May 2020 to around 26¢ for every $1 of sales made. This seems to
suggest that the rapid expansion was fuelled by a reduction in prices. The gross profit increased in
absolute terms by $20,000; however, there was a drastic decline in net profits during the period.
In the previous period, the business was making a profit for the year of nearly 6¢ for every $1 of sales,
whereas for the year ending 31 May 2020 this reduced to a loss of nearly 7¢ for every $1 of sales made.
This means that overhead expenses have increased considerably. Some increase in overhead expenses
may be expected in order to service the increased level of activity. However, the increase appears to be
exceptional. If we look at the list of overhead expenses, we can see that the figure for bad debts written
off seems very high (more than 10% of total sales). This may be a further effect of the rapid expansion
that has taken place. In order to generate sales, insufficient regard may have been paid to the
creditworthiness of customers. A comparison of overhead expenses with those of the previous period
would be useful.
Chapter 4 Introduction to limited companies
Learning objectives
When you have completed your study of this chapter, you should be able to:
In this chapter, we consider the nature of limited companies and how they
differ from sole proprietorship businesses and partnerships. This expands
the brief discussion of various business forms in Chapter 1 . We examine
the ways in which the owners provide finance, and outline the type of
borrowings that companies can engage in, and then explain the constraints
imposed on limited companies regarding distributions and reductions in
capital.
We shall also see how the basic financial statements, which were
discussed in the previous two chapters, are prepared for this type of
business. The particular formats required by the regulators will be dealt
with in Chapter 5 .
The main features of companies
LO 1 Identify and discuss the main features of companies
There is a wide range of company types, but the most common in Australia is the company limited by
share capital. In this book we will largely restrict our focus to this entity structure.
A limited company may be owned by just one person, but most have more than one owner and some
have many owners. The owners are usually known as members or shareholders. The ownership of a
company is normally divided into a number—frequently a large number—of shares, each of equal size.
Each owner, or shareholder, owns one or more shares in the company.
Limited companies have a number of distinguishing features, which are dealt with below.
Legal nature
A limited company has the legal capacity of a person, and has a separate legal status from those who
own the entity (the shareholders). Thus, a company is able to enter into contracts with external parties
(buy, sell, borrow, lend, employ, sue, be sued) in its own right. This means that the company assets are
owned by the company in its own right as a legal person. This contrasts sharply with other types of
businesses, such as sole proprietorships and partnerships (i.e. unincorporated businesses), where it is
the owner(s) rather than the business who must sue, enter into contracts and so on, because the
business has no separate legal identity. An Australian company comes into existence as a ‘body
corporate’ when it is registered under the Corporations Act 2001 and is issued a certificate of registration.
Since a limited company has its own legal identity, it is regarded as being quite separate from those who
own and manage it. It is worth emphasising that this legal separateness of owners and the company has
absolutely no connection with the business entity convention of accounting, which we discussed in
Chapter 2 . This accounting convention applies equally well to all business types, including sole
proprietorships and partnerships where there is certainly no legal distinction between the owner(s) and
the business.
Another consequence of the legal separation of the limited company from its owners is that companies
must be accountable to the tax authorities for tax on their profits and gains. This leads to the reporting of
tax in the financial statements of limited companies. The charge for tax is shown in the income statement
(the profit and loss account). The tax charge for a particular year is based on that year’s profit. Any tax
due but unpaid will also appear in the end-of-year statement of financial position (the balance sheet) as a
current liability. The tax position of companies contrasts with that of sole proprietorships and partnerships,
where tax is levied not on the business but on the owner(s). Thus tax does not impact on the financial
statements of unincorporated businesses, but is an individual matter between the owner(s) and the tax
authorities.
Companies are charged income tax on their profits and gains. The rate of tax is levied on the
company’s taxable profit, which is not necessarily the same as the profit shown on the income statement.
This is because tax law does not, in every respect, follow the normal accounting rules. Generally,
however, the taxable profit and the company’s accounting profit are pretty close to one another.
income tax
An amount levied on income, which is payable to the government.
There can be tax advantages to trading as a limited company rather than as a sole proprietor or a partner.
This may partly explain the rise in popularity of private limited companies over recent years.
Although a company may be granted a perpetual existence when it is first formed, it is possible for either
the shareholders or the courts to bring this existence to an end. When this is done, the assets of the
company are usually sold to generate cash to meet the outstanding liabilities. Any surplus arising after all
liabilities have been met will then be used to pay the shareholders. Shareholders may agree to end the
life of a company where it has achieved the purpose for which it was formed or where they feel that the
company has no real future. The courts may bring the life of a company to an end where creditors have
applied to the courts for this to be done because they have not been paid amounts owing.
Where shareholders agree to end the life of a company, it is referred to as a voluntary liquidation .
voluntary liquidation
A situation in which a business is closed on a voluntary basis.
Limited liability
Since the company is a legal person in its own right, it must take responsibility for its own debts and
losses. This means that once the shareholders have paid what they have agreed to pay for the shares,
their obligation to the company, and to the company’s creditors, is satisfied. Thus shareholders can limit
their losses to the amount that they have paid, or agreed to pay, for their shares. This is of great practical
importance to potential shareholders, since they know that what they can lose, as part-owners of the
business, is limited.
Contrast this with the position of sole proprietors or partners. They cannot ‘ring-fence’ assets that they do
not want to put into the business. If a sole proprietorship or a partnership business finds itself in a position
where liabilities exceed the business assets, the law gives unsatisfied creditors the right to demand
payment out of what the sole proprietor or partner may have regarded as ‘non-business’ assets. Thus the
sole proprietor or partner could lose everything—house, car, the lot. This is because the law sees Jill, the
sole proprietor, as being the same as Jill, the private individual. The shareholder, by contrast, can lose
only the amount he or she has committed to that company. Legally, the business operating as a limited
company, in which Jack owns shares, is not the same as Jack himself. This is true even if Jack were to
own all of the shares in the company.
Activity 4.1
The fact that shareholders can limit their losses to that which they have paid, or have agreed to pay, for
their shares, is of great practical importance to potential shareholders.
Can you think of any practical benefit to a private-sector economy, in general, of this ability of
shareholders to limit losses?
Consider how suppliers of goods and services might be protected, given that the liability of company
owners is limited to their agreed contributions.
Although limited liability has this advantage to the providers of equity finance (the shareholders), it is not
necessarily to the advantage of all of the others who have a stake in the business. Limited liability is
attractive to shareholders because they can, in effect, walk away from the unpaid debts of the company if
their contribution has not been sufficient to meet those debts. This is likely to make any individual, or
another business, wary of entering into a contract with a limited company. This can be a real problem for
smaller, less established companies. Suppliers may insist on cash payment before delivery of goods or
the rendering of a service. Alternatively, before allowing trade credit they may require a personal
guarantee from a major shareholder that the debt will be paid. In the latter case, the supplier circumvents
the company’s limited liability status by demanding the personal liability of an individual. Larger, more
established companies, on the other hand, tend to have built up the confidence of suppliers.
Legal safeguards
Various safeguards exist to protect individuals and businesses contemplating dealing with a limited
company. These include the requirement to indicate limited liability status in the name of the company. By
doing this, a warning is issued to prospective suppliers and lenders.
A further safeguard is the restriction placed on the ability of shareholders to withdraw their equity from the
company. These restrictions are designed to prevent shareholders from protecting their own investment
and, as a result, leaving lenders and suppliers in an exposed position. We shall consider this point in
more detail later in the chapter.
Finally, public and large limited companies are required to produce annual financial statements (income
statements, statements of financial position and statements of cash flows) and make these publicly
available. This means that anyone interested can gain an impression of the financial performance and
position of the company. The form and content of the first two of these statements are considered in some
detail later in this chapter and in Chapter 5 . Chapter 6 is devoted to the statement of cash flows.
Clearly, while limited liability is an advantage to the owners, it can pose a problem to the external parties
providing goods and services to the company.
public company
A company that can offer shares to the general public. Shares can be traded on a
public stock exchange.
A proprietary (private) company tends to be a smaller business where the ownership is divided
between relatively few shareholders who are usually fairly close to one another (e.g. a family company).
Numerically, there are more private limited companies in Australia and New Zealand than there are public
ones. However, since the public ones tend to be individually larger, they represent a much more important
group economically. Many proprietary companies are no more than a vehicle for operating businesses
that are effectively little more than sole proprietorships or small partnerships.
Proprietary companies have the words ‘Proprietary Limited’ (‘Pty Ltd’) in their name. They are restricted to
no more than 50 (non-employee) shareholders, and have restricted ability to raise money from the public.
Generally, proprietary companies are less regulated than public companies. Small proprietary companies
are relieved of many of the reporting requirements of large proprietary companies or public companies.
From 1 July 2019 a proprietary company is deemed to be large if it satisfies at least two of the following
three criteria:
While for some forms of companies the membership may be restricted, for public companies the number
of shareholders can be very large. In several significant cases in which government-owned businesses
became companies (e.g. the Commonwealth Bank, Telstra), the initial number of owners exceeded
250,000. With such a large number of owners, corporate entity structures can raise significant amounts of
ownership funds. Also, public companies have access to certain types of debt funding that are not
available to other entity structures. This will be discussed further in Chapter 14 .
Large companies typically have a very large number of shareholders. Real World 4.1 illustrates the
scale and range of shareholdings for two companies.
2. Distribution of listed shares in New Zealand Oil and Gas Limited as disclosed in the 2019
annual report
As at 12 August 2019 New Zealand Oil and Gas Limited had 5,100 listed ordinary
shareholders owning just over 164 million shares. Just over 80% of these were held by only
20 shareholders. The largest holding was that of O.G. Oil and Gas Singapore Pte Ltd and
accounted for 69.86% of the shares.
Source: New Zealand Oil and Gas Limited Annual Report 2019, pp. 39–40.
This of course raises the question: if the change in ownership of a company’s shares does not directly
affect that company, why would it welcome the fact that the shares are traded in a recognised market?
The main reason is that investors are generally very reluctant to pledge their money unless they can see
some way to turn their investment back into cash. In theory, the shares of a particular company may be
very valuable if the company has a very bright economic future, but unless this value can be realised in
cash the benefit to the shareholders is dubious. After all, you cannot spend shares; you generally need
cash. This means that potential shareholders are much more likely to be prepared to buy new shares
from the company (thus providing the company with new finance) when they can see a way of liquidating
their investment (turning it into cash).
The stock exchanges provide the means of liquidation. Although the buying and selling of ‘second-hand’
shares does not provide the company with cash, the fact that the buying and selling facility exists will
make it easier for the company to raise new share capital as and when it wishes to do so.
It is important to note that only the shares of certain companies—those that are listed on the stock
exchange—can be traded on the stock exchange. In Australia just over 2,200 companies are listed on the
ASX.
The shareholders elect directors (by law there must be at least one director) to manage the company
on a day-to-day basis on their behalf. In a small company, the board may be the only level of
management and consist of all of the shareholders. In larger companies, the board may consist of 10 or
so directors out of many thousands of shareholders. Indeed, directors are not even required to be
shareholders. Below the board of directors of the typical large company could be several layers of
management.
directors
Individuals who are elected to act as the most senior level of management of a
company.
With sole proprietorships and partnerships, the owner(s) and manager(s) are, by and large, the same
people. However, companies (other than quite small ones) will generally have a separate specialist
management team outside the ownership interest. There is a growing trend for key personnel in a
management team to be allocated shares (ownership interests) on the basis of the company’s
performance, so they may become managers and owners at the same time.
Extensive regulation
The corporate entity will be subject to much stricter regulation than the partnership and sole proprietorship
entity structure, due to the ‘limited liability’ benefit granted to owners (shareholders) and the fact that most
shareholders are widely removed from the day-to-day activities of the business and its management.
The additional regulations that apply to the limited liability company depend on the classification of that
company. However, these regulations may relate to:
In recent years, the issue of corporate governance has generated much debate. The term is used to
describe the ways in which companies are directed and controlled. The issue of corporate governance is
important because, in companies of any size, those who own the company (the shareholders) are usually
divorced from the day-to-day control of the business. Since the shareholders employ the directors to
manage the company for them, it seems reasonable to assume that the best interests of shareholders will
guide the directors’ decisions. However, in practice this does not always occur. The directors may be
more concerned with pursuing their own interests, such as increasing their pay and ‘perks’ (expensive
motor cars, overseas visits, etc.) and improving their job security and status. As a result, the interests of
shareholders and the interests of directors may conflict.
corporate governance
The system by which corporations are directed and controlled.
Activity 4.2
Can you think of ways in which the shareholders themselves may try to ensure that the directors always
act in the shareholders’ best interests?
Directors who pursue their own interests at the expense of the shareholders pose a problem for the
shareholders. However, they may also cause a problem to society as a whole. If shareholders feel their
funds are likely to be mismanaged, they will be reluctant to invest. A shortage of funds will restrict
investment choices, and the costs of funds will increase as businesses compete for the available funds.
Thus, a lack of concern for shareholders can profoundly affect the performance of the economy. To avoid
these problems, most competitive market economies have a framework of rules to help monitor and
control the behaviour of directors. These rules are usually based on three guiding principles:
Disclosure. This lies at the heart of good corporate governance. Adequate and timely disclosure can
help shareholders judge the performance of the directors. Where performance is considered
unsatisfactory, this will be reflected in the price of shares. Changes should then be made to ensure the
directors regain the confidence of shareholders.
Accountability. This involves defining the roles and duties of the directors and establishing an
adequate monitoring process. In Australia, company law requires the directors of a business to act in
the best interests of the shareholders. This means, among other things, that directors must not try to
use their position and knowledge to make gains at the expense of the shareholders. The law also
requires larger companies to have their annual financial statements independently audited. An
independent audit lends credibility to the financial statements prepared by the directors. An audit is
effectively checking of the financial reports so that the auditors can make a judgement as to whether
the accounts show a true and fair view of the financial performance and position of the organisation.
Fairness. Directors should not be able to benefit from ‘inside’ information that is not available to
shareholders. As a result, both the law and the ASX place restrictions on the ability of directors to buy
and sell the shares of the business. For example, the directors cannot buy or sell shares immediately
before the announcement of the annual trading results of the business, or before the announcement of
a significant event, such as a planned merger or the loss of the chief executive.
The number of rules designed to safeguard shareholders has increased considerably over the years. This
has been in response to weaknesses in corporate governance procedures, which have been exposed
through well-publicised business failures and frauds, excessive pay increases to directors, and evidence
that some financial reports were being ‘massaged’ so as to mislead shareholders.
Real World 4.2 provides an example of how one subsidiary tried to hide sliding profitability.
Eli Greenblat reported in The Australian that Richard Goyder, the boss of Wesfarmers, which owns
Target, has acknowledged that the ‘conglomerate has taken a knock to its most prized possession
—its reputation—after what he called a “mind-blowingly stupid” decision by a clique of Target
executives to hide sliding profitability using $21 million in improper payments from suppliers.’
Business Spectator in The Daily Telegraph explained: ‘The rebate was paid with the promise that
second-half price rises would offset the payment, which was treated in the accounts as profit,
contrary to Wesfarmers stated policy.’ Target reported increased earnings before interest and tax
of $74 million, a rise of 5.6% from $70 million. Without the adjustment they would have fallen to
about $60 million. Target’s boss resigned, and Wesfarmers went into damage control, assuring
investors that the accounting regularities were confined to Target. The impact on the Wesfarmers
overall results was relatively insignificant.
Sources: Eli Greenblat, ‘Richard Goyer: Wesfarmers takes hit from “stupid” Target’, The Australian, 12 April 2016.
Business Spectator, ‘Governance takes a pounding as allegations start to bite’, The Daily Telegraph, 5 April 2016, https://www.dailytelegraph.com.au/news/
news-story/c365f15608fd4d689a2acaada65f1d4d.
Reflection 4.1
In Reflection 2.1 we were introduced to a young entrepreneur, Lucas, who was opening a high-
class restaurant. Let us now move five years on. He has operated as a sole trader very
successfully for the past five years, with the support of his parents. He is now planning to open a
chain of five restaurants strategically placed around the city. Both Luke and his parents feel that it
is time to consider changing from being a sole-trading business to a limited company. He has
picked up from a variety of sources that corporate governance is seen as important. This, together
with the increase in regulations associated with corporate status, have made him hesitate before
going corporate. Advise him.
The ways in which unscrupulous directors can manipulate the financial statements are many and varied.
Before leaving this section, however, it is worthwhile reminding ourselves of the importance of sound
internal control, which can be described as the systems and policies adopted by an entity to safeguard
assets, promote efficiency and ensure reliable and accurate accounting records. The Accounting and You
section that follows raises issues of fraud and embezzlement.
The ideas of corporate governance and the role of directors introduced you to some of the issues
that need to be confronted regarding the ways in which companies and directors should behave,
and also provided examples of ways in which they should not behave. While the section covered
issues such as disclosure, accountability and fairness, there is a raft of ways in which results can
be manipulated and businesses cheated out of significant sums.
The two most typical methods used are management fraud and employee embezzlement.
Management fraud often aims to increase the share price by overstating revenues or understating
expenses. This is often associated with increases in staff bonuses. In the extreme, we can find
examples of fraud on a vast scale, such as Bernard Madoff’s infamous ponzi scheme. A ponzi
scheme is a fraudulent investment scheme that pays returns to investors from their own money, or
money paid by subsequent investors, rather than from any actual profit earned. In the case of
Madoff’s business, the amount missing from client accounts, including fabricated gains, ran into
billions of dollars. Note also Real World 1.5 for more recent examples.
Many of these frauds have taken a slightly different slant as technology changes. For example, a
range of cybercrimes have emerged, including phishing, fake invoicing and senior staff
impersonation. Clearly, good systems of internal control are necessary. It is important to note that
in many cases it is perceived pressure that creates the environment in which fraud and
embezzlement are likely to happen. If pressure is coupled with a perceived opportunity, the
likelihood increases. Interestingly, people who commit these offences often have a rationalisation
process, which they use as a justification.
These kinds of events also mean that some degree of external regulation can be justified. The next
chapter covers the more important aspects. You need to understand, though, that even close
regulation is not guaranteed to find all of these crimes, and certainly not quickly. It is worth noting
that the US Securities and Exchange Commission had conducted investigations into Madoff’s
business practices over several years but did not uncover the fraud.
The message is clear. Some regulation is appropriate, but you should not rely on this to deal with
all possible events. You must have sound systems of internal control. You always need to be
observant and questioning. If good internal control systems are absent, the chances of you
experiencing fraud or embezzlement in your workplace increase substantially. It would be a useful
exercise for you to try to identify possible gaps in internal control in your workplace just to see
whether the system is as sound as possible.
the separation of ownership and management, and the existence of a specialist management team
the perpetual existence of the entity, ensuring the stability of operations and long-term planning
the existence of a separate legal entity, which gives the entity operational and financial freedom
the limited liability for the owners (shareholders), which removes significant barriers to investment
greater access to ownership funding, enhancing the business’s ability to operate and expand
potentially greater access to debt funding
potential taxation advantages, given that the company tax rate is less than the maximum personal
taxation rate (at the time of writing the company tax rate was at 30% compared with a maximum
personal tax rate of 45%), and
potential increases in share values where shares are listed on the stock exchange.
In recent years, led by events in the United States, questions have been raised as to the long-term future
of the public company. This is not to say that their demise is imminent, or even likely, but that there are
factors which may lead to a reduction in their numbers and importance. Real World 4.3 summarises a
relatively recent article on the topic.
In an article in the CPA magazine INTHEBLACK, which was published in November 2017, Adrian
Rollins asks why companies are staying private. He provides evidence which illustrates that in the
United States the number of listed companies has taken a steep dive. He quotes Professor Jerry
Davis, author of The Vanishing American Corporation, as saying: ‘The range of activities for which
the most economical format is to organise as a corporation and sell shares to the public is rapidly
diminishing.’ Public corporations ‘will no longer be the default way of doing business’. However, the
issue in the United States is not the company structure—in the period preceding the report, 1996–
2015, the number of firms in the United States grew by about 25%—but rather that ‘fewer are
choosing to list’.
At the time of the writing of the article, the decline in public companies was pretty much confined to
the United States, as elsewhere the number of public listings was growing considerably. In
Australia, the number of listed companies was just over 2,200, a figure that has been quite stable.
The article concludes with some questions for the future, including just what a decline in public
companies could mean socially.
Source: Adrian Rollins, ‘The disappearing public company: why firms don’t want to list’, INTHEBLACK, 1 November 2017.
Reflection 4.2
You have been asked by the CEO of a small emerging high-tech company for advice on:
Concept check 1
Which of the following is NOT a feature of a company?
A. Public companies are more rigorously regulated than proprietary companies.
B. The two main categories are public companies and proprietary (private) companies.
C. Many proprietary companies are no more than a vehicle for operating businesses
that are effectively little more than sole proprietorships or small partnerships.
D. Small proprietary companies are relieved of many of the reporting requirements of
large proprietary companies or public companies.
E. A proprietary company’s shares can be traded on a public stock exchange.
Concept check 2
Which of the following is NOT one of the two requirements that proprietary companies must
satisfy to be deemed to be small?
A. Consolidated net assets at the end of the financial year are less than $25 million.
B. Gross operating revenue must be less than $25 million.
C. It employs fewer than 50 employees at the end of the financial year.
D. None of the above.
Concept check 3
Advantages of the company entity structure do NOT include:
A. Permanent existence
B. Limited liability of shareholders
C. More extensive regulatory requirements
D. Potential tax advantages
E. None of the above. All are advantages.
Equity and borrowings in a company context
LO 2 Explain equity and borrowings in a company context
As we have seen, the owners’ claim of a sole proprietorship is normally encompassed in one figure
relating to equity on the statement of financial position, usually labelled capital . This figure can be
increased by further injections of funds or by making profits, or reduced by incurring losses or by drawings
made by the owners. With companies, this is usually a little more complicated, although in essence the
same broad principles apply. With a company, the owners’ claim is divided between shares (i.e. the
original investment) on the one hand, and reserves (i.e. profits and gains subsequently made) on the
other. Capital and reserves are generally referred to as ‘shareholders’ equity’. There may also be shares
of more than one type and reserves of more than one type, so within the basic divisions of share capital
and reserves there may well be further subdivisions. This probably seems quite complicated. Shortly we
shall consider the reasons for these subdivisions and all should become clearer.
capital
Another name for owners’ equity, often associated with sole proprietorships or
partnerships. The owner’s claim on the assets of the business.
When a company is first formed, those who take steps to form it (usually known as its ‘promoters’) decide
how much has to be raised by the potential shareholders to set up the company with the necessary
assets to operate. Example 4.1 illustrates such a case, and how this is reflected in a statement of
financial position.
EXAMPLE
4.1
Let us imagine that several friends decide to form a company to operate a particular business.
They estimate that the company will need $50,000 to obtain the necessary assets to operate the
business. Between them they raise the cash to buy shares in the company, which issues 50,000
shares at $1 each.
At this point the statement of financial position (balance sheet) of the company would be:
Shareholders’ equity
For simplicity, in this and succeeding statements of financial position presented to illustrate points
about shareholders’ equity, we have simply added together current and non-current assets and
deducted external liabilities, giving net assets. This figure must equal shareholders’ equity.
The company now buys the necessary non-current assets and inventory and starts to trade.
During the first year it makes a profit of $10,000. This, by definition, means that both the net assets
and the owners’ claim expand by $10,000. (Remember that company profits belong to the
shareholders.) During the year, the shareholders (owners) make no drawings of their capital (such
drawings are known as ‘dividends’ when applied to companies), so at the end of the year the
summarised statement of financial position looks like this:
Shareholders’ equity
60,000
The profit is shown in a ‘reserve’, known as ‘retained profits’ (or ‘retained earnings’). Note that we
do not simply add the profit to the share capital. We must keep the two amounts separate (to
satisfy the Corporations Act), because there is a legal restriction on the maximum drawings of
capital (or ‘dividends’) that the owners can make. This is defined by the amount of distributable
reserves, so it is helpful to show these separately. We shall look at why there is this restriction, and
how it works, later in the chapter.
Shares represent the basic units of ownership of the business. All companies issue ordinary shares ,
the main risk-bearing shares issued by companies (see Example 4.1 ). These are often referred to as
‘equities’. All other claims on the business have a higher priority in terms of repayment. Ordinary
shareholders’ returns will come from distributions of profit (known as dividends ) or from increases in
the value of the shares. Under normal circumstances, retaining profits is likely to produce such increases.
Until recently, each share had a value, known as ‘par value’, attached to it. The Company Law Review
Act 1998 eliminated this, and shares are now deemed to have no par value.
ordinary shares
Shares of a company owned by those who are due the benefits of the company’s
activities after all other stakeholders have been satisfied.
dividends
Transfers of assets (usually cash) made by a company to its shareholders.
EXAMPLE
4.2
Suppose a company wishes to raise $250,000 in cash and issues 250,000 ordinary shares at a
price of $1 a share.
Net assets
Cash $250,000
Shareholders’ equity
These shares are fully paid as there is no further payment required of the shareholders.
A company can issue partly paid shares . Suppose that instead of issuing 250,000 shares at
$1, the company decides to raise the $250,000 it needs by issuing 500,000 partly paid shares, but
asks for (calls) only 50¢ per share now, with the remaining 50¢ per share to be called and
collected at some future date.
Net assets
Cash $250,000
Shareholders’ equity
The shareholders, in agreeing to buy shares issued at $1, have agreed to commit $1 when
required. At this stage the company has only asked for half of this amount, so the further liability of
the shareholders is restricted to 50¢ per share. Once this has been paid, the shares become fully
paid shares and the shareholders have no further liability to the company.
Where calls are unpaid, this will be reflected on the balance sheet. If, for example, the call was
unpaid on 5,000 shares, the statement of financial position would appear as follows:
Net assets
Cash $247,500
Shareholders’ equity
$247,500
Activity 4.3
a. Show the statement of financial position of a company after each of the following transactions:
The issue of 100,000 shares at an issue price of $2, of which $1 is payable immediately.
After a further call of 50¢ per share.
b. A company issues 100,000 shares on formation at $1 per share. Five years later its statement of
financial position is as shown below:
Net assets $170,000
Shareholders’ equity
Capital 100,000
$170,000
The current market price of the shares is $2. A further 100,000 shares are issued at market price. Show
the statement of financial position, assuming the issue is successful.
Some companies also issue other classes of shares, preference shares being the most common.
These usually guarantee that if a dividend is paid, the preference shareholders will be entitled to the first
part of it up to a maximum value. This maximum is normally defined as a fixed percentage of the
preference shares. If, for example, a company issues 100,000 preference shares at $1 each with a
dividend rate of 6%, this means that the preference shareholders are entitled to receive the first $6,000 of
any dividend paid by the company for a year. The profit in excess of the preference dividend is the
entitlement of the ordinary shareholders, although this amount is not necessarily (or even normally) paid
out as a cash dividend. Normally, any undistributed profits and gains accrue to the ordinary shareholders.
Thus, the ordinary shareholders are the primary risk-takers. Their potential rewards reflect this risk. Power
normally resides in the hands of the ordinary shareholders. Generally, only the ordinary shareholders are
able to vote on issues that affect the company, such as who the directors should be. One ordinary share
usually carries with it one vote.
preference shares
Shares which have a fixed rate of dividend that must be paid before any ordinary
dividend can be paid. Often preference shares have higher priority than ordinary
shares in the event of the company going into liquidation.
It is open to the company to issue shares of various classes, perhaps with some having unusual
conditions, but it is rare to find other than straightforward ordinary and preference shares. Although a
company may have different classes of shares whose holders have different rights, within each class all
shares must be treated equally. The rights of the various classes of shareholders, as well as other
matters relating to a particular company, are contained in that company’s constitution, or in the special
resolution approving the issue.
Example 4.3 illustrates the importance of ensuring that new shares are issued at an appropriate price
so as to preserve the rights of existing shareholders.
EXAMPLE
4.3
The statement of financial position of a company is as follows:
Shareholders’ equity
$1,500,000
Assuming that the market value of the shares is the same as the book value, the share price would
be $1.50. The company has decided to raise an extra $600,000 cash for expansion by issuing new
shares. If the shares are issued for $1.50 each, 400,000 shares must be issued, producing the
following statement of financial position:
Shareholders’ equity
$2,100,000
If the new issue of 400,000 shares was at a price less than $1.50, say $1, the end result would be
as follows:
Net assets $1,900,000
Shareholders’ equity
$1,900,000
If we continue our assumption that book value and market value are the same, the market value
per share will change to $1.9 million/1.4 million shares=$1.36 per share. The old shareholders are
disadvantaged, whereas the new ones are better off.
In practice, the situation is more complicated than this, with book value and market value almost
never being the same, but the principles remain the same.
A company can issue more share capital at a later date. Given that the value of the company (and
therefore of the shares) is likely to increase over time as profits are retained, the asking price for the new
shares is likely to be higher than the original asking price. Generally we would expect new shareholders
to buy new shares at a price very close to the current market value of the shares. The proceeds will be
added to cash and capital.
You need to understand why it is important that any new issues are at a price close to market price. Since
the new shareholders have the same rights as the old, the new shareholders must ‘buy in’ their share of
any increases in value since the initial share purchase. If this does not occur, then new shareholders will
benefit at the expense of the old shareholders.
Reserves
Reserves are profits and gains that have been made by the company and that still form part of the
shareholders’ (owners’) claim. Profits and gains tend to lead to cash flowing into the company. Note that
retained profits represent the largest source of new finance for Australian companies, more than share
issues and borrowings combined for most companies. These ploughed-back profits create most of the
typical company’s reserves. Retained profits can be held in an account with the same name, ‘retained
profits’, or in an account labelled ‘general reserve’. Reserves will be reduced by distributions (typically
dividends) or by any losses incurred.
reserves
Amounts reflecting increases in owners’ claims.
You should note that reserves are not cash. Reserves represent a claim by the owners on the business.
In everyday usage, we tend to talk about reserves being things held as a back-up, and these tend to
relate to assets (e.g. cash, minerals). You must recognise that an accounting reserve represents
something other than this—it is a claim.
Not all reserves result from profits earned, and therefore some reserves may not be distributable as a
cash dividend. For example, a company might revalue (upwards) non-current assets, such as property
bought several years ago for $250,000, now revalued to reflect its current value of, say, $400,000. The
property value would be increased by $150,000 and a revaluation reserve would be increased by the
same amount. Note that such capital gains can be distributed if they result from a bona fide revaluation of
all assets, but such distributions are relatively rare.
Bonus shares
It is always open to the company to take reserves of any kind and turn them into share capital. The new
shares are known as bonus shares as they involve no cost to the shareholders. They are also known
as a ‘share dividend’. Issues of bonus shares occur quite frequently. Example 4.4 illustrates how
bonus shares work.
bonus shares
Reserves which are converted into shares and given ‘free’ to shareholders.
EXAMPLE
4.4
The summary statement of financial position of a company is as follows:
Shareholders’ equity
Reserves 78,000
128,000
The company decides that it will issue, to existing shareholders, one new $1 share for every share
owned by each shareholder. The statement of financial position immediately following this will
appear as follows:
Shareholders’ equity
128,000
We can see that the reserves have decreased by $50,000, and share capital has increased by the
same amount. Share certificates for the 50,000 ordinary shares of $1 each, which have been
created from reserves, will be issued to the existing shareholders to complete the transaction.
Assume now that a shareholder of the company in Example 4.4 owned 100 shares in the company
before the bonus issue. How will things change for this shareholder as a result of the bonus issue, with
regard to the number of shares owned and the value of the shareholding?
The answer should be that the number of shares will double from 100 to 200. Now the shareholder owns
one five-hundredth of the company (200/100,000). Before the bonus issue, the shareholder also owned
one five-hundredth of the company (100/50,000). The company’s assets and liabilities have not changed
one bit as a result of the bonus issue, so, logically, one five-hundredth of the value of the company should
be identical to what it was before. Thus, each share is worth half as much, but the shareholder now owns
twice as many shares.
In practice, events are not likely to take place with quite the precision implied above. One of the
arguments used to support a bonus issue is that a reduction in share price might lead to higher levels of
activity in the market for shares, with the result that the price might not fall as much as logic would expect,
with the end result being an increase in the market value of the company. Referring to Example 4.4 ,
such a result might leave the shares trading at a value slightly higher than 50% of the pre-bonus share
price. Such a reaction may be short term if the fundamental value of the business, based on future
earnings, has not changed. However, the fact that a firm undertakes a bonus issue may indicate that
management has reason to believe that future earnings will improve, and if the market supports this
position, then the bonus issue may be associated with an increased overall share value. However, if the
share value increases overall after the bonus issue, it is not possible to determine whether the share
value may have increased anyhow had the bonus issue not taken place. A bonus issue simply takes one
part of the owners’ claim (part of a reserve) and puts it into another part of the owners’ claim (share
capital).
This inevitably raises the question: why bother? Three possible reasons are:
Share price—to lower the value of each share, without reducing the shareholders’ collective or
individual wealth.
Shareholder confidence—to provide the shareholders with a ‘feel-good factor’. Apparently
shareholders like bonus issues, because it seems to make them better off, although in practice it
should not affect their wealth.
Lender confidence—where reserves arising from operating profits and/or realised gains on the sale
of non-current assets are used to make the bonus issue, it has the effect of taking part of that portion
of the owners’ claim which could be drawn by the shareholders as drawings (or dividends), and
locking it up. There are severe restrictions on the extent to which shareholders may make drawings
from their capital. An individual or organisation contemplating lending money to the company may
insist that the dividend payment possibilities are restricted as a condition of making the loan.
Remember that a rights issue is a totally different thing from a bonus issue. Rights issues result in
an asset (cash) being transferred from shareholders to the company. Bonus issues involve no transfer
of assets in either direction.
rights issue
An issue of shares for cash to existing shareholders on the basis of the
number of shares already held, at a price that is usually lower than the current
market price.
Public issues—issues made to the general investing public (only public companies).
Private placings—issues made to selected individuals or institutions who are usually approached and
asked whether they would be interested in taking up new shares.
During its lifetime, a company may use any or all of these approaches to raising funds through issuing
new shares.
Borrowings
Most companies borrow to supplement the funds raised from share issues and retained profits. Ways in
which borrowing typically occurs are covered in Chapter 14 . In the statement of financial position, long-
term loans will be categorised as non-current liabilities, while short-term loans will be categorised as
current liabilities. Usually, long-term loans are secured on the assets of the company. This would give the
lender the right to seize the assets concerned, and sell them and satisfy the repayment obligation, should
the company default on either its interest payments or the repayment of the loan.
A common form of borrowing is through the issue of loan notes . Where a large issue of loan notes is
made, it can sometimes be taken up in small slices, by private investors, or in large slices, by investing
institutions such as pension funds and insurance companies. These slices of loans can also, at times, be
bought and sold through the stock exchange. This means that investors need not wait the full term of the
loan to obtain repayment, but can sell their slice of it to another investor at any point. Loan notes are often
known as ‘loan stock’, ‘debentures’ or ‘corporate bonds’.
loan notes
Long-term borrowings usually made by limited companies.
The fact that loan notes may be traded on the stock exchange can lead to confusing loan notes with
shares. They are, however, quite different. Holders of shares own the company, and share in its losses
and profits. Holders of loan notes simply lend money to the company under a legally binding contract.
It is important to the prosperity and stability of a company that it strikes a suitable balance between
finance provided by the shareholders (equity) and finance from borrowing. This topic will be explored in
Chapters 8 and 14 .
Reflection 4.3
Lucas, the young entrepreneur introduced in Reflection 2.1 and 4.1 , has been convinced by
you that it is sensible for the business to change from being that of a sole trader to a company.
While he has an outline strategic plan, he is worried that he may be taking on too much in one go.
He has asked for your advice regarding the use of share capital and debt; specifically, he wants to
know what the options might be for a business of this type and stage of development, and what
their advantages and disadvantages are.
Concept check 4
Which of the following statements is false?
A. Capital is the term used for owners’ equity in proprietorships and partnerships.
B. Shares represent the basic units of ownership of a company.
C. Partly paid shares are shares on which the full issue price of the share has not been
paid as at reporting date.
D. Preference shares generally have lower priority than ordinary shares in the event of
the company going into liquidation.
E. A company may have different classes of shares with different rights.
Concept check 5
Which of the following statements is true?
A. Reserves are profits and gains that have been made by the company and that still
form part of the shareholders’ (owners’) claim.
B. Reserves are usually in the form of cash.
C. Retained profits (retained earnings) is a reserve of profits that has been paid out to
shareholders.
D. Reserves represent a claim by the lenders to the business.
E. None of the above.
Concept check 6
Which of the following is NOT a characteristic of bonus share issues?
A. They convert a reserve into share capital.
B. They are also known as share dividends.
C. They lower the value of an individual share.
D. They lower overall shareholder wealth.
E. They provide shareholders with a ‘feel-good factor’.
Restrictions on the rights of shareholders to make
drawings or reductions of capital
LO 3 Explain the restrictions on the rights of shareholders regarding drawings or reductions in capital
Limited companies are required by law to distinguish between that part of their capital (shareholders’
claim) which may be withdrawn by the shareholders and that part which may not be. The distributable
(withdrawable) part—which has arisen from operating profits and from realised profits on the disposal of
fixed assets (both on an after-tax basis)—is called retained profit . As mentioned earlier, unrealised
capital profits obtained by a bona fide revaluation of all assets are also distributable. The non-distributable
part (which cannot be withdrawn) normally consists of what arose from funds injected by shareholders
buying shares in the company. In fact, many companies treat unrealised capital gains obtained by a
revaluation as, effectively, a non-distributable revaluation reserve.
retained profit
The amount of profit made over the life of a business which has not been taken
out by owners in the form of drawings or dividends.
The reason why limited companies are required to distinguish different parts of their equity relates to the
limited liability, which company shareholders enjoy, but which owners of unincorporated businesses do
not. If a sole trader withdraws all of the owner’s claim, or even more than this, the position of the
business’s creditors is not weakened since they can legally enforce their claims against the sole trader as
an individual. With a limited company, in which the business and the owners are legally separated, such
legal right does not exist. Therefore, to protect the company’s creditors the law insists that a specific part
of the capital of a company cannot legally be withdrawn by the shareholders.
The law does not specify how large the non-distributable part of a particular company’s capital should be.
It simply requires that anyone dealing with the company must be able to tell how large it is by looking at
the company’s statement of financial position. In the light of this, a particular prospective lender, or
supplier of goods or services on credit, can make a commercial judgement as to whether or not to deal
with the company.
Example 4.5 illustrates both the extent and the limits to which external claims can be protected.
EXAMPLE
4.5
The summary statement of financial position of a company is as follows:
Net assets
Shareholders’ equity
43,000
The company has asked a bank to make it a $25,000 long-term loan. If the bank agrees,
straightaway the statement of financial position will appear as follows:
Net assets
43,000
Shareholders’ equity
43,000
As things stand, there are assets of $68,000 to meet the bank’s claim of $25,000. However, the
company could pay a dividend of $23,000, perfectly legally. If it did, the statement of financial
position would appear as follows:
Net assets
$20,000
Shareholders’ equity
$20,000
This leaves the bank in a much weaker position, because net assets are now shown as having a
value of $45,000 to meet a claim of $25,000. Note that the difference between the amount of the
bank loan and the other net assets always equals the capital and reserves total. The capital
represents a ‘margin of safety’ for creditors. The larger the amount of the owners’ claim that is
withdrawable by the shareholders, the smaller the potential margin of safety for creditors.
The law is quite specific that it is illegal, under normal circumstances, for shareholders to withdraw that
part of their claim which is represented by capital. This means that potential creditors of the company
know the maximum amount of the shareholders’ claim that can be drawn or withdrawn by the
shareholders.
It is important to remember that company law says nothing about how large this margin of safety must be.
What is desirable is left as a matter of commercial judgement by the company concerned. The larger it is,
the easier the company will find it to persuade potential lenders to lend and suppliers to supply goods and
services on credit.
Sometimes, a potential creditor may insist that some of the retained profits are converted to bonus shares
(or ‘capitalised’) to increase the margin of safety, as a condition of granting the loan. Also, most potential
long-term lenders try to secure their loan against one of the company’s assets, such as freehold property.
This gives them the right to seize the specific asset concerned, sell it and satisfy their claim should the
company default. Lenders often place restrictions or covenants on the borrowing company’s freedom of
action as a condition of granting the loan. These covenants typically restrict the level of risk to which the
company, and thus the lender’s asset, is exposed.
Also, it would be quite rare for a company to pay out all of its revenue reserves as a dividend: a legal right
to do so does not necessarily make it a good idea. Most companies see ploughed-back profits as a major
—usually the major—source of new finance. The factors that influence the dividend decision are likely to
include:
the availability of cash to pay a dividend—it would not be illegal to borrow to pay a dividend, but it
would be unusual and, possibly, imprudent
the needs of the business for finance for investment
possibly a need for the directors to create good relations with investors, who may regard a dividend as
a positive feature.
Large companies tend to have a clear and consistent policy towards the payment of dividends, and any
change in the policy provokes considerable interest. It is usually interpreted by shareholders as a signal of
the directors’ views concerning the future. For example, an increase in dividends may be taken as a
signal from the directors that future prospects are bright: a higher dividend is seen as tangible evidence of
their confidence.
Real World 4.4 provides examples of how commercial realities led to a change in the level of dividends
paid.
Facing some heavy price discounts on its iron ore, and operating under a new leadership team,
Andrew Forrest’s Fortescue Metals Group made a cautious approach with its interim dividend
payment early in 2018. The company paid a dividend of 11¢ per share, representing a payout of
40% of earnings for the period. The ratio was in line with that of the previous year, but it ‘fell
outside Fortescue’s recently minted policy of returning between 50 and 80 per cent of annual
earnings as dividends’.
By May 2019, after the benchmark price of iron ore had surged from $72 to $95 a tonne, Fortescue
was able to deliver a ‘surprise 60c-a-share dividend’.
Sources: Paul Garvey, ‘Wary Fortescue trims dividend’, The Australian, 22 February 2018.
Nick Evans, ‘Fortescue special dividend delivers $1bn payday for Andrew Forrest’, The Australian, 14 May 2019.
At the start of 2018 BP signalled that ‘it could raise its dividend for the first time in four years after
the surging oil price boosted profits and compensation payments related to its Deepwater Horizon
disaster looked set to tail off’.
Source: Jack Torrance, ‘BP poised to end dividend freeze as oil prices surge’, The Australian, 2 May 2018.
NAB reduced its dividend for the first half of 2019 from 99¢ per share to 83¢ per share, reflecting
softer conditions in the sector. ‘It had been paying out close to 100 per cent of its earnings to
shareholders, a situation deemed unsustainable in times of challenged profits and flatlining
earnings.’
Source: Stephen Letts, ‘NAB slashes dividends as royal commission costs mount and housing worries bite’, ABC News, 2 May 2019.
Reflection 4.4
You are developing a new fintech company with a few friends of a similar age and experience. You
are wrestling with a number of questions, including the following:
1. What kind of income and cost structures are likely?
2. What are the chances of success?
3. If successful, how quickly might the company grow?
4. How much finance do you need over the next seven to 10 years to take it where you want it
to go?
5. What kind of returns can you achieve, and how might these returns be shared?
In the light of these questions, and a fair degree of uncertainty, what are your initial thoughts
regarding retentions or dividends?
It is possible for certain preference shares (called ‘redeemable preference shares’) to be redeemed
(repurchased by the company). Where any such preference shares are redeemed and replaced by new
shares there is no real problem, as the creditor’s position relative to shareholders is unchanged. However,
where preference shares are redeemed without any new capital issue, there seems to be a direct
contradiction of what has been said so far in this section, as the shareholders’ equity would be reduced. It
is therefore necessary for an amount equivalent to the amount of preference capital redeemed to be
transferred from retained profits directly to capital, thus maintaining the total capital of the business.
Without this proviso, unscrupulous directors could redeem capital and pay out retained profits,
disadvantaging creditors and lenders.
A company is not allowed to acquire and hold its own shares, but it can buy them back and cancel them,
so long as the buyback does not materially prejudice the creditors.
Activity 4.4
Why might a company wish to buy back its shares?
Real World 4.5 provides some examples of relatively recent share buybacks.
Insurance Australia Group Limited (IAG) announced in August 2018 a capital management
initiative, being:
a payment of 25¢ per ordinary share, comprising a capital return of 19.5¢ and a fully franked
special dividend of 5.5¢ per ordinary share and
an equal and proportionate consolidation of ordinary shares.
The total payment to shareholders was approximately $592 million. The consolidation meant that
the number of shares was reduced by 2.4%.
IAG was holding equity capital in excess of targets and regulatory requirements. There were no
significant operational demands on its capital.
Whether this was a good decision, in the light of the really bad hail storm that occurred in
December 2018, is a matter of conjecture, but the storm reinforces the risky nature of the
insurance business.
BHP announced in 2017 that its shale business was non-core and that ‘we are going to exit this
thing in the next two years’. Sale proceeds ‘were likely to go straight back to shareholders under
BHP’s new net debt target of $US10bn to $US15bn, and capital ceiling of $US8bn’, it revealed in
August 2017.
Source: Matt Chambers, ‘Shareholders to get shale sale cash within two years, says BHP’, The Australian Business Review, 24 August 2017.
Woolworths, after a successful sale of its petrol business, decided that it would return up to $1.7
billion to shareholders by an off-market buyback, conducted through a tender process. This was
successfully completed in May 2019 at a price of $28.94, a discount of 14% on the market price.
SELF-ASSESSMENT QUESTION
4.1
The summarised statement of financial position of Bonanza Ltd is as follows:
BONANZA LTD
Statement of financial position
as at 31 December 2020
Shareholders’ equity
235,000
1. Without any other transactions occurring at the same time, the company made a one-for-
five rights share issue at $2 per share payable in cash (all shareholders took up their rights),
and immediately after made a one-for-four bonus issue, at an issue price of $2.
Show the statement of financial position immediately following the bonus issue, assuming
that the directors want to retain the maximum dividend payment potential for the future.
2. Explain what external influence might cause the directors to choose not to retain the
maximum dividend payment possibilities.
3. Show the statement of financial position immediately following the bonus issue, assuming
that the directors want to retain the minimum dividend payment potential for the future.
(For the purposes of questions 3 and 4, assume that the company does not consider the
revaluation reserve to be distributable as a cash dividend.)
4. What maximum dividend could be paid before and after the events described in question 1
if the minimum dividend payment potential is achieved?
5. Lee owned 100 shares in Bonanza Ltd before the events described in question 1. Assuming
that the company’s net assets have a value equal to that shown in the accounts, show how
these events will affect Lee’s wealth?
Concept check 7
Which statement is false?
A. Retained profits are profits made over the life of a business that have not been taken
out by owners in the form of drawings or dividends.
B. It is law that a specific part of the capital of a company cannot legally be withdrawn
by the shareholders.
C. Large companies tend to have an opaque and changing policy towards the payment
of dividends.
D. The availability of cash is quite possibly a factor in a dividend payment decision.
E. None of the above.
Concept check 8
Which of the following is false?
A. Many companies treat unrealised capital gains obtained by a revaluation as a non-
distributable revaluation reserve.
B. To protect the company’s creditors, the law insists that a specific part of the capital of
a company cannot legally be withdrawn by the shareholders.
C. Many companies treat retained profits as a source of finance.
D. It is illegal for a company to borrow money to pay a dividend.
E. None of the above are false.
The main financial statements
LO 4 Explain and discuss the main financial statements prepared by a limited company
The financial statements of a limited company are, in principle, the same as those of a sole proprietorship
or a partnership. There are, however, differences in detail, which we shall now consider. Example 4.6
sets out the income statement and statement of financial position of a limited company.
EXAMPLE
4.6
DA SILVA LTD
Income statement
for the year ending 31 December 2020
$m
Revenue 840
Insurance (4)
Depreciation (45)
Operating profit 95
Taxation (24)
DA SILVA LTD
Statement of financial position
as at 31 December 2020
$m
Current assets
Cash 36
Inventories 65
213
Non-current assets
303
Current liabilities
Accounts payable 99
Taxation 12
111
Non-current liabilities
Borrowings 100
Equity
Other reserves 80
Retained earnings 25
305
Let us now go through these statements and pick up those aspects that are unique to limited
companies.
Profit
Following the calculation of operating profit, two further measures of profit are shown.
The first of these is the profit before taxation . Interest charges are deducted from the operating profit
to derive this figure. In the case of a sole proprietor or a partnership business, the income statement
would end here.
profit before taxation
The result when all of the appropriately matched expenses of running a business
have been deducted from the revenue for the year, but before the taxation charge
has been deducted.
The second measure of profit is the profit for the period (usually a year). As the company is a
separate legal entity, it is liable to pay tax on the profits generated. (This contrasts with the sole proprietor
business where it is the owner rather than the business who is liable for the tax on profits, as we saw
earlier in the chapter.) This measure of profit after tax represents the amount that is available for the
shareholders.
Audit fee
Companies beyond a certain size are required to have their financial statements audited by an
independent firm of accountants, for which a fee is charged. As we shall see in Chapter 5 , the purpose
of the audit is to lend credibility to the financial statements. Although it is also open to sole proprietorships
and partnerships to have their financial statements audited, relatively few do, so this is an expense that is
most often seen in the income statement of a company.
Taxation
The amount that appears as part of the current liabilities represents any income tax due in the next 12
months.
Other reserves
This will include any reserves that are not separately identified on the face of the statement of financial
position. It may include a general reserve, which normally consists of trading profits that have been
transferred to this separate reserve for reinvestment (‘ploughing back’) into the operations of the
company. It is not at all necessary to set up a separate reserve for this purpose. The trading profits could
remain unallocated and still swell the retained earnings of the company. It is not entirely clear why
directors decide to make transfers to general reserves, since the profits concerned remain part of the
revenue reserves, and as such they still remain available for dividend. The most plausible explanation
seems to be that directors feel that placing profits in a separate reserve indicates an intention to invest the
funds, represented by the reserve, permanently in the company, and therefore not to use them to pay a
dividend or to fund a share repurchase. Of course, the retained earnings appearing on the statement of
financial position are also a reserve, but that fact is not indicated in its title.
Real World 4.6 provides an illustration of the range of reserves found in practice. Many large
companies use similar approaches, as revaluations, foreign currency translations and cash flow hedges
are reasonably common.
Boral, in its annual report for 2019, included the following reserves, as well as retained profits.
Hedging reserve
The hedging reserve records the portion of the gain or loss on a hedging instrument in a cash flow
hedge that is determined to be an effective hedge relationship.
Some of these reserves will actually be negative and clearly will reduce total equity.
Dividends
Dividends represent drawings by the shareholders of the company. They are paid out of the revenue
reserves, and should be deducted from these reserves (usually retained earnings) when preparing the
statement of financial position. Shareholders are often paid an annual dividend, perhaps in two parts. An
‘interim’ dividend may be paid part-way through the year, and a ‘final’ dividend shortly after the year-end.
Those dividends declared by the directors during the year but still unpaid at the year-end may appear as
a liability in the statement of financial position. To be recognised as a liability, however, they must be
properly authorised before the year-end date. This normally means that the shareholders must approve
the dividend.
Activity 4.5
Assume that a company has a profit before taxation of $10 million and expects to pay income tax at the
rate of 30%. It has paid an interim dividend of 10¢ per share, and expects to pay a final dividend of 10¢
per share. There are 20 million shares issued at a price of $1.50 each. Opening retained profits were $15
million.
Show your calculation of the retained profits at the end of the year, the equity section of the statement of
financial position at the end of the year, and any other current liabilities that will be shown in the closing
statement of financial position.
Concept check 9
Which of the following is false?
A. The financial statements of a limited company are fundamentally the same as those
of a sole proprietorship.
B. The financial statements of a limited company are fundamentally the same as those
of a partnership.
C. Tax expense is recognised by a company when profits are earned.
D. Unpaid taxes will be part of a company’s current liabilities.
E. None of the above. All are true.
Concept check 10
Which of the following statements is false?
A. The asset revaluation reserve account is used to record increases in the fair value of
‘owner-occupied’ land and buildings.
B. Dividends are the corporate version of drawings.
C. The creation of a general reserve is a sensible business decision in many contexts.
D. The creation of a general reserve does not affect the ability of the company to pay
dividends.
E. None of the above. All are true.
Summary
In this chapter we have achieved the following objectives in the way shown.
Identify and discuss the main features of companies Explained the importance and implications of corporate separate legal entity
Explained the significance of perpetual life for a company
Explained limited liability and its consequences
Distinguished between private companies and public companies
Explained the role of the stock exchange in transferring share ownership
Explained the separation of ownership and management that is implicit in
companies
Identified reasons for greater regulation associated with companies
Outlined the concept of corporate governance
Listed and explained the advantages and disadvantages of limited companies
Explain equity and borrowings in a company context Identified and explained the basic ‘classification’ of equity for a limited company
Explained the nature of reserves
Explained and illustrated bonus shares
Identified the main ways in which capital can be raised
Identified the types of borrowing possible for corporate entities, and their
importance
Explain the restrictions on the rights of shareholders Identified the legal position regarding shareholders’ ability to make drawings or
regarding drawings or reductions in capital reductions in capital
Illustrated the basic reason for the restrictions
Explain and discuss the main financial statements Identified the major differences between the final accounts of a limited company
prepared by a limited company as distinct from those of a sole proprietorship or a partnership
Discussion questions
Easy
4.1 LO 1 What is meant by a company having ‘perpetual life’? Is this ‘life’ different for a limited company as compared to a proprietary
company?
4.2 LO In what sense do preference shares have an ‘advantage’ or ‘priority’ over ordinary shares?
1/2/3
4.3 LO 2 Six friends decide to form a company to start a business. They agree to supply $10,000 each to provide the initial capital. They
are thinking of having a share capital of six shares each issued at a price of $10,000. Their accountant has advised them to
have 60,000 shares at an issue price of $1 per share. Can you think why the accountant gave them this advice?
Intermediate
4.4 LO It is not unusual for the daily number of Telstra shares traded to be in the hundreds of thousands. Which type of investors do
1 you see being involved in buying and selling on the stock market on a regular basis?
4.5 LO How do you determine whether a company can be classified as ‘small’ under the Australian Corporations Act?
1
4.6 LO What are the main areas that directors need to disclose in their report?
1
4.7 LO Why would a business choose to make the following entity structure changes?
1/2
a. From a sole proprietorship or partnership to a private company.
b. From a public company to a private company.
4.8 LO Is ‘limited liability’ a good thing? Explain. How do you interpret the term in the case of bankruptcy?
1
4.9 LO What is the difference between a share issued as a ‘bonus share’ and a ‘rights share’ from the perspective of the:
2
a. shareholder?
b. company issuing the shares?
c. unsecured creditor?
4.10 LO Why is the Corporations Act particularly interested in distinguishing between ‘a return on capital’ and ‘a return of capital’?
3
4.11 LO Can reserve accounts have a negative balance? If yes, provide an example.
1/2
4.12 LO Discuss the three guiding principles relating to the monitoring and control of the behaviour of directors, namely, disclosure,
4 accountability and fairness.
4.13 LO Can you think of any reason why the price at which shares are transferred from one person to another may be different from the
1/2 amount originally invested in the company?
4.14 LO How can a company’s supplier minimise the risk carried by the limited liability of shareholders?
3
Challenging
4.15 LO Your non-accountant friend has asked you to explain what is represented by the ‘Reserve for future research and
2/3 development’ account on PHB Ltd’s balance sheet. Explain what this account represents and why it might have been created.
4.16 LO 4 Describe the similarities and differences between the main financial statements prepared for a limited company and those for
a sole proprietorship or partnership.
4.17 LO 3 What is a chief means by which the Corporations Act protects the interests of creditors and other external lenders?
4.18 LO 4 In light of the various corporate collapses and scandals in recent years (e.g. Fuji Xerox), you’re concerned about the accuracy
of corporate financial statements. What is your chief assurance that the financials are ‘accurate’?
4.19 LO Summarise the rules relating to payment of dividends. Do these rules adequately protect creditors and lenders?
1/2/3
4.20 LO Why do you think shareholders are not allowed to take drawings from limited companies?
1/3
4.21 LO 1 Why do you think public companies conduct extensive mandatory and voluntary disclosures (financial and other disclosures)
in the annual report?
Application exercises
Easy
4.1 LO Pillar Limited issued 10,000 ordinary shares at $5 and made a call at $3. Calls are in arrears at balance day for 500 shares.
2
Calculate Pillar Limited’s share capital balance.
4.2 LO a. Show the effect on the statement of financial position of the following transactions:
2 i. 100,000 shares issued at a price of $1 per share, but only 50¢ per share is called
ii. after the remaining 50¢ is called.
Equity
5,000,000
The company is planning to raise a further $2 million via a new issue of shares. Advise the company as to the price at which the
shares should be issued.
200,000
Intermediate
4.5 LO Comment on the following quote:
1/2
Limited companies can set a limit on the amount of debts that they will meet. They tend to have reserves of cash, as well as
share capital, and they can use these reserves to pay dividends to the shareholders. Many companies have preference as
well as ordinary shares. The preference shares give a guaranteed dividend. The shares of many companies can be bought
and sold on the stock exchange. Shareholders selling their shares can represent a useful source of new finance to the
company.
4.6 LO A company had the following events during its most recent financial year:
2
1. A non-current asset was sold for a profit of $20,000.
2. A profit of $45,000 was made on trading operations.
3. An issue of 10,000 $1 ordinary shares raised $30,000.
4. Property was revalued at $10,000 above its current recorded value.
1. An operating loss is made in the period to which the proposed dividends relate.
2. A decision has been made not to pay a dividend to preference shareholders.
4.8 LO a. The summarised statement of financial position of Leon Ltd is shown below:
2 Net assets 2,000,000
2,000,000
The directors decide to redeem the preference share capital. This is to be replaced by a further issue of 200,000 ordinary
shares at $1.60 per share.
Show the revised statement of financial position after this has occurred.
b. What would you have needed to do if the replacement issue had not taken place?
c. Explain the rationale for your answer to (b).
1,600,000
CF Ltd decides to make a bonus issue on a one-for-four basis, followed by a rights issue on a one-for-five basis, at a price of $2
per share.
Challenging
4.10 LO Woolwell Ltd has the following equity capital at the year-end.
3
Ordinary shares of $0.25 each $400,000
$650,000
In addition, the company has 200,000 $1 5% preference shares in issue. The board of directors wishes to eliminate the
company’s reserves. It has decided to make an immediate one-for-four bonus issue of ordinary shares. Following the issue, an
annual dividend will be paid to shareholders. The board would like the amount paid to ordinary shareholders to be the maximum
possible.
$’000
Revenue 1,850
Depreciation (220)
Taxation (60)
CHIPS LTD
Statement of financial position
as at 30 June 2020
Cost Depreciation
ASSETS
Current assets
Cash at bank 16
Inventories 950
1,386
Non-current assets
Current liabilities
Tax 60
538
Non-current liabilities
Borrowings (secured 10%) notes) 700
Equity
1,168
1. Purchase invoices for goods received on 29 June 2020 amounting to $23,000 have not been included. This means that
the cost of sales figure in the income statement has been understated.
2. A motor vehicle costing $8,000 with depreciation amounting to $5,000 was sold on 30 June 2020 for $2,000, paid by
cheque. This transaction has not been included in the company’s records.
3. No depreciation on motor vehicles has been charged. The annual rate is 20% of cost at year-end.
4. A sale on credit for $16,000, made on 1 July 2020, has been included in the financial statements in error. The cost of
sales figure is correct in respect of this item.
5. A half-yearly payment of interest on the secured loan, due on 30 June 2020, has not been paid.
6. The tax charge should be 30% of the reported profit before taxation. Assume that it is payable, in full, shortly after year-
end.
Prepare a revised set of financial statements incorporating the additional information in 1–6. (Work to the nearest $1,000.)
4.12 LO Rose Ltd operates a small chain of retail shops which sell high-quality teas and coffees. Approximately half of the sales are on
4 credit. Abbreviated and unaudited accounts are given below.
ROSE LTD
Income statement
for the year ended 31 March 2020
$’000 $’000
Sales 12,080
Depreciation (625)
(4,286)
ROSE LTD
Statement of financial position
as at 31 March 2020
$’000 $’000
Current assets
Cash at bank 26
Inventory 1,583
2,605
Current liabilities
2,565
Non-current liabilities
Shareholders’ equity
2,468
Since the unaudited accounts for Rose Ltd were prepared, the following information has become available:
1. An additional $74,000 of depreciation should have been charged on fixtures and fittings.
2. Invoices for credit sales on 31 March 2020 amounting to $34,000 have not yet been included; cost of sales is not
affected.
3. Bad debts should be provided at a level of 2% of debtors at year-end.
4. Inventory purchased for $2,000 was damaged and is now unsaleable.
5. Fixtures and fittings to the value of $16,000 were delivered just before 31 March 2020, but these assets were not
included in the accounts and the purchase invoice has not been processed.
6. Wages for Saturday-only staff, amounting to $1,000, have not been paid for the final Saturday of the year.
7. The audit fee of $45,000 is due.
8. Tax is payable at 30% of net profit.
Use the information provided above, together with a review of the notes to the accounts found on the
web, to answer the following questions.
Questions
1. What do you understand by the term ‘cash and cash equivalents’ in the consolidated statement of
financial position (balance sheet)?
2. What is the basis of valuation of ‘trade and other receivables and contract assets’ and ‘inventories’
for 2019?
3. What do you think are likely to be the main components in the figure for ‘property, plant and
equipment’ in the statement of financial position (balance sheet)?
4. What do you understand by ‘fair value’?
5. What items do you think might be covered under the heading ‘intangible assets’ in the statement of
financial position (balance sheet)? How do you think the various items might be valued and
subsequently amortised?
6. What items are likely to be covered under the heading ‘borrowings’? How might these borrowings
be secured?
7. The main ‘provisions’ in the current liabilities are made up of ‘employee benefits’ and ‘other
provisions’. Those in the non-current liabilities include the same items. Can you suggest what
these might relate to?
8. Explain the equity section of the statement of financial position (balance sheet).
9. What is the relationship between the ‘profit for the year’ in the statement of financial performance
(incomes statement) and ‘total equity’ in the statement of financial position (balance sheet)?
Activity 4.1
Business is a risky venture—in some cases very risky. People will usually be happier to invest money
when they know the limit of their liability. If investors are given limited liability, new businesses are more
likely to be formed and existing ones are likely to find it easier to raise more finance. This is good for the
private-sector economy and may ultimately lead to the generation of greater wealth for society as a
whole.
Obviously not all suppliers of goods and services are protected, as we read regularly that they lose all or
part of what is owed to them when companies are liquidated (e.g. Harris Scarfe, Ansett, HIH). However,
certain factors, requirements or actions are in place to provide protection, including:
the legal requirement for companies to prepare financial reports in conformity with statutory
accounting standards
suppliers may require payment to be made in advance
creditors may require personal guarantees by the owners or management
lenders may take out a specific claim against tangible assets of the company (mortgage, bill of sale)
lending agreements may restrict the financial practices:
—maximum level of debt to assets
the creditors rank before the shareholders in the distribution of assets in the event of a liquidation of
the company.
Activity 4.2
Two ways are commonly used in practice by the shareholders themselves to try to ensure that the
directors always act in the shareholders’ best interests:
The shareholders may insist on monitoring closely the actions of the directors and the way in which
they use the resources of the company.
The shareholders may introduce incentive plans for directors that link their pay to the share
performance of the company. In this way, the interests of the directors and shareholders will become
more closely aligned.
Activity 4.3
The answers are as follows:
Net assets
Cash $100,000
Shareholders’ equity
Net assets
Cash $150,000
Shareholders’ equity
Capital (200,000 shares) 300,000 (i.e. 100,000 issued at $1 plus 100,000 issued at $2)
$370,000
Activity 4.4
Reasons might include the following:
Where surplus funds cannot be invested to yield returns in excess of the return being paid to
shareholders, it makes economic sense to buy back shares rather than to invest surplus funds.
Share capital represents permanent funds on which the company will pay dividends indefinitely.
Where the current level of permanent funds is excessive, it makes sense to reduce that funding and
replace it with short-term funds as required (debt).
The repurchase of shares may lower the average cost of funds to the company (cost of capital), and
this will mean that more potential projects will be deemed acceptable.
The company’s activity in the market will increase demand for shares and potentially increase or
sustain the share price, which will normally be an advantage to the company.
When the share price falls, it is a good time for the company to repurchase shares.
The activity of the company in buying its own shares will create additional demand, and this will have a
positive impact on the share price.
The repurchase of shares reduces the number of shares available for trading, and this also will have a
positive impact on the share price.
The repurchase of shares will normally lower the firm’s cost of funds, and potentially increase returns
on the remaining shares.
The earnings and dividends per share should increase given there are now fewer shares.
Activity 4.5
$m
After-tax profit 7
Added to reserves 3
Equity section
Retained profits 18
Total equity 48
Current liabilities
Income tax 3
5
Chapter 5 Regulatory framework for companies
Learning objectives
When you have completed your study of this chapter, you should be able to:
LO 1 Explain the importance of company law in relation to the directors’ duty to account,
and discuss the role of the auditor in this process
LO 2 Explain why there is a need for accounting rules, identify the main sources of
accounting rules, and outline the role of the Australian Securities Exchange with regard to
company reporting and management, with particular reference to corporate governance
LO 3 Identify the main requirements relating to the published annual report, including all of
the financial and ancillary statements
LO 4 Explain the concept of group or consolidated accounts.
Finally, we provide an outline of the reasons why, and the way in which, a
group of companies needs to prepare a set of consolidated accounts.
The directors’ duty to account—the role of company
law (corporations act)
LO 1 Explain the importance of company law in relation to the directors’ duty to account, and discuss
the role of the auditor in this process
As we have already seen, it is not usually possible for all of the shareholders to be involved in the general
management of the company, nor do most of them wish to be involved, so they elect directors to act on
their behalf. It is both logical and required by company law that directors are accountable for their actions
as stewards of the company’s assets. The directors must therefore prepare (or have prepared on their
behalf) financial statements that provide a fair representation of the financial position and performance of
the business. This requires that they select appropriate accounting policies, make reasonable accounting
estimates, and adhere to all relevant accounting rules when preparing the statements. The directors are
also expected to maintain appropriate internal control systems.
In this context, directors of all reporting entities and disclosing entities , all public companies and
all large proprietary companies are required to prepare true and fair financial statements. (Disclosing
entities include companies listed on the stock exchange and companies raising funds through a
prospectus—i.e. public issue.) Small proprietary companies are not required to prepare formal financial
statements or to have them audited, unless directed to by at least 5% of their shareholders or by the
Australian Securities and Investments Commission (ASIC). They must, however, maintain sufficient
accounting records to allow annual accounts to be prepared and audited. The financial statements are to
include the statement of financial position, the statement of financial performance (in the case of
companies, this is a statement of comprehensive income), the statement of changes in equity, the
statement of cash flows and related notes.
reporting entity
An entity that is required, or chooses, to prepare financial statements is known as
a reporting entity. A reporting entity need not be a legal entity, and can be a single
entity, a portion of a larger entity or be made up of more than one entity.
disclosing entity
An entity that issues securities that are quoted on a stock exchange or made
available to the public via a prospectus.
‘True and fair’ has not been specifically defined, nor tested in court. However, it is normally interpreted as
requiring the provision of all necessary financial information of a material nature related to both the
directors’ stewardship role and their financial information (decision-making) role. Information is material if
its omission, misstatement or non-disclosure has the potential, individually or collectively, to:
influence the economic decisions of the users taken on the basis of the financial report, or
affect the discharge of accountability by the management or governing body of the entity.
The Corporations Act also requires directors of disclosing entities to accompany the financial statements
with a ‘directors’ declaration’ and a ‘directors’ report’. In the directors’ declaration, the directors must state
whether, in their opinion, the financial statements comply with the applicable accounting standards and
represent a ‘true and fair’ view of both the financial performance and the financial position of the
company. They must also state whether, in their opinion, at the date of the declaration there are
reasonable grounds to believe that the company can meet its debts as and when they fall due.
The directors’ report is generally much longer, and contains certain required information together with an
increasing level of voluntary disclosures. Such disclosures include the names of directors, the
emoluments of directors, the principal activities of the company, a review of the operations for the year,
details of significant changes in the state of affairs of the company, the financial significance of probable
future events, details of significant events that have occurred after the balance date that may affect the
company, and details of compliance with environmental regulations. Obviously, the voluntary disclosures
extend beyond the required disclosures, and may include financial forecasts, details of human resource
management strategies, significant contributions to community life, and additional environmental
initiatives. When one company owns a controlling interest in another, so that management of the
controlled company is effectively carried out by the controlling company, ‘consolidated accounts’ (‘group
accounts’) must be prepared in addition to the individual company accounts.
The financial reports must comply with accounting standards . Companies’ financial reports should be
checked by an auditor and reported on (unless the company is a small proprietary company—and
even then shareholders or ASIC may require an audit).
accounting standards
Rules established by the professional or statutory accounting bodies, which
should be followed by preparers of the annual accounts of companies.
auditors
Professionals whose main duty is to make a report as to whether, in their opinion,
the accounting statements of a company do what they are supposed to do;
namely, to show a true and fair view, and comply with statutory and accounting
standard requirements.
Activity 5.1
a. What are the possible consequences of failing to make financial statements available to
shareholders, lenders and suppliers on the ability of the business to operate?
b. How important is the publication of well-regulated annual reports to the efficiency of the private
sector?
Auditors
Shareholders are required to appoint a qualified and independent person or, more usually, a firm to act as
auditor. The main duty of auditors is to make a report declaring whether or not the statements do what
they are supposed to do: that is, whether they fairly reflect the entity’s financial performance, financial
position and liquidity, and whether they comply with statutory requirements and accounting standards.
This requires the auditors to critically examine the annual accounting statements prepared by the
directors, and the evidence on which they are based. The auditors’ opinion must be included with the
accounting statements that are sent to the shareholders and to ASIC.
The auditor’s report provides a check on the credibility and reliability of the financial reports, and indicates
whether or not the report complies with the Corporations Act. The auditor’s report in the past have tended
to be fairly short and have normally included:
the identification of the financial reports covered by the audit report, together with responsibilities
a statement that the audit (the check) was carried out in accordance with Australian Auditing
Standards
a statement that the financial statements comply with Australian Accounting Standards
an opinion section, in which the auditor concludes whether or not the financial reports fairly represent
the company’s financial performance, financial position and cash flows—if the auditor does not think
that this is the case, the report will be ‘qualified’ with a section explaining why, and the extent to which,
the statements do not comply with the statements and tests reviewed above.
From the end of 2016 new audit reporting rules have provided useful additional requirements that should
provide greater transparency and useful insights for investors and stakeholders. The most significant is
probably the introduction of ISA 701, on ‘Communicating Key Audit Matters in the Independent Auditor’s
Report’. As implied by the title, the standard deals with the auditor’s responsibility to communicate key
audit matters in the auditor’s report. It also deals with the auditor’s responsibility to communicate other
audit planning and scoping matters in the auditor’s report. The standard applies to audits of general-
purpose financial reports of listed companies.
Key audit matters are described as ‘those matters that, in the auditor’s professional judgement, were of
most significance in the audit of the financial statements of the current period. Key audit matters are
selected from matters communicated with those charged with governance.’ They typically include areas of
higher assessed risk of material misstatement, areas where significant judgement is required, and the
effect of such transactions. The report must include a description of the most significant assessed risks of
material misstatement and a summary of the auditor’s response to those risks.
The report must include a formal declaration that they are independent and have fulfilled all relevant
ethical responsibilities
Real World 5.1 provides a summary of a report drawn up to comply with the standard.
Cochlear Limited, a global leader in implantable hearing devices, was in the forefront of its field. Its
2019 annual report includes both a declaration of auditor’s independence (page 48), and a formal
report after the financial statements (pages 93–97). The report includes, in order:
an opinion section confirming that the financial report is in accordance with the Corporations
Act, gives a true and fair view, and complies with Australian Accounting Standards and
Corporate Regulations
a section on the basis for the opinion
a section drawing attention to a patent dispute, which is described and assessed
identification of key audit matters: recoverability of trade receivables, and the warranty
provision—these are described, followed by a description of how the matter is addressed in the
audit
a section covering ‘Other information’, although the responsibility of the auditor is only to read
this material; the opinion on the financial report does not cover this
sections covering the directors’ responsibilities regarding the financial report, and the auditor’s
responsibilities for the audit of the financial report
a report on the remuneration report.
It is interesting to compare this new-style report with the short version that was typical of the past.
Source: Cochlear Limited Annual Report 2019.
Note that an audit report gives an opinion but no guarantees. In general, however, given the number of
legal cases made against auditors, it is true to say that with all the care and attention to detail involved in
audit work an unqualified audit report should reassure the investing public. Even qualified reports rarely
pose problems when the rationale for the qualification is understood.
Overall, the onus on the directors of limited companies to report on their activities is extensive. Originally,
the prime motivation was a ‘stewardship’ report, in which the directors reported to the shareholders on
their stewardship of the resources entrusted to them. Over the past 30 years, the stewardship report has
developed into a general-purpose report of use to a variety of users and potential users, such as
shareholders, potential shareholders, lenders, creditors, employees, social activists and
environmentalists.
Reflection 5.1
Lucas, your restaurateur of Reflection 4.1 , has now completed his first year and his accounts
have just been audited. While not required to comply with the new requirements, as his company is
not listed, he has asked that any substantial issues for audit purposes be identified and discussed
with him. A number of key issues have arisen. How seriously should he take these? One issue
relates to some suspected fraud by one staff member.
The relationship between the shareholders, the directors and the auditors is illustrated in Figure 5.1 .
Figure 5.1 The relationship between the shareholders, the directors and the auditors
The directors are appointed by the shareholders to manage the company on the shareholders’ behalf.
The directors are required to report each year to the shareholders, principally by means of financial
statements, on the company’s performance and position. To lend greater credibility to the financial
statements, the shareholders also appoint auditors to investigate the statements and to express an
opinion on their reliability.
In spite of all of these rules, there is evidence of some dissatisfaction, as can be seen from Real World
5.2 .
In January 2019, ASIC released a regular audit inspection report, which included the following:
1. In 20% of the key areas reviewed ‘auditors did not obtain reasonable assurance that the
financial report as a whole was free of material misstatement’ (para 3). This compared with
23% for the preceding period.
2. The report suggests that ‘further work, and, in some cases, new or revised strategies are
needed to improve quality’ (para 6).
3. In the previous report, areas for improvement were identified as the audit of asset values,
audit of revenue, and maintaining a strong culture of audit quality (para 7). This report found
some improvement in the area of asset valuation and revenues, but these areas are still
seen as being important for sustainable improvement (para 8).
4. Important areas for auditors to focus on were identified as the sufficiency and
appropriateness of audit evidence, the level of professional scepticism, and appropriate use
of the work of experts and other auditors (para 21).
5. ‘While firms continue to make good efforts to improve ... they should consider enhancing
existing initiatives and focus on new and sustainable initiatives to improve audit quality and
maintain a culture focused on this’ (para 12).
Source: Australian Securities and Investment Commission (ASIC), Audit Inspection Program Report for 2017–18. Report 607. (ASIC, Brisbane, 2019).
UK quality gap
‘In the UK accountancy firms have been warned of a gap in quality between their audits of big
businesses and those of smaller firms, which are increasingly flawed.’ The Financial Reporting
Council found that the percentage of audits that could be categorised as good or requiring only
limited improvements for larger companies was 81%, but for smaller companies this figure fell to
72%.
Source: Ben Martin, ‘Slide in audit quality at smaller firms “an emerging concern” ’, The Daily Telegraph, 15 June 2017.
An interesting point to note is that recently it has been acknowledged that climate-related risks are now
the auditor’s business (Claire Grayston, ‘Accounting for climate risk is now the auditor’s business’,
INTHEBLACK, 1 May 2019).
Reflection 5.2
You are about to appoint an auditor for your company. One of your friends, who has been a board
member of a local health service for the past three years, is a bit surprised at this, as he felt that
there would be a ‘conflict of interest’, in that the auditor would be an employee, chosen by you,
which would give the company a power and authority over the auditor which was not appropriate
for such a role. Respond to this comment.
Activity 5.2
How important is the role of the auditor?
Concept check 1
Which of the following is NOT true?
A. It is not usually possible for all of a company’s shareholders to be involved in the
general management of the company in which they own shares.
B. Most shareholders do not wish to be involved in the general management of the
company in which they own shares.
C. The shareholders are expected to maintain appropriate internal control systems.
D. Directors are accountable for the actions of the company.
E. Directors act as stewards of the company’s assets.
Concept check 2
Which of the following is NOT true?
A. The auditor’s report provides a check on the credibility and reliability of the financial
reports.
B. The auditor’s report provides a detailed account of the audit procedures performed.
C. The auditor’s report includes a statement that the audit has been conducted in
accordance with Australian Auditing Standards.
D. The auditor’s report includes the auditor’s opinion as to whether the financial
statements fairly represent the company.
E. All of the above.
Concept check 3
Public companies and all large proprietary companies are required to prepare true and fair
financial statements, including:
A. An income statement
B. A balance sheet
C. A statement of cash flows
D. A and B
E. A, B and C.
Sources of rules and regulation
LO 2 Explain why there is a need for accounting rules, identify the main sources of accounting rules,
and outline the role of the Australian Securities Exchange with regard to company reporting and
management, with particular reference to corporate governance
Although accounting rules should help to provide confidence in the integrity of financial statements, users
must be realistic about what can be achieved. Problems of manipulation and of concealment can still
occur even within a highly regulated environment. The scale of these problems, however, should be
reduced where there is a practical set of rules. Problems of comparability can also still occur, as
judgements and estimates must be made when preparing financial statements. There is the added
problem that no two companies are identical, and so accounting policies may vary between companies for
entirely valid reasons.
The International Accounting Standards Board (IASB) is an independent body that is dedicated to
developing a single set of high-quality, global accounting rules. These rules are known as International
Financial Reporting Standards (IFRS) or International Accounting Standards (IAS) , and deal
with such key issues as:
Over the years, the IASB has greatly extended its influence and authority. The point has now been
reached where all major economies adopt IFRS or have set timelines to adopt, or to converge with, IFRS.
Activity 5.3
We came across some IAS and IFRS earlier in the book. Try to recall at least two topics where financial
reporting standards were mentioned.
Activity 5.4
a. What do you think might have been the main reasons for recent pressure towards international
harmonisation of accounting practices?
b. What benefits could be gained by harmonising the Australian Accounting Standards with the
International Accounting Standards?
Figure 5.2 Sources of accounting regulations for an Australian company listed on the Australian
Securities Exchange (ASX)
The Corporations Act provides the basic framework of company accounting regulation. This is augmented
by accounting standards, which have virtually the force of law. The ASX imposes additional rules for
companies listed on the exchange.
Corporate governance
Generally, all the issues covered until now relate to the idea of developing sound systems of corporate
governance, the system by which corporations are directed and controlled. As such, it typically details the
rights and responsibilities of the corporation’s different participants. This explains the prevailing emphasis
on such things as rules for directors, matters relating to the board as a whole, different types of
shareholders, and other stakeholders. Governance also typically requires some detailed rules and
procedures for decision-making, including objective-setting and performance evaluation.
In spite of this, corporate governance remains an ongoing issue. It became a serious concern in the late
1980s when the global share market collapsed. Certain high-profile corporate failures—such as Bond
Corporation and Quintex Corporation (Christopher Skase)—added fuel to the debate and led to some
changes. More recently, in the early years of this century, the collapse of Enron, Ansett, One.Tel and HIH
led to something of a crisis of confidence. The collapse of Arthur Andersen, a major auditor with a
worldwide reputation, added fuel to the fire.
The reactions in different parts of the world were not the same. In the United States, the resulting
legislation (the Sarbanes-Oxley Act of 2002) aimed to curtail the misbehaviour and excesses of senior
managers and to ensure the correctness of the financial statements. In Australia, the following occurred:
The HIH Royal Commission basically found that HIH was mismanaged, that decisions were ill-conceived,
and that the management culture was unsound.
Activity 5.5
a. Do you think that mismanagement can be avoided by imposing highly prescriptive governance
systems and structures? Why/why not?
b. What does this imply about the difficulties in ensuring that reports are sound, in terms of setting in
place detailed rules of corporate governance?
In general, the Royal Commission’s report found that imposing highly prescriptive governance systems
and structures is fraught with danger. A ‘one size fits all’ approach will not work. The report focused more
on the role of boards and directors, and the associated cultures.
The ASX set up the Corporate Governance Council in 2002, and Principles of Good Corporate
Governance and Best Practice Recommendations was published in 2003 (© 2003 ASX Corporate
Governance Council). The main mission, identified in the ‘Foreword’ to the 2003 publication, was ‘to
develop and deliver an industry-wide, supportable and supported framework for corporate governance
which could provide a practical guide for listed companies, their investors, the wider market and the
Australian community’. The Council goes on to say that the guidelines are required to be applied, arguing
that ‘maintaining an informed and efficient market and preserving investor confidence remain the constant
imperatives’.
The 2003 document identified the essential corporate governance principles. Ten such principles were
identified. In August 2007 the principles and recommendations were reviewed and revised into eight
principles. A minor revision was made in 2010. Following a comprehensive review in 2012–13, the third
edition of the Principles and Recommendations was approved. These changes reflect global
developments in corporate governance, and enhanced risk recommendations. The structure was also
simplified and provided greater flexibility in terms of where governance disclosures are made. In 2018 the
principles were again reviewed, with the resulting fourth edition published in February 2019.
The revised principles identified by the ASX Corporate Governance Council are set out in Table 5.1 .
A listed entity should clearly delineate the respective roles and responsibilities of its board and management and regularly review their
performance.
A listed entity should instil and continually reinforce a culture across the organisation of acting lawfully, ethically and responsibly.
A listed entity should have appropriate processes to verify the integrity of its corporate reports.
A listed entity should make timely and balanced disclosure of all matters concerning it that a reasonable person would expect to have a
material effect on the price or value of its securities.
A listed entity should provide its security holders with appropriate information and facilities to allow them to exercise those rights as security
holders effectively.
A listed company should establish a sound risk management framework and periodically review the effectiveness of that framework.
A listed entity should pay director remuneration sufficient to attract and retain high-quality directors and design its effective remuneration to
attract, retain and motivate high-quality senior executives and to align their interests with the creation of value for security holders and with
the entity’s values and risk appetite.
Source: ASX Corporate Governance Council, Corporate Governance Principles and Recommendations, 4thd edition, 2019. © 2019 ASX Corporate Governance Council.
Recommendation 4.1
Recommendation 4.2
The board of a listed entity should, before it approves the entity’s financial statements for a financial
period, receive from its CEO and CFO a declaration that, in their opinion, the financial records of the
entity have been properly maintained and that the financial statements comply with the appropriate
accounting standards, and give a true and fair view of the financial position and performance of the entity
and that the opinion has been formed on the basis of a sound system of risk management and internal
control which is operating effectively.
Recommendation 4.3
A listed entity should disclose its process to verify the integrity of any periodic corporate report it releases
to the market that is not audited or reviewed by an external auditor.
This edition of the principles takes effect from the first full financial year after 1 January 2020, although
earlier adoption is encouraged.
Source: ASX Corporate Governance Council, Corporate Governance Principles and Recommendations, 4th edition, 2019, pp. 19 and 20. © 2019 ASX Corporate Governance
Council.
We recommend that you read the fourth edition of Corporate Governance Principles and
Recommendations, which can be found online on the ASX website.
The board of a listed company can decide that a recommendation is not appropriate for them. If it decides
that this is so, then it must explain why it has not adopted the recommendation. The principles adopt an ‘if
not, why not’ approach. Failure to do one or other of these can lead to the company’s shares being
suspended from listing. This is an important sanction against non-compliant directors. A major advantage
of a stock exchange listing is that it enables investors to sell their shares whenever they wish. A company
that is suspended from listing would find it hard—and therefore expensive—to raise funds from investors,
because there would be no ready market for the shares.
A corporate governance statement is now part of the annual report of listed companies, although use of a
website carefully linked to the annual report is also permitted. Real World 5.3 provides a summary of
such a statement found on the website of Cochlear Ltd that is linked to its 2019 annual report.
Cochlear Limited produced an 18-page corporate governance statement that links with its 2019
annual report. This statement is current at August 2019. The board considers that governance
practices have been consistent with the recommendations set out in the ASX Corporate
Governance Council’s Corporate Governance Principles and Recommendations (3rd edition). The
statement outlines the principal governance arrangements used by the company. It then describes
these under the following headings:
1. Roles and responsibilities of the board and management—which includes strategy, financial
oversight and reporting, risk, performance, leadership, succession and remuneration
planning, sustainability, and any other material transactions.
2. Structure and composition of the board—which includes detail regarding the committees
used, board tenure, and board skills and experience, director independence, and conflicts of
interest.
3. Board performance and succession planning—covering director appointment, induction and
development, and board performance evaluation.
4. Governance policies—which looks at 14 areas of policy, examples of which include global
code of conduct, anti-bribery, diversity, environmental policy and whistleblower protection.
5. Diversity and inclusion—which sets out workforce objectives, including growth of diversity to
reflect the business’s STEM needs and the global community served, preparing women to
take on senior roles, implementing programs to attract a diverse workforce, and developing
an inclusive working environment to retain staff.
6. Ethical and responsible behaviour—using HEAR behaviours (Hear the customer, Embrace
change and innovate, Aspire to win, and Remove boundaries) and also the global code of
conduct.
7. Remuneration and evaluation of senior executives—including remuneration and
performance evaluation.
8. Communication with shareholders—including both engagement and continuous disclosure.
9. Risk management and assurance—including oversight, economic risk, environmental and
social sustainability risk, and internal audit.
Reflection 5.3
Our restaurateur is now very concerned with the ethics within his business. Over all of his
restaurants, Lucas now employs 120 staff. Advise him how he might instil in his business a culture
of acting lawfully, ethically and responsibly.
The existence of the ASX Corporate Governance Principles has generally been agreed to have improved
the quality of information available to shareholders, resulted in better checks on the powers of directors,
and provided greater transparency in corporate affairs. However, rules can only be a partial answer. A
balance must be struck between the need to protect shareholders and the need to encourage the
entrepreneurial spirit of directors, which could be stifled under a welter of rules. This implies that rules
should not be too tight, but tight enough to limit unscrupulous directors’ attempts to find ways around
them.
It is interesting to note that the revised (2010) version of the Principles did not change any of the basic
principles, even though the world had been through the global financial crisis, which surely must rank as a
failure of leadership. The third edition took on board a number of issues raised by the global financial
crisis, notably in the area of risk management. The fourth edition made significant changes to Principle 3
to emphasise that listed entities need to align their culture and values with community expectations. This
is consistent with the recent Royal Commission findings from the misconduct investigation into the
banking and financial services industry. But only time will tell whether these updated basic principles will
be sufficient.
The International Federation of Accountants (IFAC) prepared a study on enterprise governance (CIMA &
IFAC, 2004). Enterprise governance was defined as ‘the set of responsibilities and practices exercised by
the board and executive management with the goal of providing strategic direction, ensuring that
objectives are achieved, ascertaining that risks are managed appropriately and verifying that the
organisation’s resources are used responsibly’. What was particularly interesting about this study was that
it identified two aspects of enterprise governance—conformance and performance—and argued that
these two need to be in balance. Basically, corporate governance was identified with conformance
(namely, accountability and assurance), while business governance was associated with performance
(namely, value creation and resource utilisation). Central to the argument was the idea that good
corporate governance on its own cannot make a company successful. Good corporate governance needs
to be linked strategically with good performance management systems that focus on the key drivers of
business success.
The case study at the end of this chapter (page 231) provides a summary of an interesting discussion
paper, written just after the global financial crisis, which has lessons for corporate governance. We
recommend you access and read the whole paper. It includes a number of examples of behaviour and
attitudes that relate to the global financial crisis that are very revealing and remain relevant today.
Good governance is clearly important, but care is necessary to ensure that the process doesn’t become
more important than the substance.
As part of the normal process for review, in May of 2018 the ASX initiated a consultation on a proposed
fourth edition of the Corporate Governance Principles and Recommendations. Essentially, the proposal
aimed to address a number of issues, including the idea of a social licence to operate, corporate values
and culture, whistleblower policies, anti-bribery and corruption policies, gender diversity, carbon risk, and
cyber-risks. The consultation provoked a variety of reactions, as can be seen from Real World 5.4 .
Real world 5.4
Fads, fantasies and activists
Janet Albrechtsen raised serious concerns about the (then) draft ASX recommendations on
corporate governance. In an article written in July of 2018 she stated: ‘The ASX has been more
focused on diversity targets and other social issues than sound, individually tailored processes
within a corporation.’
A second article deals with the question as to whether the Governance Council’s ‘frolic into social
justice territory is so misguided that the battle over corporate governance is more akin to another
chapter in the culture wars’. Albrechtsen and it would seem a number of other people are
concerned about the way in which ‘an intrepid bunch of social engineers’ are trying to transform
corporate Australia. Several points are raised, including:
Sources: Janet Albrechtsen, ‘Why corporate Australia should resist the Left’s social engineers’, The Australian, 25 July 2018.
Janet Albrechtsen, ‘There’s a corporate rebellion brewing over fanatical social justice movements’, The Australian, 4 August 2018.
David Murray, Chairman of AMP, argued that the draft governance principles ‘have blurred the
lines between boards and management’.
Source: Ticky Fullerton, ‘David Murray stirs the pot on corporate governance’, The Australian Business Review, 4 August 2018.
In fact, the push for a ‘social licence to operate’ disappeared from the final draft, being replaced by
words such as ‘reputation’ and ‘standing in the community’. Whether this debate is over remains to
be seen.
Source: Andrew White, ‘“Social licence” principle dumped’, The Australian Business Review, 28 February 2019.
Activity 5.6
What do you see as the likely future of corporate governance? What about ongoing issues?
Principle 1: What are the respective roles of the chair, committee members, coaches and
players?
Principle 2: What is the optimal size and nature of the managing committee?
Principle 3: What is the view of the club on equity and fairness in the sport?
Principle 4: The club’s need to account for income from fees, subscriptions and charges, and
to report on the financial condition of the club on a regular basis.
Principle 5: The club’s need to report regularly on what is going on.
Principles 6–8: Respecting rights, recognising and managing risk, and remuneration are not
likely to be as important at this level, but the principles remain.
As you progress through life, there is a reasonable prospect that you may become a member of a
school board/council, or a hospital/health service board. All of these will have governance
requirements that are likely to follow similar lines to those set out above. By way of illustration,
read the 2018 publication, Welcome to the Board, on the Victorian Public Sector Commission
website.
Reflection 5.5
You have decided to become a member of a school council or board.
1. While the school is not formally a business, it will still need to keep financial records. What
differences (if any) do you think you will find in terms of the financial records that are kept in
a school as compared with a business?
2. To what extent are the expectations of a school council in line with those of a business
board?
Concept check 4
Accounting rules (or standards) are needed to:
A. Prevent unscrupulous directors from adopting accounting policies and practices that
portray an unrealistic view of financial health
B. Allow comparison between companies
C. Provide confidence in the integrity of financial statements
D. All of the above
E. Some of the above.
Concept check 5
International Financial Reporting Standards (IFRS):
A. Are transnational accounting rules adopted (or developed) by the International
Accounting Standards Board (IASB)
B. Are transnational accounting rules that should be followed in preparing the published
financial statements of listed limited companies
C. Are now adopted or will be adopted by all major economies
D. Have minor wording differences to Australian Accounting Standards
E. All of the above.
Concept check 6
Which of the following is NOT true?
A. The Australian Securities Exchange (ASX) extends the accounting rules for those
companies listed as eligible to have their shares traded on the exchange.
B. The Corporations Act provides the basic framework for company accounting
regulation.
C. Corporate governance is the system by which corporations are directed and
controlled.
D. The ASX Corporate Governance Principles specify that companies should have a
structure to safeguard their financial success.
E. None of the above. All are true.
Presentation of published financial statements
LO 3 Identify the main requirements relating to the published annual report, including all of the
financial and ancillary statements
Accounting Standard AASB 101: Presentation of Financial Statements (the equivalent of IAS 1), applies
to reporting and disclosing entities. The essence of the standard is set out below.
The standard requires that, on the statement of financial position, a distinction is normally made between
current assets and non-current assets and between current liabilities and non-current liabilities. However,
for certain types of businesses, such as financial institutions, the standard accepts that it may be more
appropriate to order items according to their liquidity (i.e. their nearness to cash). Financial institutions,
such as banks and insurance companies, frequently select the liquidity approach to classifying assets, to
provide more relevant and reliable information to the report users. The nature of their business is largely
linked to matching available funds with external claims over time, and so classifying both assets and
liabilities on a liquidity basis provides valuable insights into the entity’s ability to service such claims.
Some of the classification groups identified above require further detailed breakdowns, generally to
comply with a specific standard; for example, inventories and non-current assets, which typically have
sub-classifications for property, plant and equipment. Other areas include equity and reserves, and
provisions. Many of these sub-classifications can be handled by way of a series of notes to the main
statements.
In terms of published statements of financial position in Australia, the most commonly presented is the
vertical format based on the entity equation. Irrespective of the format, or the equation, all of the
statements of financial position contain the same information.
An example of an unrealised gain, or loss, that has not been mentioned so far arises from exchange
differences when the results of foreign operations are translated into Australian dollars. Any gain, or loss,
bypasses the income statement and is taken directly to a currency translation reserve. Any such gains or
losses are required to be shown in the ‘other comprehensive income’ section.
A weakness of conventional accounting is that there is no robust principle that we can apply to determine
precisely what should, and what should not, be included in the income statement. Thus, on the one hand,
losses arising from the impairment of non-current assets normally appear in the income statement. On the
other hand, losses arising from translating the carrying value of assets expressed in an overseas currency
(because they are owned by an overseas branch) do not. This difference in treatment, which is ingrained
in conventional accounting, is difficult to justify.
The statement of comprehensive income ensures that all gains and losses, both realised and unrealised,
are reported within a single statement. To do this, it extends the conventional income statement by
including unrealised gains, as well as any unrealised losses not yet reported, immediately below the
measure of profit for the year. An illustration of this statement is shown in Example 5.1 .
EXAMPLE
5.1
MALIK LTD
Statement of comprehensive income
for the year ended 31 July 2020
$m
Revenue 97.2
Tax (2.4)
‘Other comprehensive income’ represents those items of income (revenue or other gains) and expenses
not required or permitted to be included in profit or loss (ordinary or operating) by any of the accounting
standards. Paragraph 7 of AASB 101: Presentation of Financial Statements specifically identifies the
following transactions for inclusion as ‘comprehensive income’:
The intention of AASB 101 is to provide more useful information so as to enable users to distinguish
between income and expenses of a recurring or permanent nature from those of a non-recurring or
temporary nature.
You need to recognise that many of the unrealised gains included in the statement of comprehensive
income will eventually be realised. At that later stage, realised gains will be recognised in operating
income. To avoid double-counting, when the subsequent gain or loss is recognised in the operating (i.e.
income statement) section of the statement of comprehensive income, an equivalent deduction will need
to be made in the ‘other comprehensive income’ section of the report. The reclassification adjustments
can be shown directly in the statement of comprehensive income in the ‘other comprehensive income’
section as offsets, or they can be shown in the notes to the statements.
The case study in Chapter 4 sets out the main financial statements for Myer, including the statement of
comprehensive income. You should refer back to this case study to see how the ‘other comprehensive
income’ fits in with the traditional income statement.
It is worth noting that all of the items listed under ‘other comprehensive income’ in the statement of
comprehensive income for Woolworths relate to ‘items that may be reclassified to profit and loss’. This
means that they are the kind of items referred to in the preceding paragraph. You should recognise that
further items can be found that would be listed as ‘items that will not need to be reclassified subsequently
to profit and loss’. Items include ‘change in the fair value of investments in equity instruments’ and
‘actuarial loss on defined benefits superannuation plans’.
SELF-ASSESSMENT QUESTION
5.1
The following information was extracted from the financial statements of I. Ching (Booksellers) Ltd
for the year to 31 December 2020:
$m
Finance charges 40
Revenue 943
Other expenses 25
Prepare a statement of comprehensive income for the year ended 31 December 2020.
Reflection 5.6
When looking at your own wealth, the rationale for the idea of comprehensive income can become
more obvious.
Suppose you run a small antiques business that produces an annual profit of $50,000 per annum.
The business operates out of a building that is worth $400,000 at the start of the year. During the
year the value of the buildings has increased by 5%.
You also have a collection of records that is worth $10,000 at the start of the year. During the year
the record collection’s value has increased by 20%, due to increased interest in vinyl. You have no
other assets of any significance.
What do you think the comprehensive income of the antiques business is for the year?
What do you think is the comprehensive income that you have personally obtained for the year?
Activity 5.7
For a business, explain how a revaluation of property from $1 million to $2 million would appear in the
financial statements. Suppose that next year the property was sold for $2.2 million. How would this
appear in the financial statements at the end of the second year?
To see how a statement of changes in equity may be prepared, let us consider Example 5.2 .
EXAMPLE
5.2
At 1 January 2020, Miro Ltd had the following equity:
MIRO LTD
$m
Revaluation reserve 20
During 2020, the company made a profit for the year from normal business operations of $42
million and reported an upward revaluation of property, plant and equipment of $120 million (net of
any tax that would be payable were the unrealised gains to be realised). A loss on exchange
differences on translating the results of foreign operations of $10 million was also reported. To
strengthen its financial position, the company issued 50 million ordinary shares during the year at a
price of $1.40. Dividends for the year were $27 million.
This information for 2020 can be set out in a statement of changes in equity as follows:
MIRO LTD
Statement of changes in equity
for the year ended 31 December 2020
$m $m $m $m $m
Notes:
1. We have chosen to show dividends in the statement of changes in equity rather than in the
notes. They represent an appropriation of equity and are deducted from retained earnings.
2. The effect of each component of comprehensive income on the various elements of
shareholders’ equity must be separately disclosed. The revaluation gain and the loss on
translating foreign operations are each allocated to a specific reserve. The profit for the year
is added to retained earnings.
More generally, the statement of changes in equity may include the information shown in Table 5.2 .
Table 5.2 Typical components of statement of changes in equity
Equity accounts Retained profit Reserves Share capital Total
Share issues − + +
Return of capital − −
Dividends paid/declared − − −
Activity 5.8
Manet Ltd had the following share capital and reserves as at 1 January 2020:
$m
During the year to 31 December 2020, the company revalued property, plant and equipment upwards by
$30 million and made a loss on foreign exchange translation of foreign operations of $5 million. The
company made a profit for the year from normal operations of $160 million during the year and the
dividend was $80 million.
Notes
Most financial statements are prepared in a form which summarises a considerable amount of detail. This
detail then needs to be shown elsewhere in the form of notes to the accounts. Careful reading of the
notes should be an essential part of any review of an annual report. The notes typically include:
a confirmation that the financial statements comply with relevant accounting standards
explanations of the measurement bases and accounting policies used (e.g. the basis of inventories
valuation or depreciation)
details relating to any sub-classifications in the statements (e.g. breakdown of current and non-current
assets)
supporting information relating to items appearing on the four major financial statements, and
other significant disclosures.
Concept check 7
Which statement is false?
A. AASB 101 does not prescribe the format, but it does set out the minimum information
that should be presented on the face of the statement of financial position.
B. AASB 101 requires no distinction be made between current assets and non-current
assets, and between current liabilities and non-current liabilities.
C. AASB 101 recognises that some of the classification groups identified in B above
require further detailed breakdowns.
D. In terms of published statements of financial position in Australia, the most commonly
presented is the vertical format based on the entity equation.
E. None of the above is false.
Concept check 8
The statement of comprehensive income:
A. Extends the conventional income statement to include certain other gains and losses
that affect shareholders’ equity
B. Overcomes a weakness of conventional accounting whereby there is no robust
principle that precisely specifies what to include in the income statement
C. Ensures that all gains and losses, both realised and unrealised, are reported within a
single statement
D. All of the above
E. A and C only.
Accounting for groups of companies
LO 4 Explain the concept of group or consolidated accounts.
The treatment of companies so far has dealt with single companies. In fact, many companies acquire
shares in other companies to obtain a controlling interest in these companies. There are a number of
reasons for this, including:
Control can normally be achieved by ownership of at least 50% of the ordinary share capital.
The controlling company is known as the parent company (or holding company ), and the (partly)
owned company is known as a subsidiary company . Many large companies control multiple
subsidiaries. Just how these operate together varies tremendously, but they are nevertheless seen to
operate as a group, and this has certain consequences.
parent company
A company that invests in another company by purchasing sufficient shares to
obtain a controlling interest. Also known as a ‘holding company’.
holding company
See parent company.
subsidiary company
A company that is controlled by another, by the fact that this other company owns
a controlling interest in the company concerned.
It is important to note that, even in the case where a subsidiary is 100% owned, there may be good
reasons to retain a separate identity. Reasons might include:
the subsidiary might have a market identity which is important to maintain, and this can best be
achieved through retention of its current corporate status
the staff of the subsidiary might feel that they have greater autonomy and independence if it retains its
separate identity, or
the directors of the parent might prefer to retain the limited liability status of each company individually.
In most cases each individual company is still required to prepare its own accounts, but in addition the
parent company is also required to prepare a set of group or consolidated accounts . These group
accounts amalgamate the financial statements of all of the group members. Thus the group accounts will
include all of the revenues and expenses incurred by the individual members of the group, and all of the
assets and liabilities of the members of the group, subject to some adjustments dealt with below. The
overall aim of a set of group or consolidated accounts is to show the accounts as if the parent had owned
and operated all of the assets of the business directly, rather than via a set of subsidiaries. The parent
company is required to provide financial accounts that relate to its own performance as a single company,
but also to provide a set of group accounts.
In principle, the process of consolidation is relatively straightforward. In essence, all that is needed is to
add up the various revenues and expenses that appeared in the individual company income statements
to obtain the group income statement, and all of the assets and claims in the various statements of
financial position to obtain the group statement of financial position. However, while this is the case in
principle, a number of complications usually occur, the most important of which are dealt with below.
Goodwill arising on consolidation. When the amount paid by the parent is more than the book value
associated with a subsidiary, the extra amount paid will need to appear on the group statement of
financial position as an asset, called goodwill on consolidation .
goodwill on consolidation
The amount paid by an investing company for the purchase of sufficient
shares to acquire a controlling interest in another company, less the value of
the equity or net assets, usually calculated on a fair value basis.
Non-controlling interests (also known as minority interests ). As stated above, all revenue,
expenses, assets and liabilities must be reflected to their full extent in the group financial statements.
This must be the case whether the parent owns 100% of the subsidiary company’s shares, or less.
The critical question relates to control. Where the ownership is less than 100%, then part of any net
income and net assets must be attributable to interests other than that of the parent, namely non-
controlling interests. Outside shareholders have financed part of the group’s activities and are entitled
to part of any group income.
Example 5.3 shows how the statement of financial position for the group owned by Parent Ltd, a
company which controls a subsidiary, Sub Ltd, is built up.
EXAMPLE
5.3
Parent Ltd owns 80% of the ordinary share capital of Sub Ltd. Parent Ltd paid $32 million for the
controlling interest.
The statements of financial position of the two companies immediately after the takeover by
Parent Ltd of control over Sub Ltd are as follows:
takeover
Where one company buys enough shares in another to obtain a controlling
interest.
Cash 8 5
Accounts receivable 12 7
Inventories 19 8
39 20
Non-current assets
70 30
Current liabilities
Accounts payable 10 5
Non-current liabilities
Debentures 24 10
Equity
Reserves 25 10
75 35
Under circumstances such as a takeover, we would reasonably expect that the figures should be
based on current fair value.
The goodwill on consolidation would be calculated as follows. The investment in shares gives
Parent Ltd an 80% holding, which is clearly a controlling interest, so group accounts are required.
The cost of this holding is $32 million. The net assets acquired amount to 80% of the equity at the
time of purchase, which is $35 million×80%=$28 million. This means that the amount paid exceeds
the fair value of the net assets by $4 million and this must appear in the group statement of
financial position.
The non-controlling interests amount to 20% of the equity of Sub Ltd, which amounts to
$35 million×20%=$7 million.
$m
Current assets
Cash (8+5) 13
Inventories (19+8) 27
59
Non-current assets
Goodwill on consolidation 4
72
Current liabilities
Non-current liabilities
Debentures (24+10) 34
Equity
Reserves 25
Non-controlling interests 7
82
You should note that all of the figures but two—the goodwill on consolidation and the non-controlling
interest—are simply the sum of the various parts relating to the parent and subsidiary. Goodwill on
consolidation is usually shown under intangible assets in the statement of financial position.
In the year that follows the takeover, the summarised income statements of Parent Ltd and Sub Ltd are
as shown in Example 5.4 , together with a consolidated income statement and workings.
EXAMPLE
5.4
Income statement
for the year ending 31 December 2021
Revenue 40 20
Gross profit 20 12
Income statement
for the year ending 31 December 2021
$m
Revenue (40+20) 60
Gross profit 32
Attributable to
11.2
The non-controlling interest’s share of profits is 20% of the profit of Sub Ltd, with the remainder
being all the entitlement of Parent Ltd.
A further complication, beyond the scope of this book, relates to intra-group transactions, that is,
transactions that take place between the companies within the group. This might include loans from one
member of the group to another. These need to be eliminated in the group accounts, as do any profits
recognised by one company within the group that are not realised by ongoing sale outside of the group.
For example, if a subsidiary company sells goods to a parent at a price which yields a profit of, say,
$100,000, and these goods are not sold on beyond the group, we have a profit that is realised by the
subsidiary, but which has not been realised as a group.
This brief overview of group accounts is intended to help you understand the final accounts of groups of
companies. Group structures and accounts can be very complicated.
Activity 5.9
The following summary statements of financial position relate to H Ltd and S Ltd as at 31 December
2020, immediately after H Ltd had acquired 60% of the share capital of S Ltd for $4 million.
H LTD AND S LTD
Statement of financial position
as at 31 December 2020
H Ltd $m S Ltd $m
Current assets 4 2
Non-current assets 6 4
Investment in S Ltd 4 –
Total assets 14 6
Liabilities 3 1
Equity
Reserves 5 2
Total equity 11 5
In the course of the next year, H Ltd made profits after tax of $3 million, and S Ltd $1.5 million.
Prepare a consolidated statement of financial position as at 31 December 2020, and show how the profit
after tax for 2021 would be allocated to H Ltd and to the non-controlling interests in the group income
statement for 2021.
It is worth noting that investment in shares of another company does not always involve acquisition of a
controlling interest. Frequently, a smaller amount of ownership will still enable the investing company to
be able to exert an influence on the company whose shares are owned. Typically, a company that is
between 20% and 50% owned by an investor company is known as an associate company of the
investor company. In cases like this, the consolidated accounts also need to show:
associate company
A company that is partly owned by another company, such that the ownership
does not give the investor company control, but does give it the opportunity to
exert considerable influence. Typically, the ownership is between 20% and 50%.
Concept check 9
Which of the following is false?
A. A company that acquires a controlling interest of shares in another company is
known as the parent or holding company.
B. The owned (or partly owned) company is known as the subsidiary.
C. Goodwill on consolidation arises when the amount paid by the parent is more than
the book value associated with the subsidiary.
D. It is generally inappropriate to recognise goodwill except in special circumstances.
E. None of the above. All are true.
Concept check 10
Which of the following statements is false?
A. The minority interest is the proportion of a subsidiary company that is owned by other
than the parent company.
B. There is no minority interest if the subsidiary is 100% owned by the parent.
C. A further complication with consolidated accounts relates to transactions that take
place between the companies within a group.
D. The overall aim of a set of consolidated accounts is to show the accounts as if the
parent had owned and operated all of the assets of the business directly.
E. None of the above. All are true.
Concept check 11
CBD Ltd recently paid $4,000,000 for 60% of LKJ Ltd’s equity. LKJ Ltd had total assets of
$6,500,000 and liabilities of $1,300,000. What amount of goodwill on consolidation will CBD
Ltd record?
A. $100,000
B. $2,700,000
C. $880,000
D. $1,200,000
E. None of the above.
Summary
In this chapter we have achieved the following objectives in the way shown.
Explain the importance of company law in relation to the directors’ duty to account, and Identified a range of legal requirements
discuss the role of the auditor in this process relating to disclosure
Examined the role of the auditor
Explain why there is a need for accounting rules, identify the main sources of accounting Explained the need for accounting rules
rules, and outline the role of the Australian Securities Exchange with regard to company Discussed the internationalisation of
reporting and management, with particular reference to corporate governance business and the growth of
International Accounting Standards
Identified the relationship between the
Australian Accounting Standards and
the International Accounting Standards
Identified the main extensions to
disclosure requirements relating to
listed companies
Examined and described the ASX
Corporate Governance Principles
Examined fairly critically the concept of
corporate governance
Identify the main requirements relating to the published annual report, including all of the Outlined the requirements of AASB
financial and ancillary statements 101: Presentation of Financial
Statements relating to:
— the statement of financial position
— notes
Explain the concept of group or consolidated accounts Outlined the main issues relating to a
parent–subsidiary relationship and its
implications for a set of group accounts
Discussion questions
Easy
5.1 LO What is the role of a company director?
1
5.2 LO You have heard that management accounting is not regulated by accounting rules, under the premise that companies should be
2 allowed to adopt the methods and procedures that are best suited for them. Why does financial accounting not have the same
degree of freedom?
5.3 LO What is meant by the term ‘corporate governance’? What would be included in corporate governance activities?
2
5.4 LO Describe the key components of the annual report, including an explanation of the purpose of each report element.
3
5.5 LO When are group or consolidated accounts required, and what is the purpose of their preparation?
4
Intermediate
5.6 LO How does the auditor assist directors in fulfilling their directorship role?
1
5.7 LO The Australian Accounting Standards Board (AASB) has adopted International Financial Reporting Standards (IFRS) for
2 financial reporting. Must your marginally profitable proprietary company with absolutely no dealings outside of Australia comply
with IFRS? If you have to comply, do IFRS allow firms to adjust the standard where strict compliance will not provide true and
fair reporting? Explain.
5.8 LO Discuss the purpose of the statement of comprehensive income from an accounting concept viewpoint. Describe the
3 applicability of specific accounting principles in your discussion.
5.9 LO The empirical research into the usefulness of the new statement of comprehensive income is mixed. Does it matter where
1 financial information about changes in owners’ equity is recorded or disclosed (i.e. in the statement of comprehensive income)?
5.10 LO You think you may have discovered an error in a company’s statement of financial position. They’re showing a value for
4 goodwill, and you know that unrealised assets—such as human capital, a strong customer base and good supplier relationships
—cannot be shown as assets. What should you do?
5.11 LO Explain why corporate governance is currently a ‘hot topic’ for organisations and standard setters.
2
5.12 LO Explain what you understand by ‘true and fair’ in the context of company reporting.
1/3
5.13 LO In terms of financial reporting, how does the focus of the Australian Securities Exchange differ from that of the Australian
2 Accounting Standards Board?
Challenging
5.14 LO Does a ‘clean’ (i.e. unqualified) audit opinion give you assurance that you are not investing your hard-earned money in another
1 HIH Insurance? What other safeguards exist in company law to provide such assurance?
5.15 LO What two corporate structure features must exist if a company is showing a ‘minority interest’ account on its balance sheet?
2
5.17 LO After reading Real World 5.2 , how important do you think auditors are in assuring investors that they are dealing with a
1 confident and informed market?
5.18 LO Adele Ferguson, in an article entitled ‘Conflict of interest at the heart of audit disasters’ (The Age, 5 December 2012), which
1 related to an earlier ASIC audit report, argued that there is a real or perceived conflict of interest, because auditors get paid by
the company they have been hired to independently audit. She argued that another option might be for the regulator to appoint
an auditor, rather than leave it to the company. Do you think she is correct?
5.19 LO What do you think are the links between the four major financial statements?
3
Statement of financial position
Statement of comprehensive income
Statement of changes in equity
Statement of cash flows
5.21 LO Over the past two decades Australia has moved through the following stages:
2
Producing its own standards with reference to differences between these and the equivalent international standards
Changing its standards to be compatible with the equivalent International Accounting Standards—the process was labelled
‘harmonisation’, and involved adapting international standards for use in Australia
Changing its standards to be consistent with the equivalent International Accounting Standards—the process was labelled
‘convergence’, and involved adopting the International Accounting Standards for use in Australia.
a. Why would Australia give up its standards in favour of International Accounting Standards?
b. What could disadvantage Australia in giving up setting its own individual accounting standards?
Application exercises
Easy
5.1 LO Visit the Australian Securities Exchange (ASX) website, find a listed company you are interested in, and go to its website and
2 download its latest annual reports (usually found under Investor Relations or Investor Centre). What rules and regulations do you
think the company has complied with when preparing the annual report?
Asset revaluation
5.3 LO Gibbons Ltd purchased 100% of the shares of one of their competitors (PJB Ltd) at a total cost of $2.5 million. At the purchase
4 date Gibbons Ltd had total assets of $14 million and liabilities of $11 million, while PJB Ltd had assets of $5 million and liabilities
of $2 million.
5.4 LO The following statements of financial position relate to H Ltd and S Ltd as at 31 December 2020.
4 H Ltd $’000 S Ltd $’000
17,000 9,000
17,000 9,000
H Ltd acquired all of S Ltd’s capital on 1 January 2019 for $6.8 million, when reserves of S Ltd were $700,000.
Prepare a group (consolidated) statement of financial position as at 31 December 2020.
How would this statement change if the reserves of S Ltd at the time of purchase had been $1 million?
Intermediate
5.5 LO The Corporate Governance Council of the Australian Securities Exchange (ASX) initially identified 10 essential corporate
2 governance principles. These were revised in 2010 into eight principles, with the latest version published in 2019. Complete the
table below.
Full principle Principle name in three words or Appropriateness of principle for a sports club (Yes or No, and
name fewer explain)
5.6 LO The accounts of NuFarm Ltd as at 30 June 2020 included the following:
3 $
Sales 1,340,000
Additional information:
Prepare a statement of comprehensive income for the year ended 30 June 2020.
5.7 LO The following statements of financial position relate to H Ltd and S Ltd as at 31 December 2020.
4 H LTD AND S LTD
Statement of financial position
as at 31 December 2020
15,200 7,500
15,200 7,500
The investments in S Ltd had cost $5 million, for 4 million shares, at a time when S Ltd’s reserves stood at $1 million.
Challenging
5.8 LO Murphy Ltd provides the following equity accounts as at 1 January 2020.
3 Murphy Ltd $m
During 2020, the company made a profit for the year from normal business operations of $90 million. Income tax at a rate of
30% has not yet been paid. Murphy reported an upward revaluation of land and buildings of $80 million (before any tax that
would be payable were the unrealised gains to be realised). The company issued 10 million ordinary shares during the year at a
price of $3.00. Dividends declared for the year were $85 million and will be paid in the first quarter of 2021.
5.9 LO Ortiz Limited supplies the following information for its most recent financial (calendar) year.
3 Administrative expenses $150,000
Revenue $4,000,000
Ortiz’s accountant has asked for your assistance with her preparation of a statement of comprehensive income as she has
never prepared one.
5.10 LO The summarised statements of financial position of Matt Ltd and James Ltd as at 31 December 2020 are as follows:
4
MATT LTD AND JAMES LTD
Statement of financial position
as at 31 December 2020
Investments in S Ltd
60,400 52,000
60,400 52,000
1. Matt Ltd acquired the shares in James Ltd on 31 December 2019 when the reserves of James Ltd were $10 million.
2. During 2020, Matt Ltd sold goods that had cost $300,000 to produce to James Ltd for $400,000. At 31 December 2020,
James Ltd still had half of these goods in stock, valued at cost to James Ltd, and included in current assets.
3. At 31 December 2020, James Ltd owed Matt Ltd $200,000. This amount had been included in the current assets and
current liabilities of Matt Ltd and James Ltd, respectively.
No dividends were paid by either company in 2019 or 2020, and none is proposed.
Prepare a consolidated balance sheet as at 31 December 2020.
5.11 LO The following income statements relate to H Ltd and S Ltd for the year ended 31 December 2020:
4 H LTD AND S LTD
Income statement
for the year ending 31 December 2020
Dividends
Preference (800)
Prepare a consolidated income statement for the year ended 31 December 2020.
5.12 LO The following were extracted from the accounts of HiLite Ltd as at 30 June 2020:
3 Sales $
a. Loss on sale of available-for-sale investments recognised as ordinary income. It had previously been revalued down by
$10,000.
b. Gain on defined superannuation fund being recognised directly to equity.
Prepare a statement of comprehensive income for the year ended 30 June 2020. Expenses are to be classified by nature.
Chapter 5 Case study
The January 2010 discussion paper quotes the president of IFAC, Robert Bunting, as saying: ‘Regardless
of who is to blame, the [global financial] crisis was unquestionably exacerbated by corporate governance
failures.’ He specifically identified the lack of proper risk management processes, and governance
systems that did not provide adequately for risky strategies.
The paper sets out a range of related factors that lead to a board’s effectiveness, which include
frameworks relating to processes and structures, and people and behaviours. Much of the work to date
focuses on the first group, with limited work on the second. Points of relevance in the paper relating to
people and behaviours include the following:
It is important not to make too rigid a distinction between structure and culture in shaping behaviour.
Composition of the board is important: members need to work together as a team; diversity is
important.
Professional behaviour between board members and between board members and the executive
management team is important, as is mutual respect.
It is important to understand and manage the human aspects of the business.
The prevalence of emotional factors in corporate success and failure means that they should be
recognised as being at the heart of boardroom leadership and effectiveness.
There is a need to develop a culture of ‘effective challenge’, in which decisions are thoroughly debated
and subject to proper scrutiny. All too often boards develop a ‘group think’ approach, in which all
members think the same way, leading to less rigour in analysis.
In spite of containing very able members, some boards do not work well together, or do not have the
collective desire to do what is necessary to challenge the status quo.
In some cases, the CEO has tight control over the workings of the board, with the result that awkward
questions become too hard to ask.
Talent development and reward, and sound succession planning, both at board level and at executive
level, are important.
With regard to frameworks, processes and structures, the following are particularly noteworthy:
Boards must properly understand risk and integrate it into strategic thinking. Simply ticking boxes in a
risk framework is not enough.
Organisations tend to oscillate between under-scrutiny in good times and over-scrutiny in bad times.
Greed reflects a failure of leadership. It is often associated with ‘disaster myopia’, which is the
tendency to underestimate the probability of adverse outcomes that have not occurred in recent
memory.
The discussion paper recognises that implementing some of these ideas is not easy. However, it points
us in a direction that expands the ideas on more traditional corporate governance.
We recommend you read the whole paper. It includes a number of examples of behaviour and attitudes
that relate to the 2007–08 global financial crisis that are very revealing.
Source: Adapted from Gillian Lees, ‘Enterprise governance: restoring boardroom leadership’, January 2010, pp. 5–7. C.I.M.A. © 2010, Chartered Institute of Management
Questions
1. Do you think that the regulatory framework discussed in this chapter provides an adequate
foundation for management and oversight?
2. How might a company strive to safeguard the integrity of its financial reporting?
3. What is the role and effectiveness of the auditor?
4. Is the division of corporate governance between conformance and performance useful?
5. The discussion paper summarised above identifies processes and structures as a key part of
governance. List the range of processes and structures mentioned in the ASX Corporate
Governance Principles.
6. The discussion paper talks about the importance of people and behaviours on board effectiveness.
a. What do you think is meant by ‘board culture’?
b. Do you think it is important that board members behave in a professional manner to each
other? Why/why not?
c. Do you agree that diversity is an important component of a good board?
d. Why do you think that mutual respect between board members is important? What kinds of
issues are likely to arise if mutual respect is lost?
e. What do you understand by the term ‘group think’, and how might it be prevented? How
might a culture of ‘effective challenge’ be developed?
f. What reasons can you think of that might prevent a board working effectively as a team?
g. Is there an optimal size and composition for a board? Explain your answer.
h. How might a board encourage ethical and responsible decision-making?
i. What kind of relationship should a CEO seek to build with the board?
Activity 5.1
a. If shareholders do not receive information about the performance and position of their investment,
they will have problems in appraising their investment. Under these circumstances, they would
probably be reluctant to invest. Furthermore, individuals and organisations would be reluctant to
engage in commercial relationships, such as supplying goods or lending money, where a company
does not provide information about its financial health.
b. As suggested in the solution to the first part of the question, this is very important. The information
provided through annual reports facilitates the efficient running of the private sector. The annual
reports, taken together, provide a vast array of financial and business information which facilitates
a range of investment (and disinvestment) decisions. When coupled with limited liability and an
active market for shares and other securities, the overall system is very efficient.
Activity 5.2
The audit is an important part of the checking and verification process, and enables investors and other
report users to make decisions with reasonable confidence.
Activity 5.3
We came across financial reporting standards in Chapter 2 , when considering:
Activity 5.4
a. While many reasons could be given for the pressure to standardise accounting practices globally, it
would appear that the major pressure groups were the stock exchange bodies across many
countries and the major corporations involved in significant global activities.
b. The arguments in favour of harmonisation of accounting rules and reporting practices include:
more ready comparison across firms in different countries
reduced costs for global enterprises from not having to prepare multiple reports
lower aggregate costs to prepare accounting standards
enhanced international capital flows (increased confidence in the financial reports)
lower costs of capital for organisations
improved understanding of financial reports, and
greater accountability of regulatory bodies.
The stated benefits of harmonising Australian Accounting Standards with the international
equivalent standards are:
improved comparability of different countries’ financial reports
enhanced international capital flows due to consistent global standards
reduced accounting and reporting costs for multinational enterprises as fewer separate reports
need to be produced, and
greater understanding of financial reports by the stakeholders due to uniform recording and
reporting regulations.
Activity 5.5
a. No, because rules and regulations do not eliminate mismanagement, and more time would be
spent on trying to get around them.
b. Ensuring reports are sound is very difficult to do. There is a need for wider information about
culture and management practices, and for a set of reasonable governance guidelines.
Activity 5.6
Several fundamental questions arise:
Just what are the information needs of a modern investment community? It is likely that conventional
reporting requirements will be expanded to include sustainability reporting in the future, particularly
accounting for carbon and water.
How do we deal with the broadening range of stakeholders and changing priorities?
Just what information does an extended stakeholder group need?
Debates are likely to continue, with concerns about over-regulation, the idea of a social licence to
operate, and the broadening of stakeholder interests.
Activity 5.7
The revaluation will result in the property being increased from $1 million to $2 million with a revaluation
reserve being opened for $1 million. So the balance sheet will show property at $2 million and the
reserves will show a revaluation reserve of $1 million. The other $1 million will either be shown as a
liability, if the property was bought using debt, or would have reduced cash. For the year in question there
will be a gain under other comprehensive income of $1 million, representing an unrealised gain on
revaluation. This is a gain that may be reclassified to profit and loss.
The next year the profit on sale would be included in the income statement, as would the now realised $1
million that was included in the previous year’s other comprehensive income, giving a realised profit of
$1.2 million. In other comprehensive income there will be a deduction of $1 million, because the
unrealised profit is now realised and is therefore reclassified.
Activity 5.8
MANET LTD
Statement of changes in equity
for the year ended 31 December 2020
$m $m $m $m $m
Notes
1. Dividends are shown in the statement of changes in equity. They are deducted from retained
earnings. An alternative would be to show them as a note to the financial accounts.
2. The effect of each component of comprehensive income on the various components of
shareholders’ equity must be separately disclosed. The revaluation gain and the loss on translating
foreign operations are each allocated to a specific reserve. The profit for the year is added to
retained earnings.
Activity 5.9
H LTD AND S LTD
Consolidated statement of financial position
as at 31 December 2020
$m
Goodwill on consolidation 1
Total assets 17
Liabilities (3+1) 4
Equity
Ordinary shares 6
Reserves 5
13
Goodwill $1 million
The whole of the profit for H Ltd is allocated to H Ltd, plus 60% of S Ltd’s profit of $1.5 million; so
$3 million+$0.9 million goes to H Ltd, and 40% of $1.5 million is allocated to non-controlling interests.
Chapter 6 Measuring and reporting cash flows
Learning objectives
When you have completed your study of this chapter, you should be able to:
LO 1 Explain why cash and cash flows are important to businesses and similar
organisations
LO 2 Explain the nature, purpose and layout of the statement of cash flows
LO 3 Prepare a simple statement of cash flows using the direct method
LO 4 Prepare a simple statement of cash flows from operating activities using the indirect
method, effectively a reconciliation of profit with cash flow from operating activities, and
explain how useful this is in decision-making
LO 5 Identify some of the potential complexities that arise with statements of cash flows
LO 6 Explain what the statement tells us, and illustrate how the statement of cash flows can
be useful for identifying cash flow management strengths, weaknesses and opportunities,
both historically and in forecasting and planning.
Reflection 6.1
What lessons might our young restaurateur of earlier chapters,
Lucas, learn from the Accounting and You above? Summarise the
main lessons to be learnt, as a starting point. Then consider just
how the issues listed impact on cash. How might you minimise the
possibility of failure through over-trading?
The importance of cash and cash flow
LO 1 Explain why cash and cash flows are important to businesses and similar organisations
Simple organisations, such as small clubs and other not-for-profit associations, still require that their cash
flows are sufficiently strong to be able to support their activities. However, the nature of these activities is
such that organisations of this type can often limit their accounting activities to a record of cash receipts
and cash payments. Periodically (normally annually), a summary of all cash transactions for the period is
produced for the members, showing one single figure for each category of payment or receipt; for
example, membership subscriptions. This summary usually forms the basis of the club’s decision-making,
and is the main means for the committee to fulfil its moral duty to account to the club members. This is
normally sufficient for such organisations. Table 6.1 illustrates such a report.
$ $
Receipts
Fundraising 3,190
Interest 470
21,230
Payments
Functions 3,410
Insurance 920
Utilities 1,430
Statements of this type may need to be amplified when considering future activities.
As we have seen in earlier chapters, organisations that are more complicated than simple clubs have to
produce statements that reflect movements in wealth and the net increase (profit/surplus) or decrease
(loss) for the period concerned.
The statement of cash flows is a fairly late addition to the annual published financial statements. At one
time, companies were required to publish only an income statement and a statement of financial position.
It seems the prevailing view was that all of the financial information needed by users would be contained
within these two statements. This view may have been based partly on the assumption that, if a business
were profitable, it would also have plenty of cash. While in the long run this is likely to be true, it is not
necessarily true in the short to medium term. In practice, unless a business’s cash flows are monitored in
the short to medium term, there may not be a long term for that business.
We saw in Chapter 3 that the income statement sets out the revenue and expenses for the period,
rather than the cash inflows and outflows. This means that the profit (or loss), which represents the
difference between the revenue and expenses for the period, may bear little or no relation to the cash
generated for the period.
To illustrate this point, let us take the example of a business making a sale (generating revenue). This
may well lead to an increase in wealth that will be reflected in the income statement. However, if the sale
is made on credit, no cash changes hands—at least, not at the time of the sale. Instead, the increase in
wealth is reflected in another asset: an increase in trade receivables. Furthermore, if an item of inventory
is the subject of the sale, wealth is lost to the business through the reduction in inventories. This means
that an expense is incurred in making the sale, which will also be shown in the income statement. Once
again, however, no cash changes hands at the time of sale. For such reasons, the profit and the cash
generated during a period rarely go hand in hand.
Activity 6.1 helps underline how particular transactions and events can affect profit and cash for a
period differently.
Activity 6.1
The following is a list of business/accounting events. In each case, state the effect (i.e. increase,
decrease or no effect) on both cash and profit.
Effect
.......... ..........
From what we have seen so far, it is clear that the income statement is not the place to look if we are to
gain insights about cash movements over time. We need a separate financial statement.
In 1991, a new accounting standard required entities to produce and publish, as well as the income
statement and the balance sheet, a cash flow statement reflecting movements in cash. The reason for
this was the growing belief that, despite their usefulness, the income statement and the balance sheet did
not concentrate sufficiently on liquidity. It was believed that the ‘accrual-based’ nature of the income
statement tended to obscure the question of how and where a company was generating the cash it
needed to continue its operations. The standard has been updated several times and the title of the
statement has subsequently been changed to ‘statement of cash flows’.
Why is cash so important to businesses pursuing profit/wealth? The solution to Activity 6.1 illustrates
the fact that cash and profit do not go hand in hand, so why the current preoccupation with cash? After all,
cash is just an asset that a business needs to help it to function. The same could be said of inventory or
non-current assets.
Cash is important because people and organisations will not normally accept any other way of settling
their claims against the business. If a business wants to employ people, it must pay them in cash. If it
wants to buy a new asset to exploit a business opportunity, the seller of the asset will normally insist on
being paid in cash, probably after a short period of credit, usually a month or two. When businesses fail, it
is their inability to find cash to pay claimants that really drives them under. These factors make cash the
pre-eminent business asset, and therefore the one that analysts and others watch carefully in trying to
assess the ability of the business to survive and to take advantage of commercial opportunities as they
arise. During an economic downturn, the ability to generate cash takes on even greater importance.
Banks become more cautious in their lending, and businesses with weak cash flows often find it difficult to
obtain finance.
The importance of cash and cash flow can be seen in the two examples in Real World 6.1 . The first is
taken from an article by Luke Johnson who is a ‘serial entrepreneur’. This article was written just after the
tennis at Wimbledon had finished, and covered his views on major self-inflicted mistakes that can
undermine a career. The article covered a range of mistakes, but the one given in Real World 6.1
relates specifically to the inability to distinguish profit from cash. The second highlights cash flow
problems relating to the late payment of invoices for small businesses in Australia.
Source: Extract from Luke Johnson, ‘The most dangerous unforced errors’, ft.com, 10 July 2013. © The Financial Times Limited 2013. All Rights Reserved. FT and
Source: Stuart Ridley, ‘How late payments are sending small businesses to the wall’, In the Black, 1 June 2017.
Reflection 6.2
Your friend Tim is about to start a business building and repairing agricultural equipment. What are
the key potential problem areas that he should reasonably anticipate? What steps would you
advise to head these off?
Concept check 1
Which of the following statements is true?
A. Cash flow statements provide information that can easily be obtained from the
balance sheet and income statement.
B. The income statement and balance sheet provide all of the information needed by
most financial statement users.
C. Profit and cash generally go up or down simultaneously.
D. Preparation of a cash flow statement is not at management’s discretion.
E. None of the statements are true.
Concept check 2
Which of the following will change the firm’s profit but not its cash?
A. Cash sales
B. Credit sales
C. Payment of rates
D. Receipts from debtors/receivables.
Concept check 3
Which of the following will simultaneously alter the firm’s profit and cash levels?
A. Depreciation
B. Wages paid in the current period
C. Payment of creditors/payables
D. Sale of a non-current asset.
The statement of cash flows
LO 2 Explain the nature, purpose and layout of the statement of cash flows
The statement of cash flows is, in essence, a summary of the cash inflows and outflows over the period
concerned. To aid understanding, these cash flows are divided into categories (e.g. those relating to
investment in non-current assets). Cash inflows and outflows falling within each category are added
together to provide a total for that category. These totals are shown on the statement of cash flows and,
when added together, reveal the net increase or decrease of the cash (and cash equivalents) of the
business over the period. The statement is basically an analysis of the business’s cash movements for
the period.
An example of the kind of layout for the statement of cash flows is shown in Table 6.2 .
Interest received x
Dividends received x
Cash and cash equivalents at the end of the financial year x(x)
Accounting Standard AASB 107: Statement of Cash Flows defines operating activities as ‘the principal
revenue-producing activities of the entity and other activities that are not investing or financing’. Interest
received would normally be classified as an operating activity cash inflow for financial institutions, but
there is no agreement on its treatment for other organisations. It has long been debated whether interest
received relates to operating activities or investing activities, and the current accounting standard allows
firms to choose based on their individual circumstances.
The headings in italics are the primary categories into which cash payments and receipts for the period
must be placed.
Cash flows from operating activities. This is the net inflow from operations. It is equal to the sum of
cash receipts from accounts receivable (and cash sales where relevant) less the sums paid to buy
inventory, to pay rent, to pay wages, etc. Note that the amounts of cash received and paid, not the
revenues and expenses, are what feature in the statement of cash flows. It is, of course, the income
statement/statement of comprehensive income that deals with the expenses and revenues.
Cash flows from investing activities. This part of the statement is concerned with cash payments
made to acquire additional non-current assets and cash receipts from the disposal of such assets.
These non-current assets could be tangible assets, such as plant and machinery, or such things as
loans made by the business, shares in another company bought by the business, or other
investments. Under AASB 107, interest received and dividends received could, if the directors chose,
be classified under ‘cash flows from operating activities’. This alternative treatment is available as
these items appear in the calculation of profit. For the purpose of this chapter, however, we shall
include them in ‘cash flows from investing activities’.
Cash flows from financing activities. This part of the statement is concerned with financing the
business, except to the extent of trade credit and other very short-term credit. So we are considering
borrowings (other than very short-term) and finance from share issues. This category is concerned
with procuring long-term finance from debt and equity sources, together with debt
repayment/redemption and the returns to equity holders. Under AASB 107, interest and dividends paid
by the business could, if the directors chose, appear under this heading as outflows. This alternative to
including them in ‘cash flows from operating activities’ is available as they represent a cost of raising
finance. Whichever treatment for interest and dividends (both paid and received) is chosen, it should
be applied consistently.
Net increase in cash and cash equivalents held. Naturally, the total of the statement must be the
net increase or decrease in cash over the period covered by the statement.
AASB 107 incorporates a broad concept of cash in terms of both cash and cash equivalents. Cash
represents ‘cash on hand’ and ‘demand deposits’, while cash equivalents represent short-term, highly
liquid investments that can readily be converted to a fixed amount of cash.
Details of the statement of financial position accounts making up the ‘cash and cash equivalent’ balance
in the statement of cash flows must be separately disclosed. Examples of such accounts would include
‘cash on hand’, ‘cash deposits at the bank’, ‘bank overdrafts’, ‘short-term money market deposits’ and
‘bank bills’.
Activity 6.2
At the end of its reporting period, Zeneb Ltd’s statement of financial position included the following items:
Which, if any, of these four items would be included in the figure for cash and cash equivalents?
Under normal circumstances, we would expect (or at least hope) that the cash flows from operations
would be positive. Since the cash flows do not include non-cash expenses such as depreciation, the cash
flow from operations will normally be higher than the profit recorded. Interest and tax payments are
separately identified. Companies pay tax on profits, so if the company is profitable, the cash flow will
move from the company to the tax authority. There will not normally be a cash outflow relating to tax if the
company is not profitable. The cash flow from operating activities gives users a reasonable understanding
of the trends over the years and of likely sustainability in the future. Given that a high proportion of the
funding for expansion comes from retained profits, which is approximately the cash flow from operating
activities less dividends, a full understanding of the cash flow from operating activities is important.
Activity 6.3
Assume that last year’s statement of cash flows for Angus Ltd showed a ‘negative’ cash flow from
operating activities. What could be the reason for this? Should the company’s management be alarmed
by it?
An important variation to this is what is known as free cash flow . Investopedia defines ‘free cash flow’
as representing ‘the cash a company generates after cash outflows to support operations and maintain or
its capital assets’. Without cash, it is tough to develop new products, make acquisitions, pay dividends
and reduce debt. Some people feel that there is too much emphasis on earnings, which can be
manipulated, whereas it is difficult to fake cash flow. You can read more on free cash flow at Investopedia
(www.investopedia.com).
free cash flow
Free cash flow represents the cash flow that a company is able to generate after
laying out the money required to maintain or expand its asset base.
Operating cash flow is an important part of many businesses’ key performance indicators. Real World
6.2 provides evidence of this.
a. Energy business BP plc frames one of its key financial performance targets in terms of
operating cash flows. Its performance over the five years ending December 2018 is set out
in Figure 6.1 .
Figure 6.1 Operating cash flow for BP plc ($ billion)
Showing the operating cash flows with and without Gulf of Mexico oil-spill payments
illustrates both the cash implications of the spill and its consequences, as well as the
relative stability of the normal operating cash flows.
Source: BP plc, Growing the Business and Advancing the Energy Transition: BP Annual Report and Form 20-F, 2018, p. 16.
b. In its 2018 annual reiew, Wesfarmers included ‘operating cash flows’ and ‘free cash flows’
under the heading ‘Performance Review—creating wealth and adding value’ (p. 6).
It also included ‘operating cash flow per share’ and ‘free cash flow per share’.
The section on investing activities needs to be linked with the other two sections, since we would normally
expect long-term assets to be paid for (funded) by either operations or other financing. Of course,
sometimes asset sales can fund further asset purchases. Because most types of fixed assets wear out
and because companies tend to seek to expand their asset base, the normal direction of cash in this area
is out of the company (i.e. negative).
The section on financing indicates what cash has been raised and repaid in financing transactions.
Normally, a company pays out more to service its finance than it receives from its own financial
investments (loans made and shares owned). Financing can go in either direction, depending on the
financing strategy at the time. Since companies seek to expand, there is a general tendency to associate
this area with cash coming into the business rather than leaving it.
Figure 6.2 provides a diagrammatic representation of the statement of cash flows showing likely
directions of cash flows.
Various activities of the business each have their own effect on its cash and cash equivalent balances,
either positive (increasing them) or negative (reducing them). The net increase or decrease in the cash
and cash equivalent balances over a period will be the sum of these individual effects, taking account of
the direction of each activity (cash in or cash out).
Note that the direction of the arrow shows the normal direction of the cash flow in respect of each activity.
In certain circumstances, each of these arrows could be reversed in direction.
A comparison of statements of cash flows over time enables us to identify trends and make comparisons
with other companies.
Concept check 4
Which of the following statements is false?
A. The statement of cash flows summarises cash flows by category, and covers
operating, investing and financing flows.
B. Operating flows are typically cash flows that relate to normal operations, including
cash received from customers and cash paid to suppliers.
C. Investing flows are cash flows relating to investments, and include purchase of new
non-current assets, their depreciation, and sale proceeds from any such assets sold.
D. Financing flows are cash flows relating to how the business is financed, including
such things as loans raised or repaid, and rights issues.
E. None of the above. They are all true.
Concept check 5
What do you think are the most likely patterns to be found in the cash flows from operating
and investing activities for a relatively new company (e.g. in the growth phase)?
A. Outflows of operating cash flows/outflows of investing flows
B. Inflows of operating cash flows/outflows of investing cash flows
C. Outflows of operating cash flows/increase in investing flows
D. Inflows of operating cash flows/inflows of investing flows.
Preparation of the statement of cash flows—a simple
example
LO 3 Prepare a simple statement of cash flows using the direct method
The statement of cash flows is based on an analysis and classification of cash receipts and cash
payments for the period into three activity sets (operating, investing, financing) and several categories
within each activity (see Figure 6.2 and Table 6.2 on pages 244 and 242).
Given that the emphasis of this book is on the user rather than the preparer, a section on preparing a
statement of cash flows might seem redundant. However, a broad understanding of the approach needed
to prepare such a statement will give you a better understanding of the statement itself. Also, when the
statement is turned around and used in a forward-looking or forecast mode, it can become an extremely
powerful aid in strategic planning. With this in mind, we shall use Example 6.1 to illustrate the
preparation of a statement of cash flows.
EXAMPLE
6.1
Given below is a statement of comprehensive income and a statement of financial position for a
company. This will form the basis from which we shall prepare a statement of cash flows.
$m
Sales 100
Gross profit 40
Depreciation (5)
Operating profit 18
Tax (5)
40
2019 2020
$m $m
Current assets
Accounts receivable 15 20
Inventory 22 30
49 55
Non-current assets
80 95
Current liabilities
Accounts payable 10 15
Dividend proposed 15 20
29 40
Non-current liabilities
Debenture loans 20 25
Shareholders’ equity
Retained profits 30 20
80 85
During 2020 the company spent $10 million on additional land and buildings, and $10 million on
additional plant and machinery. There were no other non-current asset acquisitions or disposals. A
new issue of shares occurred.
There are two approaches that can be taken to deriving this figure: the direct method and the indirect
method. The direct method involves an analysis of the cash records of the business for the period,
identifying all payments and receipts relating to operating activities. These are summarised to give the
total figures for inclusion in the statement of cash flows.
direct method
The method of calculating operating cash flows by analysing the cash records to
identify cash payments and receipts by type.
The indirect method uses accounting information from the income statement and the statement of
financial position to convert the profit figure to a cash figure. It relies on the fact that, sooner or later, sales
revenue will give rise to cash inflows, and expenses will give rise to outflows. This means that the figure
for profit for the year will be linked to the net cash flows from operating activities. Since businesses have
to produce an income statement, the information that it contains can be used as a starting point to deduce
the cash flows from operating activities.
indirect method
An approach to deducing the cash flows from operating activities, in a cash flow
statement, by analysing the business’s financial statements.
In fact, the accounting standard encourages entities to use the direct method, as it provides information
that may be useful in estimating future cash flows, which is not available under the indirect method (para
19 of the standard). Given this, we will concentrate in the remainder of this section on the direct method,
and will cover the indirect method in the section that follows.
The first stage of the direct method is to calculate the cash receipts from customers. Using the figures in
Example 6.1 , cash received from customers can be calculated as follows:
The same kind of approach can be used to calculate cash paid to suppliers and employees, although the
process is generally a little more complicated, as this requires knowledge of the purchases figure. The
first stage is therefore to calculate this figure.
Opening inventory 22
plus purchases x
22+x−30=60, so x=60+30−22=68.
This figure can then be inserted in the table for accounts payable to enable us to work out the cash paid
relating to accounts payable.
There are no prepayments or accruals at either the beginning or end of the year, so payments of other
expenses may be presumed to have been paid in cash, as they reflect expenses of the year. Depreciation
will not involve a cash outflow. If there are any prepayments or accruals relating to other expenses an
adjustment will need to be made, of the type made above or in the next section relating to interest.
Interest paid is usually fairly straightforward, but where there is an associated interest payable or interest
prepaid (or indeed, if there are prepaid or accrued expenses), a calculation process similar to the one
above for accounts payable will be required. The calculation of interest paid relating to interest payable
can be derived as follows:
Opening balance of interest payable 0
With regard to payments of tax, we have already noted that the actual payment of tax tends to lag behind
profits, so we would expect payments in the current year to reflect last year’s (possibly adjusted) tax
liability. In the case of Example 6.1 , it should be clear that the figure for tax due at the end of 2019 will
be paid in 2020, and the amount included against profit for 2020 will remain outstanding at the end of
2020, presumably to be paid in 2021. Alternatively, it can be calculated in the same way that we
calculated interest paid where there was tax payable at the beginning and end of the period.
The ‘operating’ section can now be completed for Example 6.1 as follows:
As for dividends, we would usually expect to see final dividends for the year as a current liability in the
year-end statement of financial position, to be paid early in the following year. In Example 6.1 , this
means that the $15 million dividends proposed at the end of 2019 will be paid in 2020. The proposed
dividends shown in the statement of comprehensive income for the year ended 30 June 2020 are also
shown as outstanding in the year-end statement of financial position, so clearly they cannot have been
paid.
The ‘financing’ section can now be completed for Example 6.1 as follows:
Putting the above sections together enables us to complete the statement of cash flows for Example
6.1 as follows:
$m
Chapter 8 deals specifically with financial analysis. However, the statement of cash flows should be
linked with this analysis, with the following points being relevant. The statement clearly shows that cash
decreased by $7 million over the course of the year, and it clearly identifies the factors that contributed to
this decrease. This enables users of the financial reports to assess the efficiency of liquidity management.
The following might be considered:
The statement of financial position also raises further issues, to be reviewed after studying Chapter 8 .
Accounts receivable have increased by one-third, or $5 million—is this increase justified relative to
sales, or is it due to tighter trading conditions or an inefficient debt collection and credit policy?
Inventory has increased by just over one-third, or $8 million—is this justified, or does it reflect poor
inventory control?
Accounts payable have increased by 50%, or $5 million. To some extent this may offset the increase
in inventory. It could also reflect a lengthening of the time the business takes to pay its debts. Whether
the new time is appropriate is a question that has to be considered in the context of the industry.
Real World 6.3 provides an example of a statement of cash flows for Telstra from its 2019 annual
report.
Real world 6.3
Example of a statement of cash flows
TELSTRA
Statement of cash flows
for the period ended 30 June 2019
2019 2018
Receipts from customers (inclusive of goods and services tax (GST)) 30,231 31,901
Payments for business and shares in controlled entities (net of cash acquired) (115) (56)
Proceeds from sale of business and shares in controlled entities (net of cash disposed) 42 49
Interest received 33 65
Other (1) 2
Cash and cash equivalents at the beginning of the year 620 936
Cash and cash equivalents at the end of the year 2.6 604 620
Concept check 6
A firm has an opening balance of receivables amounting to $10,000. During the year the
firm has sales totalling $100,000. It writes off $3,000 in bad debts. At year-end it is owed
$8,000 by customers. How much cash was received from receivables in the year?
A. $102,000
B. $105,000
C. $95,000
D. $99,000.
Concept check 7
A company has a balance on its payables account of $6,000 at the start of the year. During
the year it pays $59,000 and receives a discount amounting to $2,000. At year-end the
company owes $7,000. What was the amount of purchases made on credit for the year?
A. $74,000
B. $62,000
C. $60,000
D. $58,000.
Concept check 8
At the start of the year a firm owes wages of $2,000. It incurs a wages expense of $220,000
for the year. At the end of the year it has $3,000 outstanding. What was the amount paid for
wages in the year?
A. $225,000
B. $219,000
C. $221,000
D. $215,000.
Activity 6.4
Chen Ltd’s income statements for the years ended 31 December 2019 and 2020, and the statements of
financial position as at 31 December 2019 and 2020, are as follows:
CHEN LTD
Income statement
for the year ended December
2019 2020
$m $m
Operating profit 64 29
CHEN LTD
Statement of financial position
as at 31 December
2019 2020
$m $m
Assets
Current assets
Cash 19 −
Accounts receivable 26 25
Inventories 24 25
69 50
Non-current assets
172 186
Current liabilities
Overdraft − 2
Trade payables 37 34
Income tax 8 3
45 39
Non-current liabilities
Equity
Retained earnings 56 57
156 157
Included in ‘cost of sales’, ‘distribution expenses’ and ‘administrative expenses’, depreciation was as
follows:
2019 2020
$m $m
There were no non-current asset disposals in either year. The amount of cash paid for interest equalled
the expense in each year. Dividends were paid totalling $18 million in each year.
Reflection 6.3
Refer to some of our earlier reflections on the high-tech entrepreneur or our restaurateur, Lucas.
Are there any particular areas that you can think of relating to the cash flows of these businesses
that are not covered by the chapter to date? While the statements discussed to date primarily
relate to reporting entities, do you think that the basic statement of cash flows is useful to all
businesses? Why/why not?
Indirect method
LO 4 Prepare a simple statement of cash flows from operating activities, using the indirect method,
effectively a reconciliation of profit with cash flow from operating activities, and explain how useful this
is in decision-making
The accounting standard states that an entity shall report cash flows from operating activities using either
the direct method or the indirect method, ‘whereby profit or loss is adjusted for the effects of transactions
of a non-cash nature, any deferrals or accruals of past and future operating cash receipts or payments,
and items of income or expense associated with investing or financing cash flows’. The application of the
indirect method involves a number of stages. The first is to adjust for any items that are clearly non-
operating items, and which will appear in the investing or financing sections. The second is to add back
any non-cash expenses (such as depreciation). The final step is to adjust for any changes in current
assets and current liabilities. The process works broadly as set out in Table 6.3 .
Table 6.3 The indirect method of deducing the net cash flow from operating activities
Profit after tax x
Adjust for any items in the income statement which need to be in the investing or financing sections of the statement x(x)
Add any non-cash expenses relating to non-current assets, e.g. depreciation/amortisation/loss on disposal x
Adjust for changes over the period in non-cash current assets/current liabilities
– inventory x(x)
Subtract non-cash revenues related to non-current assets, e.g. gain or loss on disposal (x)
The indirect method, which is effectively a reconciliation of profit and cash from operations, is based on
the following logic. The starting point of the reconciliation is the profit after tax, the bottom line of the
income statement. In order to convert the profit figure to an operating cash flow, we first need to reduce
the profit figure by any items which are clearly non-operating, and which will appear in either the investing
or the financing sections. By way of illustration, investment income would be part of profit, but not of
operating profit (it is clearly not an operating cash flow), and so any amount relating to investment income
would need to be deducted in arriving at operating profit. This figure would normally appear in the
investing section.
The next stage is to add back any non-cash expenses. So if, for example, there was a foreign exchange
loss taken in calculating the profit figure, the amount of that loss would need to be added back.
Depreciation is the prime example of a non-cash expense which clearly relates to operating activities. It is
not associated with any movement in cash during the accounting period, but rather represents an
estimate of service potential or economic benefits of property, plant and equipment used up during the
period.
The remaining adjustments all relate to the operating profit after income tax. Broadly, we would expect
sales to give rise to cash inflows, and expenses to give rise to cash outflows. We have already seen that
this relationship does not follow precisely within a particular accounting period. Profit does not necessarily
equal the net cash inflow from operating activities. In Example 6.1 (page 246) we saw a difference
between the sales figure in the statement of comprehensive income and the cash received from
customers calculated as follows:
gives the amount we might expect to receive for the year 115
Put another way, the cash from customers can be arrived at as follows:
less the increase or plus the decrease in accounts receivable over the year (5)
An increase in accounts receivable over the year means that the cash received will be less than the
amount included as revenue over the year, by the amount of the increase. A reduction in accounts
receivable over the year means that the cash received will exceed the amount included as revenue over
the year, by the amount of the decrease.
Basically, the accounts receivable figure is affected by sales and cash receipts. It is increased when a
credit sale is made, and decreased when cash is received from a debtor. If over the year the sales and
the cash receipts had been equal, the accounts receivable figures would have remained the same. Since
the accounts receivable figure increased, it must mean that less cash was received than the figure for
sales included in the statement of comprehensive income. Thus, the cash receipts from sales must be
$95 million (i.e. 100−(20−15)). Put slightly differently, we can say that, as a result of sales, assets of $100
million flowed into the business during the year. If $5 million of this went to increasing the asset of
accounts receivable, this leaves $95 million to increase cash.
The same general point is true in respect of nearly all of the other items taken into account when
deducing the operating profit figure. The exception is depreciation, which was covered earlier.
Using Example 6.1 (page 246), we see that this would result in a statement as shown below:
$m
Depreciation 5
The net cash inflow of $8 million from operating activities is the same as that derived using the direct
method.
Basically, this reconciliation starts with the assumption that the profit equals the cash generated. We
know that this is not true, because the following things happen to prevent it being true:
Depreciation does not involve a cash outflow, so the cash flow from operations will be higher than the
net profit by the amount of the depreciation.
Any increase in current assets (accounts receivable, prepayments or inventory) over the course of the
year can be seen as representing a drain of cash (accounts receivable—cash not collected from sales
during the period; inventory and prepayments—cash paid related to inventory and other expenses
exceeds the cost of goods sold and expense amounts). So increases can be seen as an effective
decrease in cash flow. Any decrease in current assets means that these assets over the course of the
year can be seen as releasing cash (accounts receivable—cash collected exceeds the sales;
inventory and prepayments—cash paid for inventory and other expenses is less than the cost of
goods sold and expense amounts). So reductions represent an effective increase in cash flow.
Any increase in current liabilities (accounts payable, income tax payable, deferred tax payable and
accruals) must mean that less cash has been paid out over the course of the year than one might
have expected on the basis of the expenses included in the statement of comprehensive income. This
means that an increase in such liabilities over the year can be seen to represent an effective increase
in cash flow, over and above those included from profit. Any decrease in these current liabilities must
mean that more has been paid out over the course of the year than one might have expected on the
basis of the expenses included in the statement of comprehensive income. This means that a
decrease in such liabilities over the year (they have been paid off) can be seen to represent an
effective decrease in cash flow compared with profit.
Any gain or loss on the disposal of non-trading assets (e.g. property, plant and equipment;
investments; intangibles) needs to be adjusted for. Both the gain and the loss are non-cash in nature,
and simply represent the difference between the proceeds on disposal and the carrying amount of the
asset sold. The cash proceeds are included as a cash inflow in the investing activities section of the
statement of cash flow. Therefore, the loss is added back in the statement and the gain is deducted.
All of this means that if we take the profit for the year, adjust it to eliminate any items relating to investing
and financing, add back the depreciation charged and any other non-cash expenses, and adjust this total
by movements in non-cash current asset and current liability accounts (e.g. inventory, accounts
receivable, accounts payable, prepayments and accruals, and income tax), we have the net cash from
operating activities.
Before moving on to consider other areas of the statement of cash flows, it is useful to emphasise an
important point. The fact that we can work from the profit to derive the net cash flows from operating
activities should not lead us to conclude that these two figures are broadly in line. Typically, adjustments
made to the profit figure to derive net cash flows from operating activities are significant in size.
Activity 6.5
Explain how the reconciliation statement can be useful in working capital management.
In many ways the statement of cash flows using the indirect method provides more useful information for
decision-making than the statement of cash flows using the direct method. Cash can be positively or
negatively affected by changes in working capital. Whereas these are not obvious using the direct
method, the indirect method focuses on them. Certainly, inefficient working capital management can be
identified more easily by the indirect method. The indirect method enables a clearer focus on the working
capital components; namely, inventory, credit control relating to receivables, and control of payables.
Unless someone in an organisation is given control and responsibility for each of these areas (and they
can be under the control of different people), the chances are that the end cash result will be a residual or
unplanned result. All of these areas need to be continually worked on. As we shall see in Chapter 13 ,
working capital management needs to be positively managed, not left to chance.
Real World 6.4 provides an example of the use of the indirect method to calculate the net cash flows
from operating activities relating to Telstra, which complements Real World 6.3 . This statement
effectively reconciles the net profit for the year to net cash provided by operating activities.
It is interesting to note that most businesses in Australasia seem to use the direct method, whereas in
Europe the majority seem to use the indirect method.
One area of potential confusion relates to whether the starting point for the indirect method is the profit
before or after tax. In Real World 6.4 Telstra uses the profit after tax. The adjustment for tax is then the
difference in the tax provisions at the beginning and the end of the year. If the starting point is profit
before tax, the adjustment for tax will be the tax actually paid. If the starting point is profit after tax, the
adjustment for tax is the difference between the beginning and end balances for tax.
Concept check 9
Which of the following statements about the indirect profit reconciliation method is true?
A. AASB107 requires preparation of this reconciliation.
B. The starting point for the method is ‘profit after tax’.
C. The ending point for the method is ‘cash flow from operating activities’.
D. All of the above are true.
Concept check 10
Your company has increased its accounts receivable balance from the start of year to the
end of year (start of year was $20,000, end of year was $25,000). It has also increased its
accounts payable balance from the start of year to the end of year (start of year was $4,000,
end of year was $21,000). How will these be shown on the reconciliation?
A. Increase in receivables $5,000
Increase in payables $17,000
B. Increase in receivables ($5,000)
Increase in payables ($17,000)
C. Increase in receivables ($5,000)
Increase in payables $17,000
D. Increase in receivables $5,000
Increase in payables ($17,000).
Activity 6.6
The relevant information from the accounts of Dido Ltd for last year is as follows:
$m
Sales 500
Depreciation (34)
Inventory 15
Accounts receivable 24
Accounts payable 18
Inventory 17
Accounts receivable 21
Accounts payable 19
The example to date relates to a company that is required to prepare a statement of financial
performance in the form of a statement of comprehensive income. All of the principles outlined are equally
applicable to other entities, although the statement of financial performance may be in the form of a
traditional income statement or profit and loss account.
Some complexities in statement preparation
LO 5 Identify some of the potential complexities that arise with statements of cash flows
While so far we have used only relatively simple examples, there is obviously a range of potential
complications, many of which are beyond the scope of this book. The main complications relate to the
sections on investing and financing.
It is worth noting the movements in non-current assets over the year. These can generally be summarised
as in Table 6.4 . The following points are important:
x (x) x
Setting out a table of this sort enables us to follow through movements in assets relatively easily.
Activity 6.7
The following are the extracts from a statement of financial position as at 1 January and 31 December.
1 January 31 December
$ $
bonus issues (which result in an increase in share capital without any cash inflow)
issue of shares directly for non-cash assets or to extinguish debt
repurchase or redemption of shares.
It is not usually difficult to see that called-up share capital increased over a period. Of course, if we were
told that some of this was in the form of a bonus issue, the cash proceeds from shares would need to be
adjusted. Suppose that in the course of the year the share capital of a company increased by $90 million,
from $150 million to $240 million, but that the first tranche of the increase was in the form of a bonus
issue of $30 million, so that the cash issue could have been only $60 million ($90 million−$30 million).
A comparison of the long-term liabilities at the beginning and the end of the year should indicate the net
cash flows from borrowings. However, as with the issue of shares, the calculation of cash received from
long-term liabilities (or cash repaid on long-term loans) may be more complicated than just computing the
change for the year in the liability balance. These problems include:
The issue of debt directly for non-monetary assets (e.g. debentures issued in exchange for a building).
In this case, the increase in the liability does not represent a cash inflow.
The conversion of debt directly into shares (e.g. convertible notes). In this case, the reduction of the
liability does not represent a cash outflow.
The accounting standard requires that the gross borrowing and gross repayments are shown. The
change in the long-term liability for the period shows only the net change.
For dividends, we usually expect final dividends for the year to be shown as a current liability in the year-
end statement of financial position, and to be paid early in the following year. Care must be taken when
interim dividends are paid part-way through the year, as these will also be paid in the year. Generally, we
expect the cash outflow for dividend payments to include any proposed dividends outstanding from the
preceding year, plus any interim dividends (if any) declared in the current year.
SELF-ASSESSMENT QUESTION
6.1
Torbryan Ltd’s statement of comprehensive income for the year ended 31 December 2020 and the
statement of financial position as at 31 December 2019 and 2020 are as follows:
TORBRYAN LTD
Statement of comprehensive income
for the year ended 31 December 2020
$m
Sales 591
163
TORBRYAN LTD
Statement of financial position
as at 31 December
2019 2020
$m $m
Current assets
Prepaid expenses 6 16
Inventory 44 41
167 197
Non-current assets
550 635
Current liabilities
Bank overdraft 14 −
Accounts payable 44 39
Dividend payable 40 50
Accrued expenses 11 15
141 150
Non-current liabilities
Shareholders’ equity
Retained profits 16 53
176 432
During 2020 the company spent $40 million on additional plant and $55 million on additional
fixtures. It made no other non-current asset acquisitions or disposals. A new issue of shares
occurred. The land and buildings were revalued. At the end of 2019 there were 150,000 shares on
issue.
Prepare a statement of cash flows for the company for 2020 using the direct method of
calculating cash flows from operations. Then use the indirect method to provide a
reconciliation statement between operating profit and operating cash flows.
Concept check 11
Which of the following is the most straightforward in calculating cash flow from investing
activities?
A. Long-term asset acquisition is done using the historical cost assumption.
B. Long-term assets may be revalued at the end of the accounting period.
C. The gain or loss on disposal of a long-term asset is not obvious.
D. There is a trade-in of an asset similar to the one being purchased.
Concept check 12
Calculation of the change in long-term liabilities from start of year to end of year often
provides you with the net cash flow from borrowings. Which of the following will cause you
problems when using this method?
A. Both borrowings and repayments occur in the same accounting period.
B. Debt is paid by issuing shares to the lender.
C. Debt is issued in direct exchange for long-term assets.
D. All of the above will cause problems.
What does the statement of cash flows tell us?
LO 6 Explain what the statement tells us, and illustrate how the statement of cash flows can be useful
for identifying cash flow management strengths, weaknesses and opportunities, both historically and in
forecasting and planning
The statement tells us how the business has generated cash during the period, and where that cash has
gone. Since cash is properly regarded as the life blood of just about any business, this is potentially very
useful information. Tracking the sources and uses of cash over several years might show financing trends
that a reader of the statements could find useful for predicting the company’s future behaviour. Looking
specifically at the statement of cash flows for Torbryan Ltd (Self-assessment Question 6.1 ), we can
see the following:
Net cash flow from operations was strong; much larger than the profit figure. This would be expected,
because depreciation is deducted in arriving at profit.
Working capital tended to absorb some cash—not surprising if activity (sales output) had expanded
over the year. The information supplied did not show whether there was an expansion or not. If there
was not, questions would arise about working capital management.
There were net outflows of cash in the servicing of finance, payment of tax and purchasing non-
current assets.
There seemed to be a healthy figure of net cash inflows before financing.
There was a fairly major outflow of cash to redeem some debt finance, which was partly offset by the
proceeds of a share issue.
The net effect was a rather healthier-looking cash position in 2020 than the one in 2019.
We have already seen that the reconciliation of operating profit and operating cash flows (using the
indirect method) can be extremely useful in focusing on working capital management issues. Each
component of working capital needs to be managed, but the reconciliation statement clearly identifies the
impact of decisions (possibly non-decisions) on cash flows. The operating flows section probably
identifies the most sustainable part of the organisation’s cash flows. The investing and financing flow
sections clarify the situation that the organisation faces in these two areas. When turned around and used
for forecasting purposes, the statement of cash flows, in conjunction with the other financial statements,
becomes an integral part of the planning and decision-making process.
Activity 6.8
a. Do you see any particular difficulties in using the financial reporting framework for forecasting
purposes?
b. How do you think a forecast statement of cash flows might help in planning and decision-making?
Reflection 6.4
The Chapter 6 case study expands the details relating to Tim’s business plans (see Reflection
6.2 ). The case requires the preparation of forecast financial statements. These can clearly be
done as one-off statements, which are subsequently analysed. However, this case is a start-up
business with a fair degree of uncertainty. What do you think might be the advantages of using a
spreadsheet to model the future statements? How might the risks be identified and potentially
reduced by the use of sensitivity analysis—where variables (e.g. the period that debtors take to
pay, or the volume of sales) are changed one at a time to assess the impact of a single change—
and/or scenario analysis (where the figures are run using a number of alternative scenarios for the
future)? How might a spreadsheet help?
Concept check 13
Which of the following statements is more likely to be false?
A. Cash flow is just as important as profit.
B. Depreciation leads to cash flow from operations being more than profit.
C. A profitable company should have a positive cash flow from financing.
D. A growing company will probably have a negative cash flow from investing.
Concept check 14
Which of the following statements is false?
A. Classification by activity provides information that allows users to assess the impact
of those activities on the financial position of the entity and the amount of its cash
and cash equivalents.
B. Cash flow from operating activities is a key indicator of the entity’s ability to generate
sufficient cash to repay loans, maintain operating capacity, pay dividends and make
new investments without recourse to external sources of finance.
C. Separate disclosure of investing flows is important because the figure represents the
expenditure on resources intended to generate future income and cash flows.
D. Separate disclosure of financing flows is important because it helps predict claims on
future cash flows by providers of capital.
E. None. All are true.
SELF-ASSESSMENT QUESTION
6.2
The management of your company is perplexed as to why the company’s bank balance has gone
down in the past year, even though profits have been satisfactory. Relevant information is given
below.
Statement of financial position
as at 2020
1 January 31 December
$’000 $’000
Current assets
Cash 50 10
Accounts receivable 60 80
Inventory 70 100
180 190
Non-current assets
Vehicles—cost 25 30
13 20
Plant—cost 50 70
20 35
143 175
Current liabilities
Dividends proposed 10 15
130 120
Non-current liabilities
Loans 80 50
Shareholders’ equity
Retained profits 33 95
113 195
$’000 $’000
Sales 379
Opening inventory 70
Purchases 250
320
Depreciation
—Plant (5)
—Vehicles (4)
Dividends (15)
During the year, vehicles that had cost $10,000 and had been depreciated by $6,000 were sold for
$7,000. Sales in the previous year had been $350,000.
1. Prepare the statement of cash flows for the year, using the direct method. Then use the
indirect method to prepare a reconciliation of operating cash flows and profit.
2. Comment on the cash flows, and suggest ways of resolving any problems.
3. The company is now considering its plans for the next year, and thinks that it can achieve a
20% increase in sales, with similar increases in cash expenses. It is very concerned about
the liquidity of the business. It estimates that a further $30,000 will need to be spent on plant
at the start of the new year, and at the same time a new vehicle will be needed, costing
$25,000. Depreciation of plant and vehicles will be based on 10% and 20% straight-line,
respectively. Loan interest is likely to be around 7%. Calculate the profit that might result,
and prepare a statement of financial position and a statement of cash flows for the next year
using the indirect approach to operating flows. State all of your assumptions. Do you think
the liquidity concerns are justified? What steps would you take to ensure appropriate
liquidity is maintained or improved?
Summary
In this chapter we have achieved the following objectives in the way shown.
Explain why cash and cash flows are important to businesses and similar Explained that cash is the life blood of business, and
organisations the medium by which assets are acquired, expenses
are met, debts are paid, and owners receive returns
Explain the nature, purpose and layout of the statement of cash flows Illustrated the typical layout
Identified the main components of the statement of
cash flows as:
— operating activities—commercial or trading
activities
Prepare a simple statement of cash flows using the direct method Identified the main components listed above and
worked through an example
Asked questions as to what the statement adds
Prepare a simple statement of cash flows from operating activities using the Identified and worked through the necessary steps
indirect method, effectively a reconciliation of profit with cash flow from Discussed the advantages to decision-makers of the
operating activities, and explain how useful this is in decision-making indirect method of calculating cash flows from
operations
Identify some of the potential complexities that arise with statements of cash Identified a range of complexities:
flows — movements in non-current assets
— bonus shares
— non-cash transactions
Explain what the statement tells us, and illustrate how the statement of cash Analysed the main uses of the statement of cash
flows can be useful for identifying cash flow management strengths, flows:
weaknesses and opportunities, both historically and in forecasting and planning — Identified operating cash flows, which should be
positive
Easy
6.1 LO The statement of cash flows provides an explanation of the change in cash and cash equivalents for a reporting entity. What is
1/2 included in ‘cash and cash equivalents’?
6.2 LO What is the cash flow statement’s equivalent to the statement of financial performance’s ‘bottom line’?
2
6.3 LO Identify the three categories of the sources (uses) of cash used in the statement of cash flows.
3
6.4 LO For a newly established and growing entity, what would the expected cash flows be from the three separate activities?
1
6.5 LO Is the indirect method of deriving cash flow from operations more intuitive than the direct method?
4
6.6 LO In accordance with Australian Accounting Standards, you have revalued your land and buildings upwards by $20,000. Where
5 does this revaluation show on the statement of cash flows?
6.7 LO What information does the cash flow statement provide that is not available from the statement of financial position or the
6 statement of financial performance?
Intermediate
6.8 LO 1 Explain how the following accounts could change, as indicated, without a cash flow consequence:
6.9 LO 1 As a first-year accounting student, Irene is confused. She thought she was learning that accrual accounting provided more
useful information about the financial performance and position of an organisation than the statement of cash flows. The
statement of cash flows is a step in the wrong direction in her opinion. Help Irene with her dilemma.
6.12 LO 5 The net cash flow from long-term borrowing during an accounting period can basically be determined through a comparison of
the long-term liabilities at the beginning and the end of the year. Describe two potential complications with this comparison.
6.14 LO 3 How would you convert ‘cash received from customers’ from the cash flow statement into sales revenue for the statement of
financial performance? Assume no bad debts.
Challenging
6.15 LO 4 Your brother (tech-head) insists that depreciation is a source of cash. He cites the fact that depreciation is an ‘add-back’ item
on the reconciliation of net profit to cash flow from operations. Set him straight. Be gentle.
6.16 LO What would you expect to observe in the reconciliation of ‘profit after tax’ to ‘cash flow from operating activities’ over a period
4/6 of years in a business suffering financial stress?
6.17 LO 6 A stated advantage of the statement of cash flows is that it identifies possible sources of future cash flows. Explain how it
might do this.
6.18 LO If you were just starting your own business, what steps might you take to minimise the possibility of failure through over-
1/6 trading?
6.19 LO You brother heard that the statement of cash flows is particularly useful when a company is planning for significant capital
1/6 expenditure. But he doesn’t understand why. Can you explain this to him?
6.20 LO In preparing forecast financial statements, how might sensitivity analysis, scenario analysis and spreadsheets help in the
2/4/6 identification and avoidance of risk?
Application exercises
Easy
6.1 LO Which of the following would be classified as a ‘cash equivalent’?
1
a. cash on hand
b. cash at the bank
c. accounts receivable
d. inventory
e. accounts payable
f. prepayments
g. bank overdraft
h. debentures
i. deposits at call
j. bill receivable (60 days)
k. loan receivable (three months)
l. gold bullion.
6.2 LO You have been trying to explain cash flow statements to your arts major flatmate. He thinks a company that makes a large profit
1 will obviously have a large increase in cash. Complete the following table as a means of explaining to your flatmate why this will
not always be the case.
1 Increase No effect
2 Decrease No effect
3 No effect Increase
4 No effect Decrease
6.3 LO For each item listed, identify the activity and whether it is an inflow, an outflow or of a non-cash nature:
1/2
Activity Cash flow
$ $ $
Intermediate
6.5 LO Classify each of the following items as:
2/3
a. cash or non-cash
b. if cash, whether an inflow or outflow
c. if cash, what type of activity (operating, investing, financing).
C Interest paid
E Advance to employees
H Purchase of equipment
I Depreciation of equipment
M Interest received
6.6 LO Investing activities
3
You extract the following information on plant and equipment:
Year 1 Year 2
$ $
Other: The book value of the plant and equipment sold was $6,179.
$ $
*
Allocated
Other:
6.8 LO The following information concerns the non-current assets of TAO Ltd for the years ended 30 June 2019 and 2020.
3/5
Non-current assets
2019 2020
$m $m
Land 93 231
You also extract the following information on the non-current assets for the year ended 30 June 2020.
Prepare the statement of cash flows extract for TAO Ltd’s investing activities for the year ended 30 June 2020.
6.9 LO You are given the following financial statement extracts for Morgan Trading Ltd.
3
MORGAN TRADING LTD
Statement of comprehensive income
for the year ended 30 June 2020
$ $
Sales 156,900
2019 2020
$ $
Using the direct method, compute the following cash flow amounts for Morgan Trading Ltd for the year ended 30 June 2020:
6.10 LO Heins Ltd had an $11,000 loss from operations for 2020. Depreciation expense for 2020 was $5,700, and a dividend of $5,000
1/3 was declared and paid. The balances in the working capital accounts at the start and end of the year are shown below.
Start End
$ $
Challenging
6.11 LO Nu Bold Ltd’s statement of comprehensive income for the years ended 31 December 2019 and 2020 and the statement of
3/5 financial position as at 31 December 2019 and 2020 are as follows:
NU BOLD LTD
Statement of comprehensive income
for the years ended 31 December 2019 and 2020
2019 2020
$m $m
Gross profit 80 90
49 53
Interest revenue − −
49 53
44 46
60 80
NU BOLD LTD
Statement of financial position
as at 31 December 2019 and 2020
2019 2020
$m $m
Current assets
Inventory 17 21
Debtors 24 18
53 56
Non-current assets
191 212
Current liabilities
Trade creditors 15 16
Dividend payable 10 12
34 38
Non-current liabilities
Long-term loans 66 68
Shareholders’ equity
Retained profits 44 62
144 162
2019 2020
$m $m
Buildings 11 10
There were no non-current asset disposals in either year. In both years an interim dividend was paid within the financial year,
and a final dividend was paid just after the end of the year concerned. Prepare a statement of cash flows for the company for
2020 together with a reconciliation of operating profit and cash from operations using the indirect method.
6.12 LO The directors of Sonya Ltd are considering their plans for the next year. The company’s statement of financial position at the
3/4/6 end of the current year is expected to be as follows:
SONYA LTD
Statement of financial position
at end of the current year
$’000
Current assets
Inventory 190
Cash 10
500
Non-current assets
Equipment—cost 200
430
Current liabilities
Dividends proposed 30
230
The current plans are based on the following expectations for next year:
1. New equipment will be purchased at the start of the year for $50,000 cash.
2. The proposed dividends will be paid early in the year, and dividends amounting to $35,000 will be proposed for next
year.
3. Inventory at the end of the year will be $220,000.
4. The following trading transactions will occur evenly over the year:
Sales $1,980,000
Purchases $1,520,000
General expenses $50,000
Directors’ salaries $100,000
5. The period of credit given to customers will be two calendar months, and the period of credit taken from suppliers will
be 1.5 months. No prepayments or accruals are anticipated.
6. Depreciation on equipment is taken at 10% per annum on cost.
a. Prepare a forecast income statement, statement of financial position and statement of cash flows (preferably
using the reconciliation approach).
b. Comment on the changes in cash implicit in the plans. How might the result be improved?
Chapter 6 Case study
Your friend Tim, who was introduced in Reflection 6.2 , has asked for your assistance, as he knows
that you are doing a business course. A new industrial estate has been set up in the area (which is a rural
agricultural area) and he is wondering whether to buy a workshop there. He wants to set up as a sole
trader for the manufacture, repair and maintenance of agricultural machinery. You help him identify the
following assumptions and estimates.
1. The workshop will cost $200,000, and equipment is expected to cost $40,000.
2. You estimate that an initial inventory of materials amounting to $16,000 will be needed, and will
probably need to be maintained indefinitely.
3. Material costs are expected to be approximately 25% of the revenue earned.
4. Tim can put $40,000 into the business. He is thinking of asking the bank if he can borrow a further
$240,000. Interest is expected to be around 7%. Tim would like to pay off $24,000 of the principal
of the loan at the end of each year until the loan is paid off.
5. Tim will bring his ute into the business at a valuation of $16,000.
6. Tim expects to pay himself a wage based on an hourly rate of $40. He plans to take on an
assistant, Terry, who will be paid $30 an hour. He anticipates taking out additional drawings of
$40,000 over each year.
7. Other expenses are estimated to be:
Vehicle expenses $10,000
Insurance $5,000
Telephone/internet $6,000
Rates $10,000
8. Cash from work carried out is expected to be received one month after it has been done. Tim is
confident that enough work will be easily obtained to keep him and Terry fully occupied for the
whole year. They will both get four weeks’ paid annual leave. Work done will be charged out at $80
per hour.
9. Depreciation will be charged at 20% straight line on the equipment and 25% reducing balance on
the vehicle.
Required
a. Prepare a set of forecast financial statements for the first year. (You might like to use a
spreadsheet, which will reinforce the integrated nature of the statements.)
b. Advise Tim on his plans, particularly on the adequacy of the loan sought from the bank. Identify
any areas of concern that might require further information or consideration. Specifically comment
on:
i. The level of profit
ii. The level of drawings
iii. Levels of liquidity
iv. What happens to the forecast if customers become slow payers
v. How the plans might be modified to help develop a sustainable business over time.
Activity 6.1
You should have come up with the following:
Effect
1. Repaying borrowings requires that cash be paid to the lender. This means that two figures in the
statement of financial position will be affected, but none in the income statement.
2. Making a profitable sale on credit will increase the sales revenue and profit figures. No cash will
change hands at this point, however.
3. Buying a non-current asset on credit affects neither the cash balance nor the profit figure.
4. Depreciating a non-current asset means that an expense is recognised. This causes a decrease in
profit. No cash is paid or received.
5. Receiving cash from a credit customer increases the cash balance and reduces the credit
customer’s balance. Both of these figures are on the statement of financial position. The income
statement is unaffected.
6. Buying some inventories for cash means that the value of the inventories will increase and the
cash balance will decrease by a similar amount. Profit is not affected.
7. Making a share issue for cash increases the shareholders’ equity and increases the cash balance.
Profit is not affected.
Activity 6.2
i. A cash equivalent. It is readily withdrawable.
ii. Not a cash equivalent. It can be converted into cash, because it is listed on the stock exchange.
There is, however, a significant risk that the amount expected (hoped for!) when the shares are
sold may not actually be forthcoming.
iii. Not a cash equivalent, because it is not readily convertible into liquid cash.
iv. This is cash itself, although a negative amount of it. The only exception to this classification would
be where the business is financed in the longer term by an overdraft, when it would be part of the
financing of the business, rather than negative cash.
Activity 6.3
There are two broad possible reasons for a negative cash flow:
The company is unprofitable. This means more cash is paid out to employees, suppliers of goods and
services, etc., than is being received from operating revenues. This would be alarming, because a
major expense for most companies is the depreciation of fixed assets. Since depreciation does not
lead to a cash flow, it is not considered in the cash flow from operating activities. Thus, a negative
operating cash flow might well indicate a very much larger negative trading profit—that is, a significant
loss of the company’s wealth.
The other reason might be less alarming. A business that expands its activities (level of sales) tends to
spend quite a lot of cash relative to the amount of cash coming in from sales, usually because it is
expanding its inventory holdings to accommodate the increased demand. In the first instance, it would
not necessarily benefit, in cash flow terms, from all of the additional sales. Normally, a business may
need to have the inventory in place first before additional sales can be made. Even when the
additional sales are made, these are normally made on credit, with the cash inflow lagging behind the
sale. This is highly likely if the company is new and is expanding inventories, accounts receivable,
etc., from zero. Expansion typically causes cash flow strains for the reasons just explained, and this
can pose a problem: the company’s increased profitability might encourage optimism and a lack of
concern for the cash flow problem.
Activity 6.4
Workings for cash associated with revenues $m
Opening receivables 26
Cost of sales
Opening inventory 24
Purchases x
24+x
So Purchases=77
Purchases 77
114
=cash paid 80
Tax paid
Opening liability 8
Total due 14
Tax paid 11
CHEN LTD
Statement of cash flows
for the year ending 31 December 2020
$m $m
Operating flows
Dividends (18)
Opening cash 19
Activity 6.6
Workings for the statement of cash flows (direct method) $m
gives the amount we might expect to receive for the year 524
gives the amount we might expect to pay for the year 320
Opening inventory 15
plus purchases x
$m
Profit 122
Add depreciation 34
Thus, the net increase in working capital was $156 million. Of this, $2 million went into increased
inventory. More cash was received from accounts receivable than sales were made, and less cash was
paid to accounts payable than purchases were made of goods and services on credit. Both of these had a
favourable effect on cash.
Activity 6.7
a. Using the format on page xxx, we get the following:
Land and buildings Cost Accumulated depreciation Net
150,000 − 150,000
The new acquisitions and the depreciation for the year are obtained by solving for x, as shown.
Note that the cost and accumulated depreciation of the asset being disposed of is what gets taken
off. The fact that assets, which had cost $5,000 and had been depreciated by $3,000 (giving a
book value of $2,000), were sold for $1,000 means that there will be a loss on disposal of $1,000,
which will be a non-cash expense in the statement of comprehensive income. The sale proceeds
will be reflected in the statement of cash flows.
b. The relevant extracts from the statement of cash flows will be:
Cash flow from investing activities
Note that the reconciliation would include add-backs for depreciation totalling $15,000 plus $1,000 loss on
disposal.
Activity 6.8
a. Once you get used to the idea that the aims are different, there are no real problems. Instead of
using factual past figures, we need to use projected or forecast figures. These are clearly not as
reliable, but they are all we have. We should try to make any future estimates as good and as
justifiable as possible, and then follow through the consequences of our assumptions and
judgements regarding the future. In this way we will be able to see the end results that will occur if
all of our assumptions and judgements are correct. We may like what we see, in which case we
need to take steps to (try to) ensure that this happens. We may not like what we find, in which case
we need to reassess and change our thinking. Surely, however, this is an important process in the
development of our planning and thinking about our future.
b. They will illustrate what our cash situation is likely to be. This may require changes in plans. Areas
that might need reviewing include financing (do we need to look at other sources?), investing (can
we afford what we want to buy, or do we need to scale things down?), and working capital
management (do we need to run more efficiently, with tighter credit and lower, more efficient stock
turnover?).
Chapter 7 Corporate social responsibility and
sustainability reporting
Learning objectives
When you have completed your study of this chapter, you should be able to:
LO 1 Outline and discuss a range of social and environmental issues, and the way in which
accounting can contribute
LO 2 Explain what is meant by corporate social responsibility and sustainable
development
LO 3 Explain the development of reporting for corporate social responsibility and
sustainable development
LO 4 Explain triple bottom line reporting
LO 5 Outline the Global Reporting Initiative (GRI), and discuss its main framework in broad
terms
LO 6 Outline integrated reporting and its relationship with sustainability reporting using the
GRI Standards
LO 7 Assess the importance of corporate social responsibility and sustainability reporting,
and identify any issues that you see as critical to their success and implementation.
So far in this book we have dealt with financial reports based on fairly
well-defined rules, with a general assumption that the main objective of the
owners is wealth enhancement. This objective may well still be the major
driver, but, as we have seen, there are other stakeholders with a variety of
interests. Their needs may not be particularly well served by the traditional
accounting reports, and so there has been continuing pressure to improve
the information provided. This chapter introduces a range of improvements
in the provision of accounting information concerning areas such as
environmental and social issues and their impacts. This is extended by
specific reference to triple bottom line reporting, the Global Reporting
Initiative, with its emphasis on sustainability, and integrated reporting. The
chapter concludes with an overall review of what has been covered in the
chapter, together with some potential future issues.
At this stage, the disclosures and systems discussed in this chapter are
voluntary. Just how long this remains the case remains unclear. However,
the fact that these systems and disclosures are voluntary has not
prevented a significant number of major companies investing heavily in
them. The role of the accountant seems destined to broaden quite
significantly from the traditional financial perspective. You therefore need to
be aware of the trends and the increased amount of information available
to you as users of performance statements.
Social and environmental issues in accounting
LO 1 Outline and discuss a range of social and environmental issues, and the way in which
accounting can contribute
General background
In Chapter 1 , we identified a range of groups that use accounting information. These included owners
and managers, plus a variety of others, such as employees, community groups, governments and other
interest groups. Over many years, accounting has moved its focus from stewardship to decision--
usefulness. In more recent years, the idea of decision-usefulness has broadened considerably, with much
more emphasis on providing information that is useful to a wider range of interested parties.
Of particular significance is the far greater interest and involvement in issues that go beyond the confines
of a particular business and affect society at large. Examples include the impact of pollution on the
environment, the generation and use of energy, working conditions and prospects for employees, gender
equality, and responsible production and consumption.
Ever since the Industrial Revolution, there have been conflicts between entrepreneurs and the broader
society. Books such as Richard Llewellyn’s How Green Was My Valley, a story set in South Wales in the
late 19th and early 20th centuries, depict unashamed greed and the excessive use of economic power
and wealth, and the appalling working and living conditions of employees (encompassing health and
safety and environmental issues). In this book, the valley became a huge slag heap, one of many which
affected (and still affects) life in the valleys of South Wales.
As wealth and power become more widespread, so perspectives change, and accounting information has
slowly adapted to these changes. The stakeholder concept provides a useful framework to explain the
broadening of needs.
Stakeholder concept
The notions of stewardship accounting and decision-usefulness for owners and managers were the
driving forces of accounting until the past 20 or so years. This meant that accounting focused mainly on
providing information that enabled owners to make money. The stakeholder concept, on the other hand,
recognises that other interested parties also have a legitimate interest or stake in the business. Chapter
1 identified the following user groups:
owners/shareholders
managers
employees and their representatives
customers
government
lenders
suppliers
investment analysts
competitors, and
community representatives.
Some of these user groups have clear and undeniable stakes. For example, many employees have a big
stake in the business, its profitability, its attitude to things such as health and safety, and its long-term
success. This is particularly true if the business employs a large part of a town or city’s workforce. Others
have legitimate interests in relatively small parts of the business. Clearly, not all of these groups have
equal, or even similar, interests, and there may well be different opinions over the idea that competitors
have any legitimate interests.
Activity 7.1
Can you think of a town, city or region where prosperity and/or employment is, or has been, dependent on
one employer?
The importance of the particular business to the various groups of stakeholders might differ considerably,
and might change over time for a particular stakeholder group, but generally the stakeholder concept is
useful. Additions to the list might include potential customers, and socially oriented action groups,
including environmentalists and other pressure groups.
Businesses ignore the views and needs of these groups at their peril. Even if we assume that the
underlying objective of businesses is still wealth enhancement, businesses must be very conscious of
stakeholders’ views and the possible impact on a business’s future if it ignores them. An early example
was the boycott on tuna products instigated by the Dolphin Coalition. This was directed against an
industry-wide fishing practice that netted and killed large numbers of dolphins. Changes were
subsequently made to the fishing practice, and cans of tuna were labelled ‘dolphin safe’ where these
practices had been implemented. Health issues raised over the past few years have also led to pressure
from interested groups and considerable changes in products, and in their labelling and packaging.
However, the major issues confronting us all are climate change and global warming. Sales of large cars,
for example, have slumped, and the use of hybrids or more eco-friendly/fuel-efficient/electric vehicles has
grown.
Real World 7.1 provides a recent example of how public and consumer interests can impact on
business.
Real world 7.1
The supermarket plastic ban
In an article in The Guardian, Norman Zhou looked at the latest roll-out of anti-plastics policies in
Australia. He reported that in mid-2018, after years of campaigning by environmental groups and
consumers, Woolworths was banning all single-use plastic bags in stores across Australia, with
competitor Coles quickly doing the same. This would put an end to a practice that saw each chain
giving out approximately 3.2 billion bags a year. Queensland and Western Australia introduced a
general ban on all plastic bags from 1 July 2018. All other Australian states had already banned
lightweight plastic bags, except New South Wales.
Before the plastic ban was introduced, a survey conducted by Canstar Blue showed the majority of
Australians welcomed the proposed ban. However, when it was actually implemented the
supermarkets faced a backlash from customers. As Gary Mortimer and Rebekah Russell-Bennett
point out in an article in The Conversation, although the two retail giants tried to brand the plastic-
bag ban as a corporate social responsibility strategy, some shoppers were not happy to see that
the retailers were not reducing the use of plastic in their own packaging. Moreover, the
supermarkets had merely shifted the costs of bagging to the customer, by substituting the free
single-use bags with reusable bags that could be purchased for up to 15 cents. To mitigate this
impression, Mortimer and Russell-Bennett suggested that any profits from the sale of reusable
bags be put into ‘sustainability programs, research grants and education schemes’. Consumers
need to see that the supermarkets are genuinely interested in the positive environmental move by
seriously reducing all use of plastics and promoting societal awareness.
In an article for The Guardian, Graham Readfearn revealed that research shows that these
schemes have a significant impact on litter, citing Dr Jennifer Lavers, a marine biologist at the
University of Tasmania. Dr Lavers has been researching the impacts of plastics since the early
2000s. She avidly endorses the need to ban plastics, having seen for herself their far-reaching and
devastating effects. For example, when in 2015 she visited Henderson Island, a remote
uninhabited world heritage-listed coral atoll in the middle of the Pacific, she was shocked to see
the beaches clogged with rubbish. There were about ‘37 million pieces of plastic weighing about 17
tonnes—the equivalent of less than two seconds of global plastic production’.
While banning plastic use is clearly essential, Lavers claims governments have been far too slow
in introducing effective schemes in plastics mitigation, and such schemes will not address the
mountains of plastic that are already there. Lavers thinks what is needed is a ‘societal shift’ in ‘how
communities and businesses use and recycle plastics’. ‘If we want change and we want the
quantity of plastics going into the ocean to go down, then the rate of change in our society needs
to exceed the rate of plastics going into the ocean,’ she says. ‘And right now we are not even
close.’
Only when businesses, governments and consumers work together will environmental issues be
resolved.
Sources: Canstar Blue, ‘1 in 5 Aussies about to lose it over supermarket plastic bag ban’, 18 June 2018.
Gary Mortimer and Rebekah Russell-Bennett, ‘Why plastic bag bans triggered such as huge reaction’, The Conversation, 16 July 2018, https://
theconversation.com/why-plastic-bag-bans-triggered-such-a-huge-reaction-99935.
Graham Readfearn, ‘“Plastic is literally everywhere”: the epidemic attacking Australia’s oceans’, The Guardian, 15 April 2018.
Naaman Zhou, ‘Coles and Woolworths’ plastic bag ban and the choices that remain’, The Guardian, 6 June 2018.
Probably the main effect the various stakeholder groups have had are:
This has led to the development of corporate social reporting, environmental accounting (really a subset
of corporate social reporting), triple bottom line reporting, reporting for sustainability and integrated
reporting.
Legitimacy theory
As pointed out earlier, many businesses and business people have been criticised for their lack of social
and environmental responsibility. However, companies that do not fulfil their social and environmental
responsibilities may lose their legitimacy in society, which will in turn affect their economic performance.
The risks associated with managing these responsibilities are often referred to as ESG (environmental,
social and governance) risks. Legitimacy theory (Craig Deegan (2002), ‘Introduction: the legitimizing
effect of social and environmental disclosures—a theoretical foundation’. Accounting, Auditing and
Accountability Journal 15(3), 282–311) basically says that entities, to remain legitimate, must operate
within the bounds and norms of a society. Entities may also face pressures from peers if all other fellow
entities are socially responsible and they lag behind. Just how a business identifies society’s norms,
which may change quite quickly, is less clear. We shall come back to this later in the chapter.
The ASX requires listed companies to disclose whether they have any material exposure to economic,
environmental and social sustainability risks, and, if they do, how they manage or intend to manage those
risks.
Real World 7.2 provides some examples of behaviour that has been deemed inappropriate.
James Hardie has been severely criticised over the years for its apparent lack of support of
employees who became ill due to exposure to asbestos, a product made by the company. The
pressure eventually led to an agreement being reached which provided compensation to the
victims. There is little doubt, however, that a stigma remains associated with the company, which
may take many years to be forgotten.
The same is true of BP after the major Deepwater Horizon oil disaster in the Caribbean in 2010.
The issues of safety and the adequacy of safety precautions are particularly important in situations
of this type. The consequences of such failures can be very far-reaching, affecting many other
businesses, thousands of people, and the wildlife and ecology of a vast area. It should be
recognised, however, that for many years BP had been seen as a leader in the general arena of
sustainability and a standout among oil companies. The costs of a disaster of this type are
enormous, and the downside risks of getting something like this wrong are huge. BP is only just
getting over the financial costs of this incident, as can be seen from Real World 6.2. However, in
2017 Ted Mann reported in The Australian that the United States’ regulator of offshore gas and
drilling, the US Bureau of Safety and Environmental Enforcement, had proposed to ‘roll back’ the
safety measures that had been established in response to the Deepwater incident, stating that ‘the
previous administration’s response to Deepwater Horizon had been too broad and didn’t account
for the fact that other operators in the Gulf had learned from the economic pain BP suffered’.
Whether this represents the view of the administration at the time or is the view of the general
public is another matter altogether.
For several years now, the big banks have come under scrutiny. ANZ and Westpac have both
been accused of rigging market benchmarks. CommInsure bribery allegations led to the
resignation of the head of the ASX. The Australian’s Michael Bennet noted that Australian
Securities and Investments Commission Chairman Greg Medcraft had put banks’ senior
executives on notice to ‘ensure that efforts to improve culture and conduct do not become “white
noise” for staff below them’. This was in the context of a study that was critical of ethical standards
in the banks. Medcraft referred to the allegation that the bank’s swap rate was being rigged as ‘like
polluting the water system’. He felt that ‘management and boards’ views on culture may be too
rosy’. The Royal Commission found a huge array of what were seen as unethical practices, many
of which were identified in Real World 1.4 . Some changes in behaviour will no doubt eventuate
as a result of the Commission Report. In an article in early 2019, after the interview stages of the
Royal Commission had occurred, but before the final report, Robert Gottliebsen stated that ‘scared
bankers are probing borrowers like never before’.
More generally, a survey of 1,000 people in May and June 2016 showed that most respondents
saw senior administrators in business as unethical. Of course, this reaction is based on perception,
but even if the reality is different, much work still clearly needs to be done.
Sources: Michael Bennet, ‘ASIC tells banks to raise the bar on culture’, The Australian, 21 July 2016.
Ted Mann, ‘US regulators propose rolling back oil drill safety measures’, The Australian, 26 December 2017.
Robert Gottliebsen, ‘Big Brother banking invading our privacy’, The Australian, 24 January 2019.
Reflection 7.1
Use the web to find out more about the James Hardie asbestos issues. Then ask yourself, if you
had been in charge of the company at that time, how would you have handled the issue? Do you
think that a business facing this kind of concern now would handle it differently, and more speedily,
than James Hardie did at the time?
By and large, social responsibility is defined in a fairly broad manner. That is, there is a growing
expectation that a business will consider how its actions affect society at large, especially when pollution,
health and safety issues, and job creation or destruction are involved. Of course, sometimes one
objective conflicts with another. For example, it can be argued that coal-fired power stations pollute more
than nuclear-powered stations do, but nuclear power brings its own dilemmas, many of which are
reinforced by the problems associated with the nuclear industry in Japan following the earthquake and
tsunami in 2011. Also, it is often the case that areas with huge coal deposits tend to have most of the
power stations. One such area is the Latrobe Valley, in Gippsland, which has vast areas of brown coal,
and is capable of producing cheap power for a considerable time into the future. However, the power
stations in the valley are among the highest-polluting stations in the country. Yet they are also the biggest
employers in the area. To close the stations down quickly without taking steps to set up alternative job
opportunities, as happened to the largest one in 2017, had the potential to consign the area to recession
and depression. And it did. The actions of the state government made little difference, and the area is
now among the poorest in the country.
Being socially responsible involves setting policies and practices that will ensure that an entity (business
or other organisation) acts as a good citizen, and that each particular entity must consider the social costs
and benefits that result from its actions.
This view is not, however, shared by all. The objective of shareholder wealth enhancement can be
interpreted in a way that totally ignores any social costs that do not directly affect business returns—‘it’s
okay as long as you can get away with it’. How does a business justify to its shareholders, in financial
terms, the choice of a more expensive production process that will yield lower pollution levels but also
lower profits? If a competitor goes down the lower-cost, higher-pollution route, it will probably be able to
sell at a lower price and threaten that competitor’s position. There are clearly some inherent conflicts in
this area.
The interest in ESG has been a development of what is known as ‘socially responsible’ investing. An
article published in The Economist on 25 September 2017, titled ‘Ethical investing is booming. But what is
it?’, claims that socially responsible investing has evolved into ESG investing. ‘The environmental “E”
means shunning companies that produce a large amount of externalities—costs not captured in the
manufacturing process—like carbon or waste or other forms of pollution. The “G” for governance
encompasses an evaluation of how the company structures its board, disclosure, compensation and so
on.’ When it comes to the ‘S’ section, just what is necessary is far less clear. The possible areas are huge
in number, and some scepticism is understandable. However, the exploration of how some ‘feel-good’
ideas might be turned into something measurable is nevertheless changing our future.
Activity 7.2
a. Can you think of businesses that seem to have behaved in a way that you do not regard as socially
responsible? What are the reasons for your belief?
b. Can you think of reasons why a business might pursue activities that are less profitable but socially
beneficial?
Reflection 7.2
Your brother is a manager of a small to medium-sized private company. His company currently
only conducts financial reporting for tax and accounting purposes. He heard that some competitors
voluntarily provide sustainability reporting on their websites. He asks whether you think his
company should do the same. Can you give him some advice on the pros and cons of
sustainability reporting for a small to medium-sized company like his?
So how might business as a whole be encouraged to engage in more socially responsible behaviour?
There are several possibilities:
Make shirking of responsibilities more costly, by regulation and law and public awareness.
Market the good citizen concept (e.g. the growth of ‘green’ consumerism), where consumers’
decisions are strongly influenced by the nature of the business, product or production method.
Combine businesses into groups to develop ways of dealing with aspects of their business in a
socially responsible way.
Promote government action, which might include legislation, penalties for non-compliance or
subsidies.
In fact, while the approaches suggested above may either force or encourage businesses to engage in
more socially responsible behaviour, a long-term educational process is probably going to be more
productive. This process may come from individuals, organisations, businesses or governments, or any
combination of these. Organisations such as Ceres and its offshoot, the Global Reporting Initiative, (both
dealt with in more detail below) have taken a lead, as have a number of other bodies such as the World
Wide Fund for Nature (WWF), Greenpeace, the Climate Change Authority, The Nature Conservancy,
Amnesty International, the Great Barrier Reef Marine Park Authority, and the United Nations through the
development of its Sustainable Development Goals.
There is no doubt that the public now has a view on things such as climate change, the impact on the
environment of plastic litter, what they can expect of the financial services sector in terms of ethics, and
poor treatment in terms of the working conditions and pay of overseas workers. Society is changing, and
business needs to be aware of this. The pressure that the Royal Commission on Financial Services has
put on the financial services sector will undoubtedly change the way the sector carries out its business,
and the expectations of the public will play no small part in this. Issues come to the attention of society at
large and are disseminated via social media more quickly than ever before. By way of example, Real
World 7.3 lists some items covered under the news section of a human rights website, Business and
Human Rights Resource Centre (https://www.business-humanrights.org).
Well-known UK retailers Tesco, Mothercare and Marks and Spencer use a factory in Bangladesh
that pays its workers the equivalent of 35p an hour.
Source: Simon Murphy, ‘Tesco, Mothercare and M&S use factory paying workers 35p an hour’, The Guardian, 21 January 2019.
Oracle owes ‘$400 million in wages to women and minority workers by paying them less than other
than other employees, steering them into jobs at lower-end positions, and imposing an “extreme
preference” for immigrant visa holders’, the Labor Department said.
Source: Chris Opfer and Paige Smith, ‘USA: Labor Department sues tech firm Oracle over underpaying women and minority workers by $400m’, Bloomberg Law, 23
January 2019.
The Human Rights Law Centre report Nowhere to Turn examined 10 cases, including the BHP and
the Samarco Dam disaster, ANZ’s involvement in Cambodia, Ansell’s responsibility for alleged
labour rights abuses, and Rio Tinto’s legacy in Bougainville.
Source: Keren Adams, Nowhere to Turn: Addressing Australian Corporate Abuses Overseas (Human Rights Law Centre, Melbourne, 2018).
Some well-known fashion retailers in the United Kingdom are failing to commit to reducing their
environmental and social impact, according to the British Parliament’s Environmental Audit
Committee. Amazon and TK Maxx are among the companies being described as ‘least engaged’
in sustainable fashion and labour market initiatives.
Source: ‘MPs say fast fashion brands inaction on ethics is shocking’, BBC News, 31 January 2019.
Class discussion points
1. What does the last example suggest regarding non-involvement in corporate social
responsibility (CSR)?
2. Are there any common elements in the issues raised?
Mallen Baker has a corporate social responsibility (CSR) website that links many of the issues to a
number of organisations with a particular focus on CSR or parts of it. This site may be of significant use to
you in obtaining more information and dealing with activities and exercises. Its address is http://
mallenbaker.net/. You may also find useful information related to responsible business from the
Business in the Community website: https://www.bitc.org.uk/.
Concept check 1
Which of the following statements is false?
A. Business today cannot solely focus on wealth maximisation.
B. Social and environmental issues should be given serious consideration by today’s
businesses.
C. Today’s business managers must consider a much broader range of issues than in
the past.
D. Businesses today unanimously accept sustainability as their primary goal.
E. All of the above are true.
Concept check 2
Which of the following statements is true?
A. Some stakeholders have legitimate interests in all parts of a business.
B. Some stakeholders have legitimate interests in only a certain part of a business.
C. Environmentalists are seen as a relatively new stakeholder in business.
D. Potential customers should be considered as stakeholders.
E. All of the above.
Concept check 3
The stakeholder concept recognises a number of parties with a legitimate interest or stake
in business. The stakeholder groups would include:
A. Owners/shareholders and managers
B. Employees and customers
C. Government, lenders and suppliers
D. Investment analysts
E. All of the above.
Corporate social responsibility (CSR) and
sustainable development—what do they mean?
LO 2 Explain what is meant by corporate social responsibility and sustainable development
Although corporate social responsibility (CSR) is frequently referred to, there is no agreed definition of
CSR. Mallen Baker’s definition provides a useful starting point, though: ‘CSR is about how companies
manage the business process to produce an overall impact on society.’ The Financial Times defines CSR
as: ‘a business approach that contributes to sustainable development by delivering economic, social and
environmental benefits for all stakeholders’.
The World Business Council for Sustainable Development has defined CSR as ‘the continuing
commitment by business to behave ethically and contribute to economic development while improving the
quality of life of the workforce and their families as well as of the local community and society at large’
(Holme & Watts, 2000, p. 8). This approach tends to be associated with capacity-building for sustainable
livelihoods, respect for different cultures, and skill development. Mallen Baker (2018) has argued that
definitions of this sort are much more inclusive than the typical approach found in the United States,
where CSR is defined more in terms of a philanthropic model. In Europe, the emphasis seems to be more
on operating in a socially responsible way, while still investing in communities for solid business reasons.
This latter approach is probably more sustainable, in that it:
There is little doubt that people will continue to put pressure on businesses to play a role in social and
environmental issues. This is particularly true for transnational companies, such as BP and BHP, which
are economic giants with more economic power than many nation states.
An early example of this pressure came from the Coalition for Environmentally Responsible Economies
(Ceres). Set up in 1989, immediately after the Exxon Valdez disaster in Alaska, Ceres is a US-based
coalition of environmental, investor and advocacy groups working together for a sustainable future, with a
mission to move businesses, capital and markets to advance lasting prosperity by valuing the health of
the planet and its people (see www.ceres.org). The aim is to find solutions to today’s environmental
challenges.
At its inception, Ceres developed a set of principles that were effectively a 10-point code of environmental
conduct. The principles covered what would now be seen as a range of fairly basic ESG-type areas.
Some could be grouped quite naturally under environmental principles, including protection of the
biosphere, sustainable use of natural resources, reduction and disposal of waste, energy conservation
and environmental restoration. Others could be seen as social, including risk reduction relating to the
health and safety of works and communities in which operations took place, and safe products and
services. The remaining principles could be said to be governance-related, and included informing the
public, management commitment, and audits and reports. While the principles preceded the ESG
nomenclature, they laid the foundations for future CSR standards.
Issues relating to climate change, including investment in clean energy, carbon asset risk, and the
environmental, social and economic risks of the energy sources we use to power our economy, water,
and supply chains.
Corporate environmental reporting. As part of this work, Ceres launched the Global Reporting
Initiative (GRI) —the Sustainability Reporting Guidelines prepared by the GRI are among the
world’s most widely accepted standards for corporate sustainability reporting , and we will return
to them later.
sustainability reporting
A system of reporting that attempts to report on key issues that impact on
environmental and social sustainability.
In 2010, Ceres released a roadmap for sustainability, which is a resource to help companies re-engineer
themselves for success in a world beset with unprecedented environmental and social challenges that
threaten the economy and local communities. It is designed to guide companies toward corporate
sustainability leadership, and ultimately support an accelerated transition toward a more sustainable
global economy.
The Ceres roadmap contains 20 specific expectations for corporate sustainability leadership, broadly
divided into four areas of activity—governance, stakeholder engagement, disclosure and performance.
Figure 7.1 sets out these expectations.
In a further report, The 21st Century Investor: Ceres Blueprint for Sustainable Investing, published in
2013, Ceres wrote a blueprint for the 21st-century investor, which was later updated in 2016. The 21st-
century economy will be shaped by powerful forces such as climate change, population growth, rising
demand for energy, declining supplies of fresh water and other natural resources, and protection of
human rights and worker health and safety. Institutional asset owners and their investment managers
need to understand and manage the growing risks posed by these forces.
The Ceres principles and roadmap might seem to represent one end of a fairly wide spectrum of views.
Typical arguments that might come from the other end of the spectrum to be used against CSR include
the following:
Businesses are owned by the shareholders—any money spent on so-called social responsibility
reduces the amount available to them. Shareholders can choose for themselves whether or not to be
philanthropic.
Many companies don’t have time for this—they are too busy running their main business activity.
It’s not the responsibility of individual businesses: it is up to politicians and governments.
Corporations do not really care about CSR.
Of course, some of these arguments against CSR are not strong, and a number are based on an
incomplete understanding of CSR. For example, it can be argued that an emphasis on philanthropy as an
appropriate reaction to CSR illustrates a complete misunderstanding of CSR and, indeed, of the nature of
business. If business is about building a relationship with a range of stakeholders, the case for a broader
approach to CSR is clear. Arguments about ‘not having time’ also fail. If you don’t have time to look at the
wider issues, you may be missing opportunities and (possibly more important in this context) overlooking
threats and risks. When the role is largely political or government-based, problems arise when a business
presumes that issues are being dealt with when they are not, and when it realises that it has not kept its
eye on the ball. In some cases, given the size and nature of the industry and associated companies,
better progress will be achieved by full involvement with the main corporate players than with national
governments. Many companies spend a lot of time and money on activities that shape public policy, for
good or evil. It is significant that quite a number of the most respected companies are respected because
of their role in CSR.
Although CSR and sustainable development are not the same, they seem to have become inextricably
linked over recent years. A business that has no intention of having a long-term future (and therefore
does not need to worry about sustainable development) still needs to recognise that it has (or should
have) a corporate responsibility for its actions. The two terms have become almost interchangeable for
the more progressive businesses of the world. This may be because, since the United Nations’ approval
of its Sustainable Development Goals in 2015, the focus has been on the achievement of ‘a better and
more sustainable future for all’. The UN Sustainable Development Goals are:
Goal 1: No poverty
Goal 2: Zero hunger
Goal 3: Good health and wellbeing
Goal 4: Quality education
Goal 5: Gender equality
Goal 6: Clean water and sanitation
Goal 7: Affordable and clean energy
Goal 8: Decent work and economic growth
Goal 9: Industry, innovation and infrastructure
Goal 10: Reduced inequalities
Goal 11: Sustainable cities and communities
Goal 12: Responsible consumption and production
Goal 13: Climate action
Goal 14: Life below water
Goal 15: Life on land
Goal 16: Peace, justice and strong institutions
Goal 17: Partnerships.
Activity 7.3
Identify several companies that are currently in the news and what makes them newsworthy. What kind of
CSR issues emerge?
The whole area of CSR is particularly challenging. Although a company must not ignore its
responsibilities, there is no clear checklist to determine what these are. The public view is also continually
changing, as shown in Real World 7.4 .
Source: Glenda Korporaal, ‘Putting trust in ethical companies’, The Weekend Australian, 4–5 August 2007.
Will Hamilton cites interesting results from a survey the Responsible Investment Association
Australasia (RIAA) issued to all delegates at a recent conference:
The overwhelming majority (92 per cent) expected that ‘their superannuation or other
investments to be invested responsibly and ethically’.
80 per cent would look at putting their funds elsewhere if the organisations they currently
invested with ‘engaged in activities inconsistent with their values’.
85 per cent considered ‘superannuation should be invested responsibly taking into account
positive and negative screens’.
While over half said they would think carefully about doing so in the future, one-fifth had already
invested in ethical investments.
The Australian Council of Superannuation Investors issued an ESG reporting guide for Australian
listed companies in 2015. The guide details how companies should report their environmental,
social and governance risks, commonly referred to as ESG risks, and how they manage them.
Nevertheless, these issues are important for small businesses and other organisations as well.
Sources: Daniel Madhavan, ‘The royal commission: a super opportunity to put ethical investing first’, The Australian, 29 December 2017.
Will Hamilton, ‘Responsible investing is no longer simply niche’, The Australian, 12 December 2017.
Total assets managed under responsible investment strategies grew to encompass 55.5% of
Australian total assets under management, at $866 billion as at 31 December 2017.
Investments managed under core responsible investment—those traditionally referred to as
ethically or socially responsible investments—increased by 188% to $186.7 billion.
Investments undertaking integration of environmental, social and governance—referred to as
broad responsible investment—represent $679.3 billion, reflecting the strong take-up of ESG
integration by many of Australia’s largest asset managers.
Source: Responsible Investment Association Australasia, Responsible Investment: Benchmark Report 2018 Australia (Sydney, Responsible Investment Association
Australasia, 2018).
Just how shareholders may see the balance between profitability and CSR remains unclear, but the
attitudes revealed by the first section of Real World 7.4 probably represent a significant shift over the
previous 20 years or so. While the Ceres roadmap might appear to be optimistic, the changes in attitude
emerging from the developed world all seem to indicate a greater acceptance of social responsibility. The
second part of Real World 7.4 provides information regarding the attitudes of superannuation funds, a
major investor, while the third part provides guidance on the growth in responsible investing.
Reflection 7.3
You are a member of a group of young entrepreneurs who have a general interest in business and
entrepreneurship. In your general discussions the idea that business has a social and ethical side
has come up on a significant number of occasions, as has the importance of profitability. Do you
think that the concern with profitability identified in the Crosby Textor Shareholder Jury is likely to
remain as strong now, for your particular group of people, as it was in 2007? Why/why not?
Concept check 4
Corporate social responsibility (CSR) reporting extends the traditional financial reporting into
new areas. Which of the following are CSR areas?
A. Corporate carbon footprint
B. Increase in shareholder wealth
C. Efficiency of energy use
D. Working conditions for employees
E. Profit margin on product lines
F. Environmental impact of pollution.
Concept check 5
Which of the following statements about CSR would you dispute? Why?
A. It is no longer sufficient for business to be focused solely on the maximisation of
wealth.
B. It is the responsibility of government and politicians to look after social responsibility.
C. Ceres has a mission to move businesses to an approach that advances lasting
prosperity by valuing the health of the planet and its people, and aims to find
solutions to today’s environmental challenges.
D. Philanthropy is the solution provided by many businesses to CSR.
E. It is possible to link social responsibility with wealth creation.
Development of reporting for corporate social
responsibility and sustainable development
LO 3 Explain the development of reporting for corporate social responsibility and sustainable
development
Australia has no accounting standards for social responsibility accounting. However, there has been a
move towards voluntary disclosure, especially by large listed companies. Smaller companies have also
started to follow suit in recent years.
In making decisions that affect perceived social responsibilities, a business must be aware of the costs
and benefits, at least in broad terms, before it can make informed decisions. There could be
advantages in sharing such information.
As mentioned earlier, companies may achieve a competitive advantage by appearing to act as a good,
socially responsible corporate citizen deserving of support. Voluntary disclosure provides a means by
which a good marketing and public relations team can put pressure on non-disclosing competitors. It
highlights what the team is doing compared to what might or might not be being done by the non-
disclosing competitor.
Cultivating the ‘green’ and ‘ethical’ consumer markets or using CSR disclosure can be seen as a
strategic differentiation to compete with peers.
Voluntary reporting has grown considerably over time. In 1979, when Trotman surveyed the annual
results of the 100 largest companies listed in Australia, 69 of them made disclosures about social
responsibility. Over the next 20 years or so, a variety of studies revealed a steady increase in the
provision of information concerning environmental and social areas or aspects. Some of these studies
found that such activities were part of the public relations of the business. Others found that information
tended to emphasise the positive rather than the negative. However, the trend was set, and steady
progress occurred.
From the year 2000, when the GRI issued its first guidelines, the GRI has been seen as providing the
most highly regarded guidance on sustainability reporting. The GRI will be dealt with in a later section of
this chapter. While guidance has come mainly from the GRI, there have been a number of interesting
studies relating to sustainability reporting. Some of the more recent studies are outlined in Real World
7.5 .
Real world 7.5
Studies in sustainability reporting
To date, the majority of the ASX 200 listed companies disclose CSR information. A survey
conducted by the Australian Council of Superannuation Investors in 2018 found that 180 (i.e. 90%)
of ASX 200 companies provided some meaningful level of disclosure. Eighty-three cents in every
dollar invested in the ASX 200 is invested in entities that report to a ‘leading’ or ‘detailed’ standard.
Thirty-five companies have outperformed others in their sustainability disclosure for the past four
years. Nine companies were considered laggards (a ‘no reporting’ rating for two or more years).
Source: Australian Council of Superannuation Investors (ACSI), Corporate Sustainability Reporting in Australia: An Analysis of ASX200 Disclosure (Melbourne,
ACSI, 2018).
In a survey conducted by EY and the Center for Corporate Citizenship at Boston College in 2013,
the respondents viewed ‘the benefits of sustainability reporting going beyond relating firm financial
risk and opportunity to performance along ESG dimensions and establishing license to operate.
Sustainability disclosure can serve as a differentiator in competitive industries and foster investor
confidence, trust and employee loyalty.
improved reputation
increased employee loyalty
reduced incorrect information about the organisation’s corporate social performance
helping the organisation refine its corporate vision or strategy
increased consumer loyalty
waste reduction within the organisation
improved relationship with regulatory bodies
monitoring of long-term risk and improvement in long-term risk management
other forms of cost savings within the organisation
helping the organisation to take measures to increase long-term profitability
improved access to capital, and
preferred insurance rate.
Source: EY and Boston College Center for Corporate Citizenship (BCCCC), Value of Sustainability Reporting (Chestnut Hill, MA, BCCCC, 2013), pp. 2–3.
Using a large sample of charitable contributions made by US public companies from 1989 through
2000, Lev and colleagues found that charitable contributions are significantly associated with
future revenue, which is particularly pronounced for companies that are highly sensitive to
consumer perception. They also show a positive relationship between contributions and customer
satisfaction.
Source: Baruch Lev, Christine Petrovits and Suresh Radhakrishnan (2010), ‘Is doing good good for you? How corporate charitable contributions enhance revenue
Concept check 6
There have been a number of studies conducted around the world on voluntary reporting
practice. These studies have provided a good range of examples of CSR disclosures, both
positive and negative.
For each item in the following list indicate whether the item is (a) Positive, (b) Negative, (c)
Both positive and negative, or (d) Not a CSR disclosure.
A. Achievement of quarterly sales targets
The problems identified above highlighted the need for a reporting framework that was more
comprehensive than the traditional reporting framework; that is, a new form of disclosure to integrate
financial, environmental and social reporting. Triple bottom line reporting emerged in the late 1990s.
The phrase ‘triple bottom line’ was coined by John Elkington in his 1997 book Cannibals with Forks: The
Triple Bottom Line of 21st Century Business. The essence of triple bottom line reporting is sustainable
development, which requires much greater collaboration between industry, government and society at
large. In reporting on a particular entity (which might include business corporations, governments and
local governments), we need to devise a reporting system that embraces sustainable development, or at
least shows us how to move towards this ideal. Such a report would focus on three areas:
economic prosperity
environmental quality
social justice.
So far in this book we have tended to deal with things that can be measured. However, not everything in
the triple bottom line agenda falls easily into this category. So instead we need a set of performance
indicators for these three elements.
Companies generally aim to create wealth, primarily for their shareholders. Typically, they want to do this
for the long term, so they should be interested in what has been described as ‘sustainable value creation’.
This is likely to mean that companies should meet society’s need for goods and services without
destroying natural or social capital. It has been argued that this approach increases the time over which
performance should be measured.
Basically, the triple bottom line focuses on three components which together give total value added:
Of course, the impact of some activities on the environment or society is often negative and seldom easily
measured, as we have said before. The major challenge of triple bottom line reporting is not the
production of each of the three parts, but their integration. In spite of this, triple bottom line reporting has
gained in support and sophistication. Many companies see obvious benefits in its use and development,
such as:
embedding good corporate governance and ethics systems, which can produce a values-driven,
integrated culture
better management of risk and resource allocation
formalising and enhancing communication with key stakeholders
attracting better staff
better benchmarking, enhancing the scope for competitive advantage, and
better access to financial markets.
You should note that triple bottom line reporting or sustainability reporting has not been limited to
companies. For example, Maroochy Shire Council had prepared triple bottom line reports for some time,
with sections covering a financial report card, an environmental report card and a social report card. The
council was subsequently merged with other councils to form the Sunshine Coast Regional Council. For
many years the council has maintained a commitment to reporting of this type. The council sets out a
clear vision: ‘To be Australia’s most sustainable region. Healthy. Smart. Creative.’ In the 2017–18 annual
report, corporate goals for the period 2018–2022 are identified as:
a smart economy
a strong community
a healthy environment
service excellence
an outstanding organisation.
The report then highlights a range of outcomes relating to each of these goals.
It is interesting to map the development of the report (and presumably the underlying thinking of the
council). The approach appears to have developed through financial reporting to triple bottom line
reporting, to an approach where these elements seem to be dealt with in a completely integrated way.
The council’s annual report makes for interesting reading.
The next section, on the Global Reporting Initiative, takes the concept of triple bottom line reporting into a
new phase. Triple bottom line reporting seems likely to be absorbed as part of the move to full-scale
sustainability reporting.
Concept check 7
Which of these statements do you think is false?
A. The essence of triple bottom line reporting is sustainable development, which
requires much greater collaboration between industry, government and society at
large.
B. Not everything in the triple bottom line agenda can be measured easily.
C. The triple bottom line report focuses on economic prosperity, environmental quality
and social justice.
D. Companies should meet society’s need for goods and services without destroying
natural or social capital.
E. None are false. They are all true.
Activity 7.4
a. What are the three components of a triple bottom line report?
b. What benefits might accrue to a business by use of triple bottom line reporting?
c. What do you see as the possible motives for using triple bottom line reporting?
The global reporting initiative (GRI)
LO 5 Outline the Global Reporting Initiative (GRI), and discuss its main framework in broad terms
General background
The Global Reporting Initiative (GRI) (see <www.globalreporting.org>) is ‘an international, independent
organisation that helps businesses, governments and other organisations understand and communicate
the impact of business on critical sustainability issues such as climate change, human rights, corruption
and many others’ (Sustainability Reporting Guidelines, G2, 2002, pp. 1–3). It has been a leader in the
development of detailed guidelines for sustainability reporting (and development), culminating in the
issuing of the first recognised standards for sustainability reporting, in October 2016. As the approach
using guidelines has changed to one using standards, there have been some changes to the mission and
vision of the GRI. These are identified later in this section. All GRI content is reproduced here with
permission of The Global Reporting Initiative (GRI).
The next section outlines the history and development of the GRI and its guidelines, and this is followed
by a section on the new standards. It is interesting to note that, as new guidelines and now standards
have been introduced, there has been a tendency for the documents to become more technical, with less
concentration on the principles underlying the guidelines. For this reason, the next section will spend
some time discussing an earlier set of guidelines (G3), which has a good balance between principles and
practice, thus providing an excellent starting point for those readers new to the topic.
You should note that all we can do in a book of this type is to make you aware of the key issues relating
to sustainability reporting, and give you a broad understanding of the approach used by the GRI. At a
later stage in your studies and career, there is little doubt that you will need to confront these issues,
either as a manager, trying to balance the various components of a difficult decision, or as an accountant,
seeking to measure the various aspects of the areas covered by the sustainability standards.
Subsequent versions have been developed, with version 3 (known as the G3 Guidelines) being
introduced in 2006, and an update and completion of G3 (known as G3.1) being produced in March 2011.
The expanded guidelines covered reporting on gender, community and human rights related
performance.
The G3 Guidelines considered that the goal of sustainable development was to ‘meet the needs of the
present without compromising the ability of future generations to meet their own needs’ (G3.1, p. 2).
To do this a globally shared framework was required, which was seen as being provided by the GRI. In
May 2013, G4 was introduced. All of the above points remain valid. G4, by focusing on these basic
issues, aimed to improve the way in which these issues could be addressed in a practical way. G4 made
the following observations.
An ever-increasing number of companies and other organisations want to make their operations sustainable. Moreover, expectations that
long-term profitability should go hand-in-hand with social justice and protecting the environment are gaining ground. These expectations
are only set to increase and intensify as the need to move to a truly sustainable economy is understood by companies and organisational
financiers, customers and other stakeholders.
Sustainability reporting helps organisations to set goals, measure performance, and manage change in order to make their operations
more sustainable. A sustainability report conveys disclosures on an organisation’s impacts—be they positive or negative—on the
environment, society and the economy. In doing so, sustainability reporting makes abstract issues tangible and concrete, thereby
assisting in understanding and managing the effects of sustainability developments on the organisation’s activities and strategy. (G4, p. 3)
G4 recognised that there had been a strong growth in sustainability reporting, an increased interest in
critical sustainability topics by report users, an increased need for harmonisation between systems, and
an increased integration between financial and sustainability reporting.
G4 moved firmly in the direction of standard ways of reporting, and provided encouragement that
sustainability reporting could become standard practice for all businesses, whether large or small. In
doing so, it would become a rather more technical and potentially more prescriptive approach in the
future.
Current position—the GRI Standards
In October 2016 the GRI issued its new standards, which ‘are the latest evolution of GRI’s reporting
disclosures, which have been developed through more than 15 years of a robust multi-stakeholder
process. The standards are based on the GRI G4 guidelines, the world’s most widely used sustainability
reporting disclosures, and feature an improved format and a new modular structure. The new GRI
Standards definitively replace[d] the G4 guidelines’, which were phased out by 1 July 2018. Note that the
claim of being ‘the world’s most widely used sustainability reporting’ is based on a survey carried out by
KPMG. A major advantage of the new standards is that they provide a common language to cover the
wide range of issues that come under the umbrella of ‘sustainability’. The new standards, by using a well-
understood, shared language, are expected to make sustainability much easier to report on and
understand.
The standards have been developed by a new Global Sustainability Standards Board (GSSB), a fully
independent standard-setting body, with input from a wide variety of different sources, representing the
GRI’s commitment to a multi-stakeholder approach.
The GRI Standards comprise 36 modules that cover a range of topics, outlined below. One aim of the
new modular approach is to facilitate updates on a topic-by-topic basis rather than requiring a new set of
guidelines, which is seen as a major advantage. This is also likely to mean that the standard-setting
process for sustainability reporting will develop to be much more in line with the process used by the
Accounting Standards Board. The standards contain all of the main content and disclosures from G4. A
clear distinction is made in the standards between requirements, recommendations and guidance.
In the introduction to the 2016 Consolidated Set of GRI Sustainability Reporting Standards, in the
overview section on page 3, the standards were identified as being:
‘designed to be used by organisations to report about their impacts on the economy, the environment,
and/or society’
‘structured as a set of interrelated documents’
‘developed primarily to be used ... to help an organisation prepare a sustainability report which is
based on the Reporting Principles and focuses on material topics’.
A report prepared in accordance with the standards ‘demonstrates that the report provides a full and
balanced picture of an organisation’s material topics and related impacts, as well as how these impacts
are managed’ (p. 4). The report can be completed as a stand-alone sustainability report, an example of
which will be discussed later, or ‘can reference information disclosed in a variety of locations’ (p. 4). If the
latter approach is used, a GRI content index is required.
Foundation
GRI 101: Foundation:
sets out the reporting principles for defining report content and quality
explains the basic process for using the standards
sets out the ways in which the standards can be used.
Activity 7.5
By reference to GRI 101, consider whether some of the reporting principles represent a shift away from
those developed for financial reporting, in principle or in application.
Core—requires ‘the minimum information needed to understand the nature of the organisation, its
material topics and related impacts, and how these are managed’ (p. 21)
Comprehensive—‘This builds on the core option by requiring additional disclosures on the
organisation’s strategy, ethics and integrity and governance. In addition, the organisation is required to
report more extensively on its impacts by reporting all of the topic-specific disclosures for each
material topic covered by the GRI standards’ (p. 21). These will be covered next.
In order to claim that a report has been prepared in accordance with the GRI Standards, the organisation
must comply with all criteria for the respective option (see p. 23).
General disclosures
GRI 102: General Disclosures is used ‘to report contextual information about an organization and its
sustainability reporting practices. This includes information about an organization’s profile, strategy, ethics
and integrity, governance, stakeholder engagement practices, and reporting process.’ The details
required are summarised below:
Organisational profile—this covers a wide range of things, including detail on: the organisation’s
ownership and legal form, and name and location of head office; the range of activities, brands,
products and services; markets served and location of activities; scale of the organisation; information
on employees and other workers; information about its supply chain; significant changes to the
organisation and its supply chain; external initiatives; membership of associations; and reference to
the ‘precautionary principle’. This last point is an approach to risk management which states that, if an
action has a possible risk of causing harm to the public, or to the environment, in the absence of
scientific consensus that the action is not harmful, the burden of proof that it is not harmful rests with
those taking the action (pp. 7–13).
Strategy—this requires key impacts, risks and opportunities to be described, together with a
statement from the senior decision-maker about the relevance of sustainability to the organisation and
its strategy (pp. 14–15).
Ethics and integrity—requires a description of the organisation’s values, principles, standards and
norms of behaviour, and mechanisms for advice and concern about ethics (pp. 16–17).
Governance—requires disclosure of governance structure, and a range of issues related to
economic, environmental and social topics more quickly than ever before. These include details of:
committees; delegation and processes for consulting stakeholders; the composition of the highest
governance body and its committees, in quite a high degree of detail; processes regarding possible
conflicts of interest; the role of the highest governance body in setting purpose, values and strategy,
and evaluating the highest governance body’s performance; effectiveness of the risk management
process; review of economic, environmental and social topics; the highest governance body’s role in
sustainability reporting and ensuring that all material topics are covered; the process for
communicating critical concerns and the nature and total number of critical concerns; remuneration
policies and the process for determining remuneration, in quite some detail; stakeholders’ involvement
in determining remuneration, and how stakeholders views are sought; determining the annual
compensation ratio, and the percentage increase in annual total compensation ratio. The annual
compensation ratio is the ‘ratio of the annual total compensation for the organization’s highest-paid
individual in each country of significant operations to the median annual total compensation for all
employees (excluding the highest-paid individual) in the same country’. Consideration of this ratio is
seen as significant to value creation generally (pp. 18–28).
Stakeholder engagement—disclosures required include: a list of stakeholder groups; details of the
percentage of total employees covered by collective bargaining agreements; the basis for identifying
and selecting stakeholders; details of the approach to stakeholder engagement; and details of the key
topics and concerns raised through stakeholder engagement (p. 32).
Reporting practice—these disclosures provide an overview of the process followed to determine the
content of the sustainability report, and the identification of material topics and boundaries. They
include: a list of entities included in the consolidated financial statements; an explanation of the
process for defining report content and topic boundaries; a list of material topics; the effects of any
restatements of information given in previous reports; significant changes in reporting from a previous
period in the list of material topics and boundaries; the reporting period, the date of the most recent
report, and the reporting cycle; a contact point for questions regarding the report; the basis that the
report is in accordance with the GRI Standards; the GRI content index; and a description of the
organisation’s policy and practice with regard to seeking external assurance for the report (pp. 33–42).
Management approach
Disclosures under GRI 103: Management Approach ‘enable an organisation to explain how it manages
the economic, environmental, and social impacts related to material topics. This provides narrative
information about how the organization identifies, analyzes, and responds to its actual and potential
impacts’ (p. 4). Disclosures cover the following areas.
Material topic and their boundaries—for each material topic the boundary should be identified, by
describing where the impacts occur and the organisation’s involvement with the impacts.
The management approach and its components—for each material topic, information must be
disclosed relating to an explanation of how the topic is managed, together with the purpose of the
management approach, and a description of a range of issues including policies, commitments, goals
and targets, responsibilities, resources and grievance mechanisms (p. 8).
Evaluation of the management approach—for each material topic the organisation must provide an
explanation as to how the management approach is evaluated. This typically includes things such as
assessing performance against goals and targets, and explaining how results are communicated and
obstacles dealt with (p. 11).
Note that disclosures about the management approach are required in all of the GRI 200, 300 and 400
series, together with topic-specific disclosures.
Economic performance
‘In the context of the GRI Standards, the economic dimension of sustainability concerns an organization’s
impacts on the economic conditions of its stakeholders, and on economic systems of local, national, and
global levels’ (GRI 201: Economic Performance, p. 4). It is important to note that the GRI does not focus
on the financial condition of an organisation. These last two points are central to understanding the role of
sustainability reporting. The related standards GRI 201–206 cover detailed areas including: economic
performance generally; market presence; indirect economic impacts; procurement practices; anti-
corruption safeguards; and the prevention of anti-competitive behaviour. The standards require much
more disclosure than is required by financial reports. For example, the indirect impacts standard is
interesting, as many impacts can be easily hidden when major decisions are made by organisations. The
closing of the Hazelwood plant in the Latrobe Valley, described in Reflection 7.1 , provides an
interesting case to consider. The procurement practice standard requires disclosure of ‘support for local
suppliers, or those owned by women or members of vulnerable groups’ (p. 4), lead times given to
suppliers, and any negative impacts on the supply chain.
Environmental impacts
GRI 300: Environmental Impacts relates generally to environmental topics. GRI 301–308 deal with
specific issues, including: impacts related to use of materials, including those recycled or reclaimed; use
of energy, both renewable and non-renewable; use of water; impact on biodiversity; emissions, effluents
and waste; environmental compliance; and supplier environmental assessment. These standards
required detailed disclosure relating to these areas. For example, the energy standard also deals with
‘upstream’ and ‘downstream’ activities related to the organisation’s activities. Specific disclosures required
cover energy consumption, energy intensity, reduction of consumption, and reductions in energy
requirements. Regarding water, activities have the potential for considerable economic and social
consequences for local communities and others who are impacted. Disclosures are thus needed on water
withdrawn, sources significantly affected, and water recycled and reused. The biodiversity standard
requires disclosure of impacts relating to living and non-living natural systems, and specific disclosures
relating to areas of high diversity value
Social
GRI 400: Social relates to social topics, which are covered in detailed standards GRI 401–419. The
detailed topics covered are: employment, including job creation and working conditions;
labour/management relations; occupational health and safety; training and education; diversity and equal
opportunity; non-discrimination; freedom of association and collective bargaining; child labour; forced or
compulsory labour; security practices; rights of indigenous people; human rights assessment; local
communities; supplier social assessment; public policy; customer health and safety; marketing and
labelling; customer privacy; and socioeconomic compliance.
Activity 7.6
The GRI Standards set out a range of disclosure requirements. Assess their usefulness. How many of
these might you expect to find in a traditional financial report?
Just how far most companies are prepared to go in this whole area remains unclear. There is little doubt
that over the years more companies, including many significant companies—such as BHP, Westpac, ANZ
Bank and National Australia Bank—have become organisational stakeholders in the GRI. The G3
versions of the guidelines were clearer (and probably more general) than the first guidelines, probably
reflecting the growth in stakeholders. The G4 Guidelines progressed the detailed application of the overall
approach, and the GRI Standards now provide both a common language for sustainability and a practical
way for implementation. Questions can be asked as to whether all of the standards really relate to
sustainability, or whether some reflect what has been seen as a desirable direction that is expected to
result in improvement across the board that will improve things generally. Whether, in a new era of
increased nationalism, anti-globalisation and concern for jobs at a local level, all of these standards will
thrive, remains to be seen. In general, however, the aim of a sustainability report as a means of
communicating sustainability performance and impacts—whether positive or negative—is both desirable
and laudable.
The 2019 sustainability report provided a comprehensive review of how BHP plans to resource its
future. The company has developed a sustainability framework, with key components being the
areas of ethics and business conduct, people, society and climate change. The 2019 sustainability
report tracked performance across a range of targets related to these areas.
BHP at a glance
Chief Executive Officer’s review
About this Sustainability Report
Our FY2019 sustainability performance
Our sustainability approach
— Samarco
— Tailings dams
— Performance data—Water
— Performance data—Society
— Performance data—People
EY Assurance statement
BHP locations
Source: BHP Sustainability Report, 2019.
It is interesting to note that BHP has also produced a Sustainability Reporting Navigator, which
indicates the sections in the various reports that specifically address what the organisation has
done to address the GRI Standards and uphold the 10 principles of the UN Global Compact and
the International Council on Mining and Metals.
Page 8 of the report provided a summary of the sustainability performance compared to 2018 and
2017. The report emphasised ‘health and safety’ as BHP’s number 1 priority. The 2015 Samarco
tragedy in Brazil was still a major focus of 2019; as was the development of the United Nations
Sustainable Development Goals. These are 17 ambitious goals dedicated to improving the
wellbeing of present and future generations, and aiming to end poverty, protect the planet and
ensure prosperity for all, as part of a new sustainable development agenda. Page 12 of the 2019
sustainability report indicates how BHP contributes to these goals and provides a framework for
much of the report. The report ends with a number of appendices covering economic performance
data, and performance data on people, society and the environment. The sustainability reports are
available on the BHP website and are recommended reading.
Reflection 7.4
The same group referred to in Reflection 7.3 has just listened a talk on the UN Stainable
Development Goals. Being currently owners of relatively small businesses, they generally have not
given too much thought to these goals. Several of their businesses are going well, and they are
now looking at these goals rather more carefully. The group has agreed to have a discussion on
whether the goals are reasonable, and whether they can, and should, also be used by small
businesses as well as large businesses.
There is little doubt that the work of the GRI represents a significant step forward in terms of the
environmental and social information required. It will be interesting to see whether the introduction of
sustainability standards, as compared with guidelines, increases their use, and to what extent. It is worth
pondering whether the GRI process, which is voluntary, indicates that business (at least some sections of
it) is well ahead of governments in recognising the importance of sustainability. Of course, different
countries and their governments have different economic, social, cultural and political conditions, and it is
probably unrealistic to expect all countries to move forward at the same rate. However, there is little doubt
that pressure for greater disclosure will continue to grow in the developed world, as will the rewards for
being a good corporate citizen.
One final point in this section on the GRI is that the GRI has now reached the point where its long-term
aspiration and objective—namely, a formal standard-setting process for sustainability reporting—has
been achieved. This in turn has resulted in a revision and broadening of the GRI’s vision—a thriving
community that lifts humanity and enhances the resources on which all life depends—and of its mission—
to empower decisions that create social, environmental and economic benefits for everyone.
Concept check 8
Which of these is a way in which sustainability reports should be similar to current financial
reports?
A. Scope of the report
B. Reliance on monetary measures
C. Comparability
D. Degree of auditability of the report.
Concept check 9
The GRI identifies categories of standard disclosures. These are:
A. Economic, environmental, social
B. Environmental, financial, business process, social
C. Economic, environmental, social, learning and growth
D. Financial, business process, customer, learning and growth
E. None of the above.
Concept check 10
Which of the following statements is most doubtful? Why?
A. Sustainability reporting helps organisations set goals, measure performance and
manage change so as to make their operations more sustainable.
B. Profitability will always go hand in hand with social justice and protection of the
environment.
C. Sustainability reporting makes abstract issues tangible and concrete, thereby
assisting in understanding and managing the effects of sustainability developments
on the organisation’s activities and strategy.
D. Sustainability reporting is enhanced by the fact that the GRI has developed a globally
shared framework.
Activity 7.7
Find a sustainability report of a company and summarise the social and environmental impacts identified
therein. Then assess how your summary compares with what you might have expected for a business of
the type chosen.
SELF-ASSESSMENT QUESTION
7.1
In 2012, CPA Australia issued a paper entitled ‘A Guide for Assurance on SME Sustainability
Reports’. This paper was clearly targeted at the professional accountant who might be expected to
assist in generating a sustainability report for a client business. In the paper a definition was given
for a sustainability report, and the question was asked: ‘Why is sustainability reporting important for
my clients?’ A further question was: ‘What is my role?’
Define a sustainability report and answer the questions asked of the accountant.
There is little doubt that many businesses are now taking their social and environmental
responsibilities far more seriously than was the case in earlier years. The move from a single-
minded satisfaction of shareholder needs to a much more broadly based recognition of a range of
stakeholder needs and interests has progressed significantly. Business models and strategies are
consequently now much broader. This raises the question whether the traditional business school
education remains appropriate. Your answer to this question will depend on your particular
interests and philosophy of business.
An article by Diana Middleton, ‘Demand for ethical routes to profits’, in The Australian on 2
December 2009, raised some interesting questions about the attitudes of would-be entrepreneurs.
These young entrepreneurs felt that ‘it was critical to create a product that was environmentally
friendly and sustainable and whose sales could help support good causes’. The article suggested
that young entrepreneurs are increasingly approaching business along these lines. Typical actions
that result include accessing goods and materials from economically depressed parts of the world.
One impact of this has been changes in business studies curricula, which now have an emphasis
on ‘social entrepreneurship’. The article suggests that this move is a ‘generational progression’, as
younger people have been brought up to be more socially aware. It is seen as something of a
reaction to the perception that has existed for a time—the stigma of the ‘greedy MBA’. Of course,
this may be a reaction to the fact that finding a job has become much more difficult, and there are
fears that the global financial crisis may repeat if the culture does not change.
You might like to think about the implications that this movement might have on your ideas and
training regarding your future career.
Integrated reporting
LO 6 Outline integrated reporting and its relationship with sustainability reporting using the GRI
Standards
The International Integrated Reporting Council (IIRC) , which is a global coalition of regulators,
investors, companies, standard setters, the accounting profession and non-government organisations
(NGOs), produced a framework for integrated reporting in December 2013.
An integrated report is a concise communication about how an organisation’s strategy, governance, performance and prospects lead to
the creation of value over the short, medium and long term.
(IIRC, The International Integrated Reporting Framework, December 2013, p. 7)
Not surprisingly, there are many similarities between the framework and the GRI Guidelines/Standards,
which reinforces the view expressed earlier that the extension of content in reporting is inevitable. There
are, however, some unique features. These are outlined below.
integrated reporting
A process founded on integrated thinking, which results in a periodic
‘integrated report’ by an organisation about value creation over time, and
related communications regarding aspects of value creation.
It highlights the long-term value creation for the organisation using various forms of capital. It
categorises capitals into financial, manufactured, intellectual, human, social and relationship, and
natural, although organisations preparing an integrated report are not required to adopt this
categorisation compulsorily.
The IIRC framework emphasises integrated thinking and strategic focus. For example, in its
framework it says (p. 5): ‘An integrated report should provide insight into the organization’s strategy,
and how it relates to the organization’s ability to create value in the short, medium and long term, and
to its use of and effects on the capitals.’
The IIRC framework is principles-based. It does not provide detailed guidelines on the structure or
content of the integrated report.
The GRI Standards comment on the relationship between integrated reporting and sustainability
reporting. Integrated reporting is seen as building on sustainability foundations, while sustainability
reporting is seen as an intrinsic element of integrated reporting. However, the standards recognise that
integrated reporting is primarily aimed at providers of financial capital, with an integrated representation of
the key factors that are material to the organisation’s present and future value creation. GRI believes that
integrated reporting which incorporates appropriate, material sustainability information equally alongside
financial information provides reporting organisations with a broad perspective on risk.
Strategic focus and future orientation: An integrated report should provide insight into the
organization’s strategy, and how it relates to the organization’s ability to create value in the short,
medium and long term, and to its use of and effects on the capitals.
Connectivity of information: An integrated report should show a holistic picture of the combination,
interrelatedness and dependencies between the factors that affect the organization’s ability to create
value over time.
Stakeholder relationships: An integrated report should provide insight into the nature and quality of
the organization’s relationships with its key stakeholders, including how and to what extent the
organization understands, takes into account and responds to their legitimate needs and interests.
Materiality: An integrated report should disclose information about matters that substantively affect
the organization’s ability to create value over the short, medium and long term.
Conciseness: An integrated report should be concise.
Reliability and completeness: An integrated report should include all material matters, both positive
and negative, in a balanced way and without material error.
Consistency and comparability: The information in an integrated report should be presented: (a) on
a basis that is consistent over time; and (b) in a way that enables comparison with other organizations
to the extent it is material to the organization’s own ability to create value over time.
Over 90 businesses participated in a Pilot Programme Business Network, including Unilever, Coca-Cola,
Microsoft, China Light and Power, Hyundai, SAP and HSBC. The Johannesburg Stock Exchange (JSE) in
South Africa was the first stock exchange to require listed companies to prepare an integrated report, or
explain why they were not doing so. Companies listed on the JSE released their first integrated reports for
financial years starting after March 2010. As of July 2019, more than 1,500 businesses from more than 30
countries around the world have adopted integrated reporting (International Integrated Reporting Council
(IIRC), ‘When? Advocate for global adoption’ (IRRC, London, accessed 6 May 2020), https://
integratedreporting.org/when-advocate-for-global-adoption/)).
From 2016 to 2017, the Association of Chartered Certified Accountants (ACCA) together with IIRC
reviewed 41corporate reports by participants in the Business Network and interviewed some
representatives. Those interviewed identified many benefits from adopting integrated reporting. These
include:
Source: Association of Chartered Certified Accountants (ACCA), Insights into Integrated Reporting: Challenges and Best Practice Responses (ACCA, London, 2017), p. 8.
While the historical financial statements meet compliance purposes, they do not provide meaningful
information about business value. The International Integrated Reporting Framework encourages the
preparation of a report that shows an organisation’s performance against strategy, explains the various
capitals used and affected, and gives a longer-term view of the organisation. The IIRC claims that the
integrated report creates the next generation of the annual report, as it enables stakeholders to make a
more informed assessment of the organisation and its prospects.
Users need a more forward-looking focus without the necessity of companies providing their own
forecasts and projections. Companies have recognised the benefits of showing a fuller picture of
company value and a more holistic view of the organisation. Some early adopters view the process of
integrated thinking as more important than the report itself. It builds sustainability thinking into the risk-
management process, and then an understanding of how that carries through into the strategy-setting for
the whole business.
Real World 7.7 provides an example of the kind of content of an integrated report.
The IIRC developed an integrated reporting examples database that contains exemplars of
integrated reports. The Crown Estate’s integrated reporting is listed as one of leading practices.
The sample integrated report is divided into four sections:
overview
performance
governance
financial statements.
It describes its business model as a resilient one by relying on six capitals: financial resources,
physical resources, natural resources, people, know-how and networks. It lists the value it creates
as follows:
The integrated report shows how an organisation’s strategy, governance, performance and
prospects, in the context of their external environment, lead to the creation of value over the short,
medium and long term. Early adopters found that it is not an easy process to transform from the
traditional annual report to integrated reporting. The barriers include, for example, the significant
time it takes to align the internal stakeholder groups, a problem highlighted given the report
requires significant commitment from the board and effective communication between teams. The
integrated report encourages forward-looking statements, which also poses particular challenges
because of the legal implications and concerns of company lawyers, and for competition reasons.
To avoid these risks, it is encouraged to use neutral and factual language and avoid the reports
looking like marketing or promotional tools.
Concept check 11
Which of the following statements is false? Why?
A. Integrated reporting focuses solely on sustainability reporting.
B. Integrated reporting highlights the long-term value creation for the organisation using
various forms of capital.
C. An integrated report should be concise.
D. Integrated reporting focuses on a smaller target audience than that of the GRI
Standards.
Reflection 7.5
Your high-school friend now runs a medium-sized farm in Northern Queensland. Given that the live
export industry is criticised by the animal rights organisations, he is wondering whether he should
use the GRI Standards or integrated reporting to report the farm’s CSR performance on the
website, particularly on issues related to animal welfare. What is your suggestion? What are the
pros and cons of each of the methods?
Assessment of corporate responsibility and
sustainability reporting
LO 7 Assess the importance of corporate social responsibility and sustainability reporting, and identify
any issues that you see as critical to their success and implementation.
Recent studies provide evidence of the growth and recognition of the need for ESG impacts to be
disclosed and discussed.
Australia’s top entities (75 companies, 15 public-sector organisations and 10 superannuation funds) are
failing in two key aspects of corporate responsibility reporting: first, they lag behind the world average in
acknowledging human rights as a business issue, and second, less than half recognise climate change as
a financial risk.
In 2018, the World Business Council for Sustainable Development (WBCSD) issued a report entitled
Sustainability Reporting in Australia: Jumping into the Mainstream (WBCSD/The Reporting Exchange,
Singapore, 2018, p. 4). It pointed out that:
The Australian Securities Exchange’s (ASX) Listing Rules and Corporate Governance Principles and
Recommendations are two of the most important reporting provisions for Australian publicly-listed
companies.
Recommendation 7.4 in the latter recommends that listed entities disclose whether they are exposed
to any material economic, environmental or social risks, and how they manage them.
Additionally, the Listing Rules require companies to disclose how they meet these recommendations,
and, where they do not, to disclose the reason for divergence.
Over 80% of reporting provisions in Australia are at least partly concerned with environmental issues, with
climate change and emissions/pollution being the second and third most popular subject areas,
respectively, behind corporate accountability.
In 2018, Ceres produced a report called Turning Point: Corporate Progress on the Ceres Roadmap for
Sustainability, which examined how some of the largest companies in the United States are responding,
and positioning themselves for the future. The results are outlined below.
Source: Ceres, Turning Point: Corporate Progress on the Ceres Roadmap for Sustainability (Ceres, Boston, 2018), pp. 8–17.
The above examples suggest that there is a growing demand for a much broader source of information
than that which has been provided in the past. A business can no longer focus solely on wealth
enhancement for the shareholder group. ESG issues are now serious, and there is a great deal of
emphasis on the sustainability demands that come from every sector—society, environmentalists,
customers, employees and shareholders. It is becoming obvious that management itself must deal with a
much broader set of questions and issues than it has in the past, to be able to develop sound long-term
strategy. Whether all of this translates into broad acceptance of the GRI, with the further development of
measurement systems that will certainly expand the role of accountants, remains to be seen.
As we have seen in discussing triple bottom line reporting and integrated reporting, management has to
expand its information base considerably if it is to compete in the digital economy. It seems reasonable to
suppose that both management and society at large are moving in the same direction. Just what pace
both are going at is debatable, however. Whatever conclusion you reach, it seems inevitable that the
issues raised in this chapter will not go away. Accountants will need to develop a set of expanded skills in
these areas, and good business people will need to become much more familiar with wide-ranging
measurement systems.
But is this enough? In 2018 John Elkington carried out what he called a ‘management concept recall’ in
relation to triple bottom line reporting (John Elkington, ‘Why it’s time to rethink the “triple bottom line” ’,
The Australian, 2 July 2018, News Corp Australia). Why did he do this? The ideas explained above in the
section on triple bottom line reporting have been incorporated into most of the ideas set out in the rest of
this chapter. His concern is that ‘success of sustainability goals cannot be measured only in terms of profit
and loss. Sustainability must also be measured in terms of the wellbeing of billions of people and the
health of our planet, and the sector’s record in those areas has been decidedly mixed’. While
acknowledging that triple bottom line reporting is recognised as ‘taking account of the full cost involved in
doing business’ and also contributing significantly towards sustainability reporting, ‘the original idea was
wider still, encouraging businesses to track and manage economic (not just financial), social and
environmental value added—or destroyed’. Triple bottom line reporting was seen as wider than
accounting: ‘It was supposed to provoke deeper thinking about capitalism and its future.’ However, this
didn’t happen in the way originally envisaged. While there is ‘a hardwired culture’ in business generally
that focuses on profits and profit targets, the same culture rarely applies to the sustainability targets.
‘Clearly, the triple bottom line has failed to bury the single bottom line paradigm,’ Elkington concludes.
Elkington found a ‘ray of hope’ in the B Corporation movement: ‘Certified B Corporations are a new kind
of business that balances purpose and profit. They are legally required to consider the impact of their
decisions on their worker, customers, suppliers, community, and the environment. This is a community of
leaders, driving a global movement of people using business as a force for good.’
(https://bcorporations.net/)
There is no doubt that the sustainable development movement has made a tremendous amount of
difference to how we all think about sustainability and its various perceived components. But there are still
many negatives that could be interpreted as a sign that the actuality is not yet living up to its promise. It is
easy to wonder just how much of it is compliance-oriented—we do this because we have to. There is a
need to ensure that businesses are living the philosophy, and it is not clear that they are. The 2019
Brumadinho Dam breach in Brazil provides a good example of an event that would horrify society at large,
and focus attention to ensure that such an event would be about as unlikely to recur as is humanly
possible. Yet this is clearly not so—as it is the second such breach by the same company. Real World
7.8 provides commentary on the issue.
In late January 2019, a tailings dam broke in Brazil. A week later, the cost in lives was at least 84
dead and 276 still missing. The burst came less than four years after a similar dam burst which
had killed 19 people. Both bursts happened at sites constructed and maintained by the same
company (Vale SA), although BHP was also involved in the 2015 burst. Following the 2019
incident, the consequences in terms of lost production were expected to be of the order of 40
million tonnes, which saw the price of iron ore surge within a week by 4.4%. Price of shares in
BHP, Rio and Fortescue consequently rose (Williams 2019; Associated Press [AP] 2019).
For the surviving residents, near and far, consequences were nothing like as good. The accident
has devastated the local mining community. The loss of life is horrendous, and is of a scale that is
difficult to comprehend. The future prospects for those who are left have virtually disappeared.
Families have been broken up or destroyed. The Associated Press reported that the flows of waste
‘turned the normally greenish water of the Paraopeba river brown about 18km downstream from
the dam’. Local residents have been warned to ‘stop fishing in the river, bathing in it and using its
water for the plants they cultivate for food’. The consequences of the burst for downstream
communities are considerable. Downstream rivers supply ‘drinking and irrigation water to hundreds
of municipalities and larger cities’. A fundamental question for the authorities is how to contain the
contamination.
In The Wall Street Journal, Jeffrey Lewis and Paolo Trevisani reported while Vale had already
decommissioned nine dams, it would take them up to three years to dismantle the 10 remaining
similar dams. They were looking at removing the reservoir contents and destroying the structure,
and also redeploying the 5000 workers affected by the decommissioning. The CEO said Vale was
unequivocal in putting safety first, admitting: ‘The accident radically changed our approach to this
situation.’
Brazilian police have arrested five people in relation to the burst. Two of them were part of a
German auditing and certification organisation that had assessed the dam’s safety in June and
September 2018. This company ‘has worked as both a consultant and an independent safety
evaluator for the dam’s owner, raising questions among experts over potential conflicts of interest’.
Robert Gottliebsen noted that when the dam collapsed ‘a shudder went through many of the
world’s mining companies’. He points out that there are thousands of these dams across the world
and there is often a danger of collapse, but the cost of eliminating them and restoring the
environment is prohibitive, and in many cases few contingency funds are available anyway. So the
dams remain; ‘a perpetual blight on the landscape’. The mining industry suffered a major slump
several years ago, with the result that many companies were short of cash. ‘There is a great fear
around the world that tailings dam shortcuts were taken to maintain production and defer
rectification projects.’
The costs of returning materials to the mine would increase the mines’ overall operating costs, and
hence increase the selling price of iron ore substantially. Given the importance of the mining sector
to Brazil, for employment and government income, it may well be that the government will be
unable to afford to close many mines and very little will change.
Lewis and Trevisani noted the immediate effect on Vale’s shares the day after the dam burst:
tumbling ‘by nearly a quarter’, before regaining some ground the following day, ‘closing 1.7 per
cent higher’.
Sources: Associated Press, ‘Waste from broken dam threatens Brazil water supply’, The Australian, 31 January 2019.
Jeffrey T. Lewis and Paulo Trevisani, ‘Dams to go after Brazilian disaster’, The Wall Street Journal, 30 January 2019.
Patricia Kowsmann and Alistair MacDonald, ‘Experts question dam inspectors’ ties to Vale’, The Australian Business Review, 3 February 2019.
Perry Williams, ‘Dam disaster boosts Patricia iron ore miners’, The Australian, 31 January 2019.
Robert Gottliebsen, ‘Tailings dam sludge could come back to bite mining’, The Australian, 30 January 2019.
Real World 7.8 provides an opportunity to consider an industry (or a least a small part of it) from a
number of perspectives, including: the need for the mining output; the range of countries using the output;
the costs of production and associated costs; the impact on company profits; the importance of revenue
accruing to the government; impact on employment prospects; impact on the local community, including
employment prospects, education, community support—e.g. health; adverse impacts on the environment,
including toxic waste or emissions, damage done to the environment, and costs (indeed the possibility) of
rehabilitation; impact on water. The list of possibilities goes on. Consideration of this should enable you to
appreciate how hard it is to make sure the decision made is the best possible overall.
A further point to consider relates to just what are society’s norms, and how a business can keep track of
what may be something of a moveable target. What is the likely impact of the dam burst we have just
been discussing on long-term attitudes towards environmental and social risk? My suspicion—and hope
—is that society’s attitudes will harden and not condone or ignore such ultimately irresponsible and risk-
laden undertakings; but this is far from certain. An interesting article by Ian Laughlin raised the question
as to whether conventional risk management techniques are working (Social Risks for a Financial
Services Business (The Dialogue series. The Actuaries Institute, Sydney, January 2018). He has the view
that professional standards in the financial services area are much higher than they were, but society’s
expectations are also much higher than they were. The era of information technology and social
networking means information is more readily available, and is communicated very quickly, and with this a
societal view soon emerges. Whether this view is consistent with the facts may be another thing
altogether.
Laughlin also identifies a range of social risks for a business, which are shown here in Table 7.1 .
Self-awareness risk Engages in or condones poor behaviour without realising how it will be seen by others
Values risk Has espoused values which are inconsistent with social expectations
True values risk Displays actual values which are different to the espoused values
Insight risk Has a poor appreciation of current social norms and expectations
Generation risk The differing social attitudes of various generations are not understood and addressed by the business
Revenge risk A scorned customer effectively uses social media to exact revenge
Political opportunism risk Politicians can criticise a business for their own ends
Fake news risk The media will take an accusation and blow it up
Post-fact risk Statements are made purporting to be true even though they are clearly not, but they still gain currency
Source: Adapted from Ian Laughlin, Social Risks for a Financial Services Business. The Dialogue series (The Actuaries Institute, Sydney, January 2018), pp. 4–8.
Internal social risks are those that should be under the control of the board and management. External
risks relate to ‘what is happening in the community and the impact of this on the business’. Given the
pace of change in social attitudes, the chances of misjudgement by a business is high. While in some
ways social risk should be addressed just like any other risk, there are particular difficulties in this area.
Laughlin sees financial services businesses requiring ‘deep expertise in identifying, assessing and
monitoring that society’s attitudes and norms’. The proceedings of the Royal Commission on Financial
Services show just how far out of touch many such businesses were. Laughlin goes on to explore the
concept of ‘risk sensing’, by which he means monitoring and interpretation. ‘This in turn suggests the
need for financial services businesses to have deep and effective capabilities to monitor and assess
social risks.’ This may well require different resources and capabilities. Laughlin suggests the
appointment of a social risk officer, ‘dedicated to the risks that emerge from attitudes and norms in
society, how they are changing, and the implications for the business’.
Reflection 7.6
Lucas, our restaurateur, is concerned about feedback from one of his restaurants relating to the
quality of service. He has come across the Laughlin article and is wondering how the internal risks
identified might help him focus on his problem. Advise him.
Real World 7.9 offers an optimistic note by providing information relating to philanthropy, the actions of
a company that might be deemed to be both philanthropic and also socially and environmentally
progressive, information relating to B Corporations, and a description of two businesses that see
themselves as socially oriented.
Real world 7.9
Positives for sustainability development
Philanthropy
In 2017 Bill Gates gave a substantial number of shares in Microsoft to the Bill and Melinda Gates
Foundation. At the time, this was worth US$4.68 billion. Since 2015 he has given a further 8 million
shares each quarter. The Foundation focuses on global health, and development and educational
programs. Its website states that it believes: ‘The path out of poverty begins when the next
generation can access quality healthcare and a great education.’ For developing countries the
focus is on ‘improving people’s health and wellbeing’. In the United States the focus is on
accessing the opportunities needed ‘to succeed in school and life’.
Jay Greene, ‘Bill Gates donates $6bn to Bill & Melinda Gates Foundation charity’, The Wall Street Journal, 16 August 2017.
Philanthropy plus
BHP has set up a foundation that, its homepage explains, ‘works to address some of the most
critical sustainable development challenges facing our generation’. The main areas are natural
resource governance, environmental resilience and education equity. Collaborative work is going
on in a number of projects, ‘work in genuine partnership with leading organizations and invest in
projects that have the power to drive large scale systemic change commensurate with the
challenges the world is now confronting (p. 6)’. Projects may go for several years and across many
countries. The UN Sustainable Development Goals underpin the foundation’s thinking. The
foundation has invested substantial amounts of money— US$65 million at the time of its inaugural
report in 2018. An example of one of the projects is the 10 deserts project in Australia, which the
foundation’s 2019 booklet describes as aiming ‘to build the largest indigenous-led connected
conservation network on Earth’ (p. 27).
Source: BHP Foundation (2019), BHP Foundation Booklet (BHP Group Ltd, Texas), pp. 4–27.
B Corporations
At the start of 2018 there were close to 2,500 B Corporations. At this stage there are only a handful
in Australia and New Zealand. However, examination of the B Corporation website enables us to
see what drives these businesses. For example, Greyston Bakery, a $10-million for-profit bakery in
New York, has an ‘open hiring policy that provides the people of Yonkers, NY with employment
opportunity regardless of work history. Committed to a Triple Bottom Line, Greyston Bakery
continues to be a pioneer in the world of social enterprise’ (https://bcorporation.net/directory/
greyston-bakery-inc and https://www.greyston.org/history-open-hiring).
Sources: Dennis Lomonaco, ‘Be nice or leave: the pragmatic case for B-Corps’, Forbes, 22 January 2018.
Michele Giddens, ‘The rise of B Corps highlights the emergence of a new way of doing business’, Forbes, 3 August 2018.
Social businesses
In a supplement entitled Rewarding Success, in The Australian of 22 March 2018, there was an
article on the business Mathspace. It covered the development of the business, starting with the
founders’ move away from derivatives trading. The business was essentially developing software
that gave step-by-step tuition to students. There were considerable risks in what they were doing,
particularly in terms of cash flow, given that opportunities to sell to schools come only once a year.
The response was: ‘I stayed motivated purely on the purpose ... I asked myself if there was
something else I would rather be doing. And there isn’t.... If we’re not starving we just keep going.’
Source: Jackson Hewett, ‘Sustained profits prove case for social businesses’, The Australian, 22 March 2018.
There is little doubt that the reporting framework that has developed over the past 20 or so years has led
to much greater transparency in reporting, and considerable advances in measurement. Whether this is
sufficient to get the world back onto a completely sustainable basis seems unlikely, without it being
accompanied by businesses, individuals and governments really living the ideas. How successful we shall
be remains to be seen. However, the work done over the past 20 years has at least put us on a more
appropriate pathway for the future.
Reflection 7.7
Assume you were the manager of a healthcare provider in Australia with a reputation for
profitability and efficiency. You have heard that some of your competitors have been certified as B
Corps. You were wondering what that means and why it would be beneficial to a business.
Conduct some research and outline the potential benefits to your business of being a B Corp.
Summary
In this chapter we have achieved the following objectives in the way shown.
Outline and discuss a range of social and environmental issues, and Provided a general background
the way in which accounting can contribute Described and illustrated the stakeholder concept in the context
of social and environmental issues
Introduced the legitimacy theory
Explain what is meant by corporate social responsibility and Explained social responsibility
sustainable development Defined corporate social responsibility
Illustrated by examples
Set out the Ceres roadmap
Described context
Outlined the importance of accounting for corporate social
responsibility
Explain the development of reporting for corporate social Outlined the reasons for voluntary disclosures
responsibility and sustainable development Reviewed the sustainability reporting history in Australia, and the
relationship with development of reporting guidelines
Summarised key findings from studies in sustainability reporting
Explain triple bottom line reporting Described and explained triple bottom line reporting
Outline the Global Reporting Initiative (GRI), and discuss its main Set the GRI in context
framework in broad terms Explained the benefits of the GRI process
Described the purpose and form of a sustainability report
Identified a range of standard disclosures and performance
indicators
Illustrated by use of a real-world example how sustainability
reporting can be carried out
Outline integrated reporting and its relationship with sustainability Outlined the work of the International Integrated Reporting
reporting using the GRI Standards Council (IIRC)
Explained the benefits of integrated reporting
Described the relationship between integrated reporting and the
GRI Standards
Illustrated by use of a real-world example how an integrated
report can be carried out
Evaluated the barriers for integrated reporting
Assess the importance of corporate social responsibility and Appraised the current status of corporate social responsibility
sustainability reporting, and identify any issues that you see as and sustainability reporting in Australia and around the world,
critical to their success and implementation and associated implementation factors
Illustrated by real-world failures and positives
References
Australian Department of Environment and Heritage (ADEH) (2003), Triple Bottom Line Reporting in
Australia: A Guide to Reporting Against Environmental Indicators (ADEH, Canberra).
Ceres (2018), Turning Point: Corporate Progress on the Ceres Roadmap for Sustainability (Ceres,
Boston).
CPA Australia (2012), A Guide for Assurance on SME Sustainability Reports (CPA Australia, Melbourne).
Dan S. Dhaliwal, Oliver Zhen Li, Albert Tsang and Yong George Yang (2011), ‘Voluntary nonfinancial
disclosure and the cost of equity capital: the initiation of corporate social responsibility reporting’. The
Accounting Review, 86(1), 59–100.
Craig Deegan (2000), Financial Accounting Theory (McGraw Hill Book Company, Sydney).
Craig Deegan (2002), ‘Introduction: the legitimizing effect of social and environmental disclosures—a
theoretical foundation’. Accounting, Auditing and Accountability Journal, 15(3), 282–311.
John Dowling and Jeffrey Pfeffer (1975), ‘Organizational legitimacy: social values and organizational
behavior’. Pacific Sociological Review, 18(1), 122–136.
John Elkington (1997), Cannibals with Forks: The Triple Bottom Line of 21st Century Business (Capstone
Publishing, Mankato, MN).
John Elkington (2018), 'Why it's time to rethink the triple bottom line', The Australian, 2 July.
Global Reporting Initiative (GRI) (2002), Sustainability Reporting Guidelines (GRI, Amsterdam, The
Netherlands), www.globalreporting.org. GRI does not endorse the text of the book in any way.
Global Reporting Initiative (GRI) (2006), Sustainability Reporting Guidelines (version G3) (GRI,
Amsterdam, The Netherlands), www.globalreporting.org. GRI does not endorse the text of the book
in any way.
Global Reporting Initiative (GRI) (2011), Sustainability Reporting Guidelines (version G3.1) (GRI,
Amsterdam, The Netherlands), www.globalreporting.org. GRI does not endorse the text of the book
in any way.
Global Reporting Initiative (GRI) (2013), Sustainability Reporting Guidelines (version G4) (GRI,
Amsterdam, The Netherlands), www.globalreporting.org. GRI does not endorse the text of the book
in any way.
Global Reporting Initiative (GRI) (2016), Consolidated Set of GRI Sustainability Reporting Standards
(GRI, Amsterdam, The Netherlands), www.globalreporting.org. GRI does not endorse the text of the
book in any way.
Richard Holme and Phil Watts (2000), Corporate Social Responsibility: Making Good Business Sense
(World Business Council for Sustainable Development, Geneva).
International Integrated Reporting Council (IIRC) (2013), The International <IR> Framework (IRRC,
London).
International Integrated Reporting Council (IIRC) (n.d), ‘When? Advocate for global adoption’ (IIRC,
London), https://integratedreporting.org/when-advocate-for-global-adoption/.
KPMG (2017), The Road Ahead: The KPMG Survey of Corporate Responsibility Reporting 2017 (KPMG,
Boston).
Ian Laughlin (2001), ‘Social risks for a financial services business’, Journal of Superannuation
Management, February, 1–5.
World Business Council for Sustainable Development (WBCSD) (2018), Sustainability Reporting in
Australia: Jumping into the Mainstream (WBCSD/The Reporting Exchange, Singapore).
Discussion questions
Easy
7.1 LO 1 Corporate social responsibility (CSR) reporting extends the traditional financial reporting into new areas. Describe three of
these new areas.
7.3 LO At a personal level, articulate your views on ethical governance. In the course of this, examine your views on the extent to
1/2/3 which the search for wealth should be limited by moral values or social conscience.
7.4 LO 3 Describe in detail the Australian Accounting Standards for corporate social responsibility (CSR) accounting.
7.5 LO 4 List the three components of triple bottom line reporting. Which component is currently accommodated by financial accounting
reporting standards? With what measure?
7.6 LO 5 What does ‘GRI’ stand for? What’s one word to describe what it’s all about? Who is it meant to benefit?
Intermediate
7.8 LO Can you think of any current issues relating to businesses or industries in your area where business interests, social needs
1/2 and environmental consequences are in conflict? How might you attempt to balance these conflicting needs in both the short
term and the long term?
7.10 LO 2 Just how much responsibility should an organisation take for social and environmental issues?
7.11 LO Assume that you are the CEO of a company that is the major employer in a small town in rural New South Wales. What
1/2/3 responsibility would you have for your employees? Would your company size affect your decision?
7.12 LO Is there any evidence that companies that are socially responsible, in terms of pollution and waste avoidance, benefit in terms
1/2/3 of profits?
7.13 LO To what extent are social and environmental concerns consistent with a shareholder wealth maximisation objective?
1/2/3
7.14 LO How well equipped is the typical business person to understand the full range of issues covered by a full-scale sustainability
1/2/3 report?
7.15 LO 1 Why CSR? Don’t accountants have enough to do with their preparation of the traditional financial statements?
7.16 LO 6 How does the integrated reporting differ from GRI Standards?
7.17 LO 7 Some commentators criticise that disclosures in the sustainability reports tend be positive rather than negative. Find and study
some real sustainability reports, and then see whether you agree with that allegation. Why/why not?
Challenging
7.18 LO 5 Is the form of the GRI report too complex? Will it lead to information overload?
7.19 LO While many corporate social reporting ideas are sound, many are still unmeasurable. How much does this detract from this
1/2/3 style of reporting?
7.20 LO 5 How realistic is the GRI for anything other than the largest transnational companies? To what extent might the basic principles
be used by smaller domestic companies?
7.21 LO Can you think of any changes to business studies curricula that might be required to support a new era of business where an
1–6 emphasis on sustainability and sustainability reporting becomes the norm?
7.22 LO 4 What is the major challenge of triple bottom line reporting? What are the benefits of meeting this challenge?
7.23 LO 6 Why do you think integrated reporting might enable long-term strategic thinking?
7.24 LO 7 What do you think are the main factors affecting successful implementation of sustainable development?
Application exercises
Easy
7.1 LO Complete the following table for triple bottom line reporting.
4 Component Traditional financial statement focus % Traditional financial statement focus
name explanation
7.2 LO There have been a number of studies conducted as to voluntary reporting practice around the world. These studies have
4 provided a good range of examples of environmental disclosures, both positive and negative.
For each item in the following list indicate whether the item is (a) Positive, (b) Negative, (c) Both positive and negative, or (d)
Not an environmental disclosure.
7. Recycling of materials
Intermediate
7.3 LO Complete the following table as an outline of the GRI (the Global Reporting Initiative), its framework and linkages to accounting.
5 Stakeholders
Mission
Mandatory?
Timeframe
Management approach
Economic impacts
Environmental impacts
Social impacts
7.4 LO Use the internet to find examples of corporate social responsibility reporting, summarise them, and comment on them. You
1–5 might find the Mallen Baker website of assistance here.
Challenging
7.5 LO Find out as much as you can about two major transnational corporations, and comment on their CSR practices over time.
1–5
7.6 LO As the mayor of a small town in rural New South Wales, you have been approached by a multi-national mining company that
1/2/3 wants to open both a large underground mine and an open-pit mine 2 kilometres outside of your town.
The company wishes to provide appropriate CSR reporting and has asked you to advise them with regard to which groups
they should consider, and to provide a list and description of the information they might provide.
7.7 LO 5 The GRI provides guidance regarding boundaries for sustainability reporting. How useful are these, and what do you see as
the major difficulties in applying them? It is suggested that you use an appropriate report, e.g. BHP’s sustainability report, to
provide a focus for your answer.
7.8 LO What does Real World 7.1 tell you about the difficulties of balancing business decisions with social consequences?
1/2 Examine the background to the plastic bag ban. Should the retailers have seen the problems coming?
7.9 LO 5 BHP Billiton, in its 2019 sustainability report, set out targets and performance for the year in the areas of health and safety,
environment, climate change, water, people, and ethics and business conduct. Summarise the ways in which BHP Billiton
contributes to the United Nations Sustainable Development Goals, as indicated in its 2019 sustainability report.
7.10 LO In an article in Financial Review of 10 February 2020, entitled ‘Investors scared off by Australia’s climate wars’, James
1/2 Fernyhough says there is concern about Australia’s ‘chaotic and highly politicised approach to climate policy’. He quotes
Jeremy Lawson, a chief economist at a UK fund management giant, who says: ‘External investors considering accessing the
Australian low-carbon market must do so with their eyes open, recognising that the political and policy backdrop is likely to
remain contested and thus subject to significant regulatory risk.’ The complex and volatile political situation was off-putting.
a. Why do you think foreign investors are scared off by Australia’s climate change policy?
b. How important is the climate risk to investors?
c. Do you agree with Mr Lawson’s criticism of business in this area?
Chapter 7 Case study
The Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry
provides an example of an occurrence which may substantially change the way society thinks about
banking and financial services. This case provides detail of a poll conducted for superannuation industry
which revealed changing community attitudes to the Royal Commission and the financial services
industry.
Complaints that the commission was ‘toothless “froth and bubble” in February (2018) shifted through
to a consensus that its hearings had revealed widespread “dishonesty” among the banks and a need
for far tougher regulation in December’.
75% cared about the result.
68% felt that the outcome would be good for ordinary Australians.
Favourability towards the big banks moved from 51% to 32% in August, and back to 36% in
December.
Industry superannuation funds were favourably viewed by 69% in December 2017, and 65% in
December 2018.
In December 2018, 32% were aware that the Commission had uncovered misconduct.
Comments were made covering the fact that several banks charged customers who were dead, fees
were charged for no service, financial advisers had sent people broke, insurance was useless.
Some respondents used very strong language to describe their feelings.
Source: Ben Butler, ‘Bank execs “off to jail, I hope”: keen interest in Hayne report’, The Australian, 1 February 2019.
Another interesting result of the Royal Commission into Financial Services is that the average ‘for’ vote on
remuneration reports at AGMs in 2018 fell substantially for the banking industry. Figures for other
industries also fell, but less badly.
Source: Sarah-Jane Tasker, ‘Royal commission fuelled investor discontent last AGM season: ASIC’, The Australian, 31 January 2019.
Questions
1. Why do you think 68% of respondents felt that the outcome from the Royal Commission would be
good for ordinary Australians?
2. Do you think there is a corporate governance failure in the wake of the banking and financial
services industry scandal?
3. Can you still trust banks for financial services after the breakout of the scandal?
4. Do you think the curriculum for business students should be revised to enhance the ethics
component? How is the CSR related to the case?
5. Download a sustainability report from one of the Big Four banks in Australia, and compare it with
what the Royal Commission found. What is your conclusion?
6. Do you agree the scandal is caused only by some unethical employees in the industry and does
not reflect on the industry itself?
7. What measures should be taken to avoid this kind of misconduct happening again?
CC3 E
CC6
CC10 B Profitability (especially short-term) can frequently conflict with social justice
CC11 A
Solutions to activities
Activity 7.1
In Australia, places such as Adelaide, Whyalla and Wollongong have tended to rely heavily on the car or
steel industries. Mining has been an important industry in regional Australian communities (e.g. Mount Isa
in Queensland). Nhulunbuy in the Northern Territory has been a Rio Tinto town. Newcastle, until quite
recently, relied on steel and port facilities. In the United Kingdom in the 1980s, large areas of the north of
England suffered wholesale decline due to reliance on the coal and vehicle industries. Cities such as
Newcastle upon Tyne and Glasgow have suffered in the past for their reliance on shipbuilding.
Activity 7.2
a. There are examples of businesses with problems such as pollution, loss of jobs, and health and
safety issues.
b. Reasons why a business might still pursue activities that are less profitable but socially beneficial
might include:
expected future legislation
enlightened self-interest
publishing results and making comparisons, thus putting pressure on competitors
marketing themselves as a good citizen (public relations).
Activity 7.3
The websites below provide good resources of news related to corporate sustainability.
Activity 7.4
a. The three components of a triple bottom line report are economic value added, environmental
value added, and social value added.
b. Benefits that might accrue from a business using triple bottom line reporting might include:
embedding of good governance and ethics systems; better management of risk and resource
allocation; enhanced communication with stakeholders; attracting better staff; greater competitive
advantage; and better access to financial markets.
c. Motives for adopting triple bottom line reporting include: a genuine commitment to a value-driven,
integrated culture; improved public relations and marketing; influencing market perceptions
regarding the quality of management; innovation; and facing and dealing with conflicts between
economic, social and environmental factors.
Activity 7.5
Reporting principles
Stakeholder inclusiveness—different in principle and application. Probably the GRI principles are more
broadly applied, with coverage beyond what might be expected of a general-purpose report.
Inclusiveness means that all stakeholders must now be seriously considered and catered for.
The sustainability context represents the biggest shift.
Materiality—similar in principle, probably more broad in practice.
Completeness requires careful attention to the boundaries of the report, which are now likely to be
much more widely drawn.
Report quality
Accuracy and balance both very similar to financial reporting principles.
Clarity may require greater explanation than that typically assumed in financial reporting.
Comparability is very similar.
Reliability may prove more difficult due to the need for more qualitative information. The GRI
recognises the need for more work on the assurance of sustainability reports.
Timeliness is very similar.
Other factors
Under financial reporting, the primary user is generally regarded as the owner. This is not the case
with sustainability reporting.
Activity 7.6
Usefulness depends on the stakeholders. Many of the indicators relating to environmental performance,
social performance, labour practices and decent work, human rights, society and product responsibility
would not be found in a traditional financial report.
Activity 7.7
No single answer.
Chapter 8 Analysis and interpretation of financial
statements
Learning objectives
When you have completed your study of this chapter, you should be able to:
Financial ratios provide a quick and relatively simple means of examining the financial health of a
business. A ratio simply expresses the relationship between one figure appearing in the financial
statements and some other figure appearing in the financial statements (e.g. profit in relation to capital
employed) or perhaps some resource of the business (e.g. profit per employee, sales per square metre of
counter space).
Ratios can be very helpful when comparing the financial health of different businesses. Differences may
exist between businesses in the scale of operations. As a result, a direct comparison of, say, the
operating profit generated by each business, may be misleading. By expressing operating profit in relation
to some other measure (e.g. capital employed), the problem of scale is eliminated. This means that a
business with an operating profit of $10,000 and capital employed of $100,000 can be compared with a
much larger business with an operating profit of $80,000 and capital employed of $1,000,000 by the use
of a simple ratio. The operating profit to capital employed ratio for the smaller business is 10% (i.e.
(10,000/100,000)×100%) and the same ratio for the larger business is 8% (i.e.
(80,000/1,000,000)×100%). These ratios can be directly compared, whereas a comparison of the
absolute operating profit figures might be much less meaningful. The need to eliminate differences in
scale through the use of ratios can also apply when comparing the performance of the same business
from one time period to another.
By calculating a relatively small number of ratios, it is often possible to build up a reasonably good picture
of the financial position and performance of a business. Thus, it is not surprising that ratios are widely
used by those who have an interest in businesses and business performance. Although ratios are not
difficult to calculate, they can be difficult to interpret. For example, a change in the profit per employee of
a business may be due to several possible reasons, such as:
a change in the number of employees without a corresponding change in the level of output
a change in the level of output without a corresponding change in the number of employees
a change in the mix of goods or services being offered, which in turn changes the level of profit.
It is important to appreciate that ratios are really only the starting point for further analysis. They help to
highlight the financial strengths and weaknesses of a business, but they cannot, by themselves, explain
why certain strengths or weaknesses exist or why certain changes have occurred. Only a detailed
investigation will reveal these underlying reasons.
Ratios can be expressed in various forms; for example, as a percentage, as a fraction, as a proportion.
The way a particular ratio is presented will depend on the needs of those who will be using the
information. Although it is possible to calculate a large number of ratios, only a relatively few, based on
key relationships, may be required by the user. Many ratios that could be calculated from the financial
statements (e.g. rent payable relative to current assets) may not be useful because there is no clear or
meaningful relationship between the items.
There is no generally accepted list of ratios that can be applied to the financial statements, nor is there a
standard method of calculating many ratios. Variations in both the choice of ratios and their calculation
will be found in the literature and in practice. However, it is important to be consistent in the way we
calculate ratios for comparison purposes. The ratios discussed below are those which many consider to
be among the more important for decision-making purposes.
Profitability. Businesses generally exist with the primary purpose of creating wealth for the owners.
Profitability ratios reveal their degree of success: they express the profits made (or figures bearing on
profit, such as sales revenue or overheads) in relation to other key figures in the financial statements
or to some business resource.
Efficiency. Ratios may be used to measure how efficiently certain resources have been utilised by the
business. Efficiency ratios are also referred to as ‘activity ratios’ or ‘turnover ratios’.
Liquidity. It is vital for the survival of a business to have sufficient liquid resources available to meet
its maturing obligations, and there are specific ratios for examining the relationship between liquid
resources held and accounts due for payment in the near future.
Financial gearing. This is the relationship between the contribution to financing the business made by
the owners of the business and the amount contributed by others, in the form of loans. The level of
gearing has an important effect on the degree of risk associated with a business, as we shall see.
Gearing ratios tend to highlight the extent to which the business uses borrowings.
Investment. Certain ratios are concerned with assessing the returns and performance of shares in a
particular business from the perspective of shareholders who are not involved with the management of
the business.
The categories of ratios outlined have a focus on the traditional financial statements. The increasing
emphasis on sustainability and integrated reporting is likely to lead to the development of a number of
ratios dealing with particular aspects of sustainability. Inevitably there will be convergence of both sets of
ratios in time.
The need for comparison
Calculating a ratio by itself will not tell you very much about the position or performance of a business. For
example, if a ratio revealed that the business was generating $100 in sales per square metre of counter
space, you could not deduce from this information alone whether this level of performance was good, bad
or indifferent. It is only when you compare this ratio with some benchmark that the information can be
interpreted and evaluated. The most common benchmarks are described next.
Past periods
By comparing the ratio that we have calculated with the same ratio, but for a previous period, it is possible
to detect whether there has been an improvement or deterioration in performance. Indeed, it is often
useful to track particular ratios over time (say, 5 or 10 years) to see whether it is possible to detect trends.
The comparison of ratios from different periods brings certain problems, however. In particular, there is
always the possibility that trading conditions were quite different in the periods being compared. There is
the further problem that, when comparing the performance of a single business over time, operating
inefficiencies may not be clearly exposed. For example, the fact that sales revenue per employee has
risen by 10% over the previous period may at first sight appear to be satisfactory. This may not be the
case, however, if similar businesses have shown an improvement of 50% for the same period or had
much better sales revenue per employee ratios to start with. Finally, there is the problem that inflation
may have distorted the figures on which the ratios are based. Inflation can lead to an overstatement of
profit and an understatement of asset values, as will be discussed later in the chapter.
Similar businesses
In a competitive environment, a business must consider its performance in relation to that of other
businesses operating in the same industry. Survival may depend on its ability to achieve comparable
levels of performance. A useful basis for comparing a particular ratio, therefore, is the ratio achieved by
similar businesses during the same period. This basis is not, however, without its problems. Competitors
may have different year-ends and so trading conditions may not be identical. They may also have
different accounting policies, which can have a significant effect on reported profits and asset values (e.g.
different methods of calculating depreciation or valuing inventories). Finally, it may be difficult to obtain
the financial statements of competitor businesses. Sole proprietorships and partnerships, for example, are
not obliged to make their financial statements available to the public. In the case of larger limited
companies, there is a legal obligation to do so. However, a diversified business may not provide a
breakdown of activities that is sufficiently detailed to enable analysts to compare the activities with those
of other businesses.
Planned performance
Ratios may be compared with the targets that management developed before the start of the period under
review. The comparison of planned performance with actual performance may therefore be a useful way
of revealing the level of achievement attained. However, the planned levels of performance must be
based on realistic assumptions if they are to be useful for comparison purposes.
Planned performance is likely to be the most valuable benchmark against which managers may assess
their own business. Businesses tend to develop planned ratios for each aspect of their activities. When
formulating its plans, a business may usefully take account of its own past performance and the
performance of other businesses. There is no reason, however, why a particular business should seek to
achieve either its own previous level of performance or that of other businesses. Neither may be an
appropriate target.
Analysts outside the business do not normally have access to the business’s plans. For these people,
past performance and the performances of other, similar, businesses may provide the only practical
benchmarks.
The second step in the process is to calculate the ratios identified in the first step as being appropriate for
the particular users. The final step is to interpret and evaluate the ratios. Interpretation involves examining
the ratios in conjunction with an appropriate basis for comparison and any other relevant information. The
significance of the ratios calculated can then be established. Evaluation involves forming a judgement
about the value of the information uncovered in the calculation and interpretation stage. While calculation
is usually straightforward, the interpretation and evaluation stages are more difficult, and often require
high levels of skill that can only really be acquired through much practice. The three steps described are
shown in Figure 8.1 .
EXAMPLE
8.1
The following financial statements relate to Alexis Ltd, which owns a chain of wholesale/retail
carpet stores.
ALEXIS LTD
Statement of financial position
as at 31 March
2019 2020
$m $m
Current assets
Bank 4 –
544 679
Non-current assets
510 587
Current liabilities
291 432
Non-current liabilities
563 534
ALEXIS LTD
Statement of comprehensive income
for the year ended 31 March
2019 2020
$m $m
Notes
1. The market price of the shares of the company at the end of each year was $2.50 for 2019
and $1.50 for 2020.
2. All sales and purchases are made on credit.
3. The cost of sales figure can be analysed as follows:
2019 2020
$m $m
2,045 2,678
As a general rule, when a ratio involves a comparison between two statements of financial position, we
use year-end figures. However, if the ratio involves both the statement of financial position and the
statement of financial performance (i.e. income statement and statement of comprehensive income), we
would use the average of the two figures from the statement of financial position rather than the year-end
figure, because it is more directly comparable with the figures from the statement of financial
performance.
A brief overview
Before we start our detailed look at the ratios for Alexis Ltd (in Example 8.1 ), it is helpful to take a quick
look at what information is obvious from the financial statements. This will usually pick up some issues
that ratios may not be able to identify. It may also highlight some points that could help us in our
interpretation of the ratios. Starting at the top of the statement of financial position, the following points
can be noted:
Reduction in the cash balance. The cash balance fell from $4 million (in funds) to a $76 million
overdraft between 2019 and 2020. The bank may be putting the business under pressure to reverse
this, which could raise difficulties.
Major expansion in the elements of working capital. Inventories increased by about 35%, trade
receivables by about 14%, and trade payables by about 36% between 2019 and 2020. These are
major increases, particularly in inventories and payables (which are linked because the inventories are
all bought on credit—see Note 2).
Expansion of non-current assets. These have increased by about 15% (from $510 million to $587
million). Note 7 mentions a new warehouse and distribution centre, which may account for much of the
additional investment in non-current assets. We are not told when this new facility was established,
but it is quite possible that it was well into the year. This could mean that not much benefit was
reflected in terms of additional sales revenue or cost saving during 2020. Sales revenue, in fact,
expanded by about 20% (from $2,240 million to $2,681 million)—greater than the expansion in non-
current assets.
Apparent debt capacity. Comparing the non-current assets with the long-term borrowings implies
that the business may well be able to offer security on further borrowing. This is because potential
lenders usually look at the value of assets that can be offered as security when assessing loan
requests. Understandably, lenders seem particularly attracted to land and buildings as security. For
example, at 31 March 2020, non-current assets had a carrying amount (the value at which they
appeared in the statement of financial position) of $587 million, but long-term borrowing was only $300
million (although there was also an overdraft of $76 million). Carrying amounts are not often a reliable
guide to current market values. Thus, land and buildings, which tend to increase in value during
periods of inflation, may have market values that exceed their carrying amount.
Lower operating profit. Although sales revenue expanded by 20% between 2019 and 2020, both
cost of sales and operating expenses rose by a greater percentage, leaving both gross profit and,
particularly, operating profit massively reduced. The level of staffing, which increased by about 33%
(from 13,995 to 18,623 employees—see Note 6), may have greatly affected the operating expenses.
(Without knowing when the additional employees were recruited during 2020, we cannot be sure of
the effect on operating expenses.) Increasing staffing by 33% must put an enormous strain on
management, at least in the short term. It is not surprising, therefore, that 2020 was not successful for
the business—not, at least, in profit terms.
Having had a quick look at what is fairly obvious, without calculating any financial ratios, we shall now go
on to calculate and interpret some.
Concept check 1
Which of the following statements is false?
A. There is no generally accepted list of ratios that can be applied to the financial
statements.
B. When comparing the financial health of different businesses, the differences that
exist in the scale of operations pose a major problem.
C. It is important to appreciate that ratios are really only the starting point for further
analysis.
D. Standard methods of calculation exist for each of the various ratios.
E. None of the above is false.
Concept check 2
Which of the following provides a good benchmark, or basis for comparison, for ratio
evaluation?
A. Industry average
B. Past performance
C. Budgeted performance
D. Similar businesses
E. All of the above.
Concept check 3
Financial ratios are usually divided into five key categories. Consider the descriptions of
those shown in list A and match them to the appropriate category shown in list B.
List A
1. These ratios are concerned with returns from, and the performance of, shares.
2. These ratios include calculations of the time taken to pay suppliers.
3. These ratios include a comparison of non-current liabilities and equity.
4. These ratios are concerned with the availability of cash, or near cash, to meet
maturing obligations.
5. These ratios include calculations of the returns from long-term funds invested in the
business.
List B
1. Financial gearing ratios
2. Profitability ratios
3. Investment ratios
4. Liquidity ratios
5. Efficiency ratios
Profitability ratios
LO 2 Identify the main ratios used to analyse profitability, and apply these ratios to a business
The following ratios may be used to evaluate the profitability of the business:
ROSF = Profit after taxation and any preference dividendAverage ordinary share capital plus reserves×100
The profit after taxation and any preference dividend is used in calculating the ratio, as this figure
represents the amount of profit available to the owners. In the above equation, ‘reserves’ means all
reserves, including general reserves, revaluation reserves and retained profits.
In the case of Alexis Ltd, the ratio for the year ended 31 March 2019 is:
Note that, when calculating the ROSF, the average of the figures for ordinary shareholders’ funds as at
the beginning and at the end of the year has been used. This is because an average figure is normally
more representative. The amount of shareholders’ funds was not constant throughout the year, yet we
want to compare it with the profit earned during the whole period. We know, from Note 8, that the amount
of shareholders’ funds at 1 April 2018 was $438 million. By a year later, however, it had risen to $563
million, according to the statement of financial position as at 31 March 2019.
The easiest approach to calculating the average amount of shareholders’ funds is to take a simple
average based on the opening and closing figures for the year. This is often the only information
available, as is the case with Example 8.1 (page 330). Averaging is normally appropriate for all ratios
that combine a figure for a period (such as profit for the year) with one taken at a point in time (such as
shareholders’ funds).
Where even the beginning-of-year figure is not available, it will be necessary to rely on just the year-end
figure. This is not ideal, but, if this approach is consistently applied, it can produce ratios that are useful.
Broadly, businesses seek to generate as high a value as possible for this ratio. This is provided that it is
not achieved at the expense of potential future returns by, for example, taking on more risky activities. A
return of 33% is a very good return.
Note in this case that the profit figure used is the operating profit (i.e. the profit before interest and
taxation), because the ratio attempts to measure the returns to all suppliers of long-term finance before
any deductions for interest payable to lenders, or payments of dividends to shareholders, are made.
For the year to 31 March 2019, the ROCE ratio for Alexis Ltd is:
ROCE=243(638 + 763)/2×100=34.7%
(The capital employed figure, which is the total equity plus non-current liabilities, at 1 April 2018 is given in
Note 8.)
Activity 8.3
Calculate the return on capital employed for Alexis Ltd for the year ended 31 March 2020.
Real World 8.1 provides some figures as to the level of return on equity and capital employed in
practice.
In a number of articles written in 2018 and 2019, Phil Ruthven (chair of the Ruthven Institute)
provided evidence of considerable variability of profitability in terms of return on shareholder funds
after tax for Australian companies. Australia’s best 100 enterprises ‘averaged a huge 47% ROSF
during the three years to 2018’. These ranged from 363% to just over 30%. Somewhat surprisingly
Philip Morris came in second with a ROSF of 231%. However, returns on ‘the totality of the
nation’s enterprises’ was only 3.8% average over the past three decades. Australia’s largest 100
corporations only averaged an 8.7% return over the past three years. World best practice
corporations should make more than 22%. Only one in eight of Australia’s 2,000 largest
companies achieve this.
Sources: Phil Ruthven, ‘It takes more than luck to achieve strong profitability’, The Australian, 12 September 2018.
Phil Ruthven, ‘Our underperforming businesses need to lift their game’, The Australian, 12 June 2019.
Microsoft maintained a return on equity above 20% until the end of 2014. In 2015, due to goodwill
and other impairment charges, this reduced to 14.36%. Over the 10 years to 2015 it achieved an
average of 34.57%. Over the three-year period ending 2018 the returns were 25%, close to 30%
and just under 20%.
Apple achieved a 10-year average return on equity of 34% over the 10-year period to 2015.
However, it has had higher returns than Microsoft over the past three years to 2015 due to higher
income growth. Figures for 2016, 2017 and 2018 were 37%, 37% and 49%, respectively.
Source: Steven Nickolas, ‘Analyzing Microsoft’s return on equity (ROE)’, Investopedia, 13 February 2016, www.investopedia.com.
Woolworths has had a return on equity in the six years to 2019 ranging from a low of 14.4% in
2016 to a high of 26.1% in 2019. There were significant items relating to impairments in 2016.
Wesfarmers has had a return on equity over the five years to 2018, ranging for 9.6% in 2016 to
12.4% in 2017. In 2019 it produced a return of 19.2%. In its report it shows detailed figures for
return on capital employed for its various divisions for 2019. These are interesting and underline
the substantial differences in the elements of the total conglomerate. The figures are:
Bunnings 50.5%
Officeworks 17%
Industrials 18.5%
There are a range of variations to these ratios that are found in practice. For example, both Qantas
and REX use a figure called ‘return on invested capital’.
The figure for REX for ‘invested capital’ is basically total assets, less payables, revenue received in
advance, and provisions, plus any off-balance sheet debt, which is effectively the same as (or very
close to) ROCE, just starting with assets and deducting current liabilities.
Another quite popular alternative to ROCE is return on total assets, which is arrived at by dividing profit
before interest and tax by average total assets.
It is important to recognise that the ratios used above reflect the book value of the assets. From an
investor perspective it is the amount paid for the shares that is important in calculating a return, and this is
dealt with in more detail in a later section. Suffice it to say at this stage that the return on equity earned by
a successful company will result in the share price being bid up very quickly. In a 2019 article Don
Stammer provided figures which showed that that the average real (i.e. after inflation) rate of return
(before tax) on Australian shares was 8.9% in the 1960s, 8.7% in the 1980s, 5.4% in the 2000s (in spite
of the global financial crisis), and 5.3% to date for the current decade (Don Stammer, ‘Three themes to
consider when pondering share returns’, The Australian, 11 June 2019).
Reflection 8.1
You have inherited $50,000 from your grandmother. You are thinking of buying shares in Microsoft
or Apple, based on their returns on equity. Is this wise? A friend has suggested that Wesfarmers is
a very safe bet. How you might choose between these two options?
The operating profit (profit before interest and taxation) is used in this ratio as it represents the profit from
trading operations before any costs of servicing long-term finance are taken into account. This is often
regarded as the most appropriate measure of operational performance for comparison purposes, as
differences arising from the way a particular business is financed will not influence this measure.
However, this is not the only way this ratio may be calculated in practice. The profit after taxation is also
sometimes used as the numerator.
For Alexis Ltd for the year ended 31 March 2019, the operating profit margin ratio is:
Activity 8.4
Calculate the operating profit margin for Alexis Ltd for the year ended 31 March 2020.
For Alexis Ltd for the year ended 31 March 2019, the ratio is as follows:
An adequate gross profit margin for a manufacturing and retail operation is essential to its success. An
inadequate gross profit margin will mean that the business has little likelihood of success. The gross profit
must cover the other expenses, and give the owners a satisfactory return. The adequacy of this margin
depends on both the buying price (or manufactured cost) and the selling price.
Activity 8.5
Calculate the gross profit margin for Alexis Ltd for the year to 31 March 2020.
What do you learn from a comparison of the profitability ratios over the two years?
Real World 8.2 sets out gross margins and operating margins achieved by a variety of businesses.
Microsoft had an operating profit margin between 28% and 32% for each of the five years from
2014 to 2018, other than for 2015, where the figure was just over 19%. The 2015 figure included
substantial impairments and integration and restructuring costs. If these had been ignored the
return would have been approximately 30%. Its gross profit margin for the same period ranged
between 64% and 69%.
Apple achieved an operating profit margin of between 26.7% and 27.8% for the three years from
2016 to 2018. Its gross profit margin for the same period ranged from 38% to 39%.
Woolworths achieved an operating margin over the six years to 2019 ranging from 3.9% to 6.8%.
It had a gross profit margin for the same six-year period which varied only slightly, from a minimum
of 27.4% to 29.5%.
Myer, another well-known retailer, although with a completely different product mix, has been
going through some difficult times, as has much of the retail sector. Its gross profit and operating
profit margins can be calculated from information in its annual reports. Over the past five years the
gross profit has remained virtually identical year-on-year, in the high forties. Operating profit
margins are quite low, and variable, especially in 2018 when a huge loss was made, mainly due to
restructuring and impairments. If the costs of restructuring and impairments are excluded in 2018
the operating profit margin comes in at 1.8%. Over the past five years operating margins excluding
these costs vary between 1.3% and 2.9%.
Target operating profit margins for some well-known car manufacturers generally fall in the 8% to
10% range, although Volkswagen and Renault had lower figures. By the end of 2016, gross profit
margins in the industry were generally in the range between 13% and 21%.
Clearly the profitability ratios differ quite substantially across different types of business. In order for
anyone to be able to analyse performance effectively they must have a reasonable understanding of the
particular industry or sector they are analysing.
It should be noted that some detailed ratios relating to conglomerates (e.g. Wesfarmers) can be difficult, if
not impossible, to calculate, as there is insufficient detail in the published information. Also, in practice,
some ratios can be calculated in slightly different ways. You should always try to ensure that you are
comparing like with like.
Reflection 8.2
Small business can be very competitive. Returns on equity achieved can be quite variable under
these circumstances. Do you think that it is appropriate to develop plans that target a desired
ROSF/ROE? If so, what kind of target returns do you think might be appropriate over time for Tim,
in the case study of Chapter 6 , and our young restaurateur, Lucas, whom we met in Chapter
2 and in later Reflections. How do you think they might respond to lower than target returns in
the early years of their new businesses?
Concept check 4
Which of the following is not one of the main ratios used to assess profitability?
A. Operating profit margin
B. Gross profit margin
C. Return on total shareholders’ equity
D. Return on capital employed
E. All of the above ratios are used to assess profitability.
Concept check 5
Which profitability ratio relates the amount of sales revenue less the cost of sales to the total
sales revenue for the period?
A. Operating profit margin
B. Gross profit margin
C. Return on shareholders’ equity
D. Return on capital employed
E. All of the above ratios are used to assess profitability.
Concept check 6
Which profitability ratio expresses the relationship between the operating profit generated
during a period and the average long-term capital invested in the business during that
period?
A. Operating profit margin
B. Gross profit margin
C. Return on shareholders’ equity
D. Return on capital employed
E. All of the above ratios are used to assess profitability.
Efficiency ratios
LO 3 Identify the main ratios used to analyse efficiency regarding usage of assets, and apply these
ratios to a business
Efficiency ratios are used to try to assess how successfully the various resources of the business are
managed. The following ratios consider some of the more important aspects of resource management:
The average inventory for the period can be calculated as a simple average of the opening and closing
inventory levels for the year. However, in the case of a highly seasonal business, where inventory levels
may vary considerably over the year, a monthly average may be more appropriate. Although useful for
external users, this monthly average information is not usually available, though. This point about monthly
averaging is equally relevant to any asset or claim that varies over the reporting period, including trade
receivables and trade payables.
For Alexis Ltd the inventories turnover period for the year ended 31 March 2019 is:
Inventories turnover period=(241 + 300)/21,745 × 365=56.6 days
(The opening inventories figure was taken from Note 3 to the financial statements.)
This means that, on average, the inventory held is being ‘turned over’ every 56.6 days. So, a carpet
bought by the business on a particular day would, on average, have been sold about eight weeks later. A
business normally prefers a low inventories turnover period to a high period, as funds tied up in inventory
cannot be used for other profitable purposes. In judging the amount of inventory to carry, the business
must consider such things as the likely future demand, the possibility of future shortages, the likelihood of
future price rises, the cost advantages of buying in larger quantities, the amount of storage space
available and the perishability/susceptibility to obsolescence of the product. The management of inventory
is explained in more detail in Chapter 13 .
This ratio is sometimes expressed in terms of months or weeks rather than days. Multiplying by 12 or 52,
rather than 365, will achieve this.
Activity 8.6
Calculate the average inventory turnover period for Alexis Ltd for the year ended 31 March 2020.
We are told that all sales made by Alexis Ltd are on credit, and so the average settlement period for
accounts receivable for the year ended 31 March 2019 is:
Activity 8.7
Calculate the average settlement period for accounts receivable for Alexis Ltd for the year end ed 31
March 2020.
This ratio provides an average figure which, like the average settlement period for accounts receivable,
can be distorted by the payment period taken by one or two large suppliers.
As accounts payable provides a free source of finance for the business, it is perhaps not surprising that
some businesses attempt to increase their average settlement period for accounts payable. However,
such a policy can be taken too far and result in the loss of suppliers’ goodwill. We will return to the issues
of managing accounts receivable and accounts payable in Chapter 13 .
In the case of Alexis Ltd, for the year ended 31 March 2019 the average settlement period is:
Activity 8.8
Calculate the average settlement period for accounts payable for Alexis Ltd for the year ended 31 March
2020.
Generally speaking, a higher sales revenue to capital employed ratio is preferred to a lower one. A higher
ratio will normally suggest that assets are being used more productively in the generation of revenue.
However, a very high ratio may suggest that the business is ‘over-trading on its assets’; that is, it has
insufficient assets to sustain the level of sales revenue achieved. When comparing this ratio for different
businesses, factors such as the age and condition of assets held, the valuation bases for assets, and
whether assets are leased or owned outright can complicate interpretation.
A variation of this formula is to use the total assets less current liabilities (which is equivalent to long-term
capital employed) in the denominator (the lower part of the fraction). The identical result is obtained. This
ratio is also sometimes known as the ‘asset turnover ratio’.
For the year ended 31 March 2019, this ratio for Alexis Ltd is:
Activity 8.9
Calculate the sales revenue to capital employed ratio for Alexis Ltd for the year ended 31 March 2020.
Generally, businesses would prefer a high value for this ratio, implying that they are using their staff
efficiently.
For the year ended 31 March 2019, the ratio for Alexis Ltd is:
Activity 8.10
Calculate the sales revenue per employee ratio for Alexis Ltd for the year ended 31 March 2020.
Comment on the efficiency ratios and their relationship to the ratios for the year ended 31 March 2019.
Alternative formats
The first three efficiency ratios have been expressed in terms of a turnover period (number of days). An
alternative is to express them simply as the number of times that asset (or liability) turns over (repeats
itself) on average during the year. The formula for such ratios is simply the appropriate figure from the
statement of financial performance (e.g. cost of sales, credit sales and credit purchases) divided by the
average statement of financial position figure (inventory, accounts receivable, accounts payable).
If you know the turnover figure (e.g. 3.2 times), you can get the turnover period by dividing 365 days by
the turnover (e.g. 365 days/3.2=114 days). Similarly, if you know the turnover period (e.g. 49 days), you
can get the turnover by dividing 365 days by the turnover period (e.g. 365 days/49 days=7.45 times). For
the worked examples, the turnovers would be:
2019 2020
Real World 8.3 provides some guidance on what ratios are found in practice.
Over the five-year period to 2018 the Ford Motor Company has the following results:
Average inventory processing period (days) —a figure which steadily rose from 23 days to 30
days.
Average receivable collection period—a figure which varied between 27 and 31 days.
Average payables payment period—a figure which steadily rose from 59 to 65 days by 2017,
before going back down in 2018 to 58. Inventory turnover—a figure which steadily went down from
15.70 to 12.15.
Receivables turnover—a figure which varied between 11.6 and 13.74. Payables turnover—a figure
which steadily declined from 6.17 to 5.64 in 2017, before going back up to 6.33 in 2018.
The reductions in the inventory and payables turnover should have been a cause for concern over
time.
Woolworths figures for 2014–2019 can be estimated from their annual reports.
Inventory turnover periods (taken from the summary page in the 2018 report) vary between 25.5
and 29 days. These figures are calculated using inventory/sales, not inventory and cost of sales.
The figures for 2019 are 26 days using sales/inventory and 37 days for the more normal
calculation using cost of sales and inventory. Payables payment periods vary between 27 and 47
days, with the past four years being 39 days or higher (using year-end ‘trade payables’/cost of
sales).
The receivables collection period can be estimated, but given the nature of the company with very
few credit customers, the figures (five or six days) will be meaningless.
Approximations can be made regarding Apple. However, the inventories are relatively
insignificant, so a ratio showing about eight days is meaningless.
Regarding the payables payment period, the question needs to be raised as to just what expenses
need to be related to the creditors. Possibilities include the cost of sales and selling, and general
and administrative expenses. If we assume that creditors all relate to cost of sales, we get figures
for 2017 and 2018 of 114 days and 144 days.
Regarding the receivables collection period, we can calculate for 2017 and 2018 figures of 28 and
31 days.
We can see that the companies for which calculations are made all take much longer to pay their
creditors than they allow for their debtors (receivables). This is a recurring problem with large companies
which we shall return to in Chapter 13 .
Reflection 8.3
Should payment of debts within a reasonable period (say one month) be a moral or ethical
imperative for all companies? Given the idea raised in Chapter 5 that listed companies have a
social responsibility, does this put greater pressure on listed companies to pay reasonably quickly?
where long-term capital comprises share capital plus reserves plus long-term borrowings. This ratio can
be broken down into two elements, as shown in Figure 8.2 . Essentially, if we multiply the ROCE by
Sales/Sales (which is obviously 1), we can split the ROCE ratio into its two component parts. The first
ratio is the operating profit margin ratio, and the second is the sales revenue to capital employed (net
asset turnover) ratio, both of which we discussed earlier.
The ROCE ratio can be divided into two elements: operating profit to sales revenue and sales revenue to
capital employed. By analysing ROCE in this way we can see the influence of both profitability and
efficiency on this important ratio.
By breaking down the ROCE ratio in this manner, we highlight the fact that the overall return on funds
employed within the business will be determined both by the profitability of sales and by efficiency in the
use of capital. Consider Example 8.2 .
EXAMPLE
8.2
Consider the following information, for last year, concerning two different businesses operating in
the same industry:
$m $m
Operating profit 20 15
This demonstrates that a relatively high sales revenue to capital employed ratio can compensate
for a relatively low operating profit margin. Similarly, a relatively low sales revenue to capital
employed ratio can be overcome by a relatively high operating profit margin. In many areas of
retail and distribution (e.g. supermarkets and delivery services) operating profit margins are quite
low but the ROCE can be high, provided that the assets are used productively (i.e. low margin,
high sales revenue to capital employed).
Example 8.3 illustrates how the ROCE of Alexis Ltd can be analysed into the two elements for each of
the two years 2019 and 2020.
EXAMPLE
8.3
Alexis Ltd’s ROCE can be analysed as shown below.
Clearly, the main issue relates to the operating profit margin, rather than sales revenue to capital
employed. The business was marginally more effective at generating sales revenue (i.e. the sales
revenue to capital employed ratio increased) in 2020 than in 2019. However, in 2020 the operating
profit margin fell substantially, with the result that ROCE also declined dramatically. Further
analysis is needed as to where the inefficiencies relating to operating costs arose.
Concept check 7
Which efficiency ratio provides an indication of the efficiency of the firm’s collection
department and/or appropriateness of customer credit policy?
A. Average inventories turnover period
B. Average settlement period for accounts receivable
C. Average settlement period for accounts payable
D. Sales revenue to capital employed
E. Sales revenue per employee.
Concept check 8
Which of the following ratios might be increased if the idea that credit provides a free source
of finance (e.g. improved cash flow) for the business were taken into account?
A. Average inventories turnover period
B. Average settlement period for accounts receivable
C. Average settlement period for accounts payable
D. Sales revenue to capital employed
E. Sales revenue per employee.
Concept check 9
The draft financial statements of Summerwine Ltd for the year ended 31 December 2020
include the following:
Sales revenue $240 million
It is subsequently discovered that $30 million of this sales revenue relates to 2021 and that
inventories valued at $10 million have been omitted from the closing inventories for 31
December 2020. After correction of these errors, the gross profit ratio will be:
A. 33.3%
B. 19.0%
C. 9.5%
D. 23.8%
Liquidity
LO 4 Identify the main ratios used to analyse liquidity, and apply these ratios to a business
Liquidity ratios assess how well the business can meet short-term commitments or claims against the
assets when they fall due. This ratio is sometimes expressed in terms of the ability or speed with which
assets can be converted to cash. The following ratios consider some of the more important aspects of the
reporting entity’s liquidity position:
Current ratio
The current ratio compares the business’s ‘liquid’ assets (i.e. cash and those assets held that will
soon be turned into cash) with the short-term liabilities (current liabilities). The ratio is calculated as
follows:
current ratio
A liquidity ratio that relates the current assets of the business to the current
liabilities.
Some texts suggest the notion of an ‘ideal’ current ratio (usually 2 times or 2:1) for a business. However,
this fails to take into account the fact that different types of businesses require different current ratios. For
example, a manufacturing business will often have a relatively high current ratio because it must hold
stocks of finished goods, raw materials and work-in-progress. It will also normally sell goods on credit,
thereby incurring accounts receivable. A supermarket chain, on the other hand, will have a relatively low
current ratio as it will hold only fast-moving stocks of finished goods and will generate mostly cash sales.
The higher the ratio, the more liquid the business is considered to be. As liquidity is vital to the survival of
a business, a higher current ratio is normally preferred to a lower ratio. However, a business with a very
high current ratio may have funds that are tied up in cash or other liquid assets, and so are not being
used as productively as they might be.
For the year ended 31 March 2019, the current ratio of Alexis Ltd is:
The ratio reveals that the current assets cover the current liabilities by 1.9 times.
Activity 8.11
Calculate the current ratio for Alexis Ltd for the year ended 31 March 2020.
The minimum level for this ratio is often stated as 1.0 times (or 1:1; i.e. current assets, excluding
inventories, equal current liabilities). In some types of business, however, where cash flows are strong, it
is not unusual for the acid test ratio to be below 1.0 without causing liquidity problems.
The acid test ratio for Alexis Ltd for the year ended 31 March 2019 is:
We can see that the ‘liquid’ current assets do not quite cover the current liabilities, and so the business
may have liquidity problems.
Activity 8.12
Calculate the acid test ratio for Alexis Ltd for the year ended 31 March 2020.
What do you deduce from the liquidity ratios for 2019 and 2020?
Both the current ratio and the acid test ratio derive the relevant figures from the statement of financial
position. As this statement is simply a snapshot of the financial position of the business at a single
moment in time, care must be taken when interpreting the ratios. It is possible that the figures from the
statement of financial position do not truly represent the liquidity position during the year. This may be due
to exceptional factors or simply to the business being seasonal in nature, and these figures represent the
cash position at one particular point in the seasonal cycle only.
Real World 8.4 provides some examples of liquidity ratios found in practice.
Ford Motor Co had the following ratios for the five years to 2018.
Current ratio—a figure that varied between 0.68 and 1.23, with the past three years being around
1.2.
Quick ratio—a figure which ranged from 0.56 to 1.11, with the past three years being in a range
from 1.07 to 1.11.
Apple’s current ratio for each of the three years to 2018 ranged from 1.12 to 1.35.
Inventories were negligible, so the quick ratio would be virtually the same.
Woolworths has more current liabilities than current assets, which is not surprising when the low
level of receivables and the slow payment of payables is considered—see Real World 8.3.
Current ratio for the five years to 2018 ranged from 0.94 in 2014 to 0.73 in 2019.
Cochlear Ltd had ratios for the five years to 2019 as follows:
Concept check 10
Which of the following is a ratio that is typically used to assess liquidity?
A. Quick ratio
B. Current ratio
C. Acid test
D. Liquid ratio
E. All of the above.
Concept check 11
Which ratio compares current assets with current liabilities?
A. Quick ratio
B. Current ratio
C. Acid test
D. Liquid ratio
E. All of the above.
Financial gearing (leverage) ratios
LO 5 Identify the main ratios used to analyse financial gearing (leverage), and apply these ratios to a
business
Financial gearing occurs when a business is financed, at least in part, by contributions from outside
parties, typically borrowings. The level of gearing (i.e. the extent to which a business is financed by
outside parties) is often an important factor in assessing risk. A business that borrows heavily is
committed to pay interest charges and make capital repayments, a potential financial burden that can
increase its risk of becoming insolvent. Nevertheless, it is the case that most businesses are geared to
some extent.
financial gearing
The existence of fixed payment-bearing sources of finance (e.g. borrowings) in
the capital structure of a business.
With such risks involved, you may wonder why a business would want to take on gearing. One reason
may be that the owners have insufficient funds, and therefore the only way to finance the business
adequately is to borrow from others. Another reason is that gearing can be used to increase the returns to
owners, as long as the returns generated from borrowed funds exceed the cost of paying interest.
Example 8.4 illustrates this point.
EXAMPLE
8.4
Two companies, X Ltd and Y Ltd, commence business with the following long-term capital
structures:
X Ltd Y Ltd
$ $
300,000 300,000
In the first year of operations they both make an operating profit (profit before interest and taxation)
of $50,000. In this case, the tax rate is assumed to be 30% of the profit before tax but after
interest. X Ltd would be considered highly geared, as it has a high proportion of borrowed funds in
its long-term capital structure. Y Ltd has lower levels of gearing. The profit available to the
shareholders of each company in the first year of operations will be:
X Ltd Y Ltd
$ $
The return on shareholders’ funds (ROSF) for each company will be:
X Ltd Y Ltd
$ $
We can see that X Ltd, the more highly geared company, has generated a better return on
shareholders’ funds than Y Ltd. This is in spite of the fact that the return on capital employed is
identical for both businesses (i.e. ($50,000/300,000)×100=16.7%).
Note that at the $50,000 level of operating profit, the shareholders of both X Ltd and Y Ltd benefit
from gearing. Were the two businesses totally reliant on equity financing, the profit for the year
(after taxation profit) would be $35,000 (i.e. $50,000 less 30% taxation), giving an ROSF of 11.7%
(i.e. $35,000/$300,000). Both businesses generate higher ROSFs than this as a result of financial
gearing.
An effect of gearing is that returns to equity become more sensitive to changes in profits. For a highly
geared company, a change in profits can lead to a proportionately greater change in the returns to equity,
as illustrated in Example 8.5 .
EXAMPLE
8.5
Assume that the profit before interest and tax was 20% higher for each company in Example
8.4 than stated. How would this affect the return on owners’ equity?
The revised profit available to the shareholders of each company in the first year of operations will
be:
X Ltd Y Ltd
$ $
The return on shareholders’ funds for each company will now be:
X Ltd =28,000100,000×100=28%
Y Ltd =35,000200,000×100=17.5%
We can see from Example 8.5 that for X Ltd, the higher-geared company, the returns to equity have
increased by one-third (from 21% to 28%), whereas for the lower-geared company the benefits of gearing
are less pronounced. The increase in the returns to equity for Y Ltd is one-quarter (14%–17.5%). The
effect of gearing, of course, can work in both directions. Thus, for a highly geared company, a small
decline in profits may bring about a much greater decline in the returns to equity. If the ROSF is less than
the rate of interest charged on borrowings, the negative impacts of gearing become considerable.
The reason that gearing tends to be beneficial to shareholders is that interest rates for borrowings are low
by comparison with the returns that the typical business can earn. On top of this, interest expenses are
tax-deductible, in the way shown in recent examples. This makes the effective cost of borrowing quite
cheap. It can be argued that, since borrowing increases the risk to shareholders, there is a hidden cost of
borrowing. Whatever your view of this, there is little doubt that there are benefits to the shareholders of
the tax-deductibility of interest on borrowings.
Figure 8.3 illustrates the effects of gearing, with the movement of the larger cog (operating profit)
causing a more than proportionate movement in the smaller cog (returns to ordinary shareholders).
The role of borrowed finance and the surrounding issues are picked up again in Chapter 14 .
The following ratios may be used to evaluate the gearing or long-term financial stability (solvency) of a
business:
Gearing ratio
The gearing ratio measures the contribution of long-term lenders to the long-term capital structure of a
business:
This ratio reveals a level of gearing that would not normally be considered as very high.
Activity 8.13
Calculate the gearing ratio for Alexis Ltd for the year ended 31 March 2020.
Other variations of the gearing ratio focus mainly on the proportion of outside debt to owners’ equity.
These include:
When comparing the gearing ratio calculated for a particular business with those calculated for other
businesses (or industry averages), great care needs to be taken to ensure that the two sets of figures are
comparable (i.e. use the same basis of calculation). The third ratio mentioned above is fairly commonly
used (as in Real World 8.6 , page 352).
The ratio for Alexis Ltd for the year ended 31 March 2019 is:
This ratio shows that the level of profit is considerably higher than the level of interest expense. Thus, a
significant fall in profits could occur before profit levels failed to cover interest expense. The lower the
level of operating profit coverage, the greater the risk to lenders that interest payments will not be met.
There will also be a greater risk to the shareholders that the lenders will take action against the business
to recover the interest due.
Activity 8.14
Calculate the interest coverage ratio for Alexis Ltd for the year ended 31 March 2020.
What do you deduce from a comparison of the gearing ratios of Alexis Ltd over the two years?
Real World 8.5 provides information about gearing ratios found in practice.
Woolworths has a reported financial leverage ratio for the six years to 2019 which varied between
2.2 and 2.6.
This is calculated using average total assets divided by average shareholders’ equity for the year.
This represents another variation on the same theme.
Using the figures for the three years from 2016 for (non−current liabilities/(non
−current liabilities+equity) we find figures between 24% and 35%. These figures suggest a
conservative approach to use of debt.
Woolworths also uses two coverage ratios along the lines of the interest coverage ratio.
One is known as the service cover ratio, which is calculated as earnings before interest and
tax (before significant item) divided by the sum of net financing costs and hybrid notes interest.
A second is known as the fixed charges cover, which is calculated by earnings before interest
and taxes, depreciation, amortisation and rent divided by interest and rent.
Wesfarmers show figures for net financial debt and shareholders’ equity, so we can calculate a
ratio based on net debt/(net debt+equity). The figures for 2017 to 2019 are 15%, 13% and 20%,
respectively, reinforcing the fact that the company uses debt very carefully and conservatively.
In its 2018 annual report the company indicated that it had a strategy of diversifying its funding
strategies and had an (all-in) effective borrowing cost of 4.14% (p. 21). By 2019 this had gone up
to 5% (p. 22).
If we were to use the ratio based on term debt/(term debt+equity), these figures go down to 37% in
2016, and to 46% in 2018.
The ratios found in practice are often variations from those suggested in this text. It is important that you
compare like with like, although this can sometimes be difficult. In many instances you may have to dig
quite deeply to calculate the appropriate ratio.
Risks associated with leverage with low-debt companies like Wesfarmers and Woolworths are minimal,
so, remembering the risk–return trade-off introduced in Chapter 1 , the expected returns from
businesses like this are likely to be lower than those from more highly leveraged businesses. Also, we
need to remember that we are not just looking at ratios individually, but at a more comprehensive picture
overall. For Wesfarmers the leverage ratios can be supplemented by strong operating cash flows and free
cash flow.
The potential advantages of gearing are clear. However, just how far to go with debt remains a difficult
question. The global financial crisis of 2008 changed attitudes towards risk in general and to debt in
particular. Over the period since the crisis, gearing ratios have trended downwards. Real World 8.6
provides an indication of the way gearing ratios have moved since 2009, and some of the implications of
the use of high levels of debt. Since that time, capital raisings have continued (an area which will be
covered in Chapter 14 ), with a consequent reduction in gearing. In spite of this, questions continue
regarding the use of debt, both at a corporate level and at a personal level.
Real world 8.6
Changing gear
In early 2009 Jeremy Grant wrote an article in the Financial Times commenting on a changing
level of debt in corporate structures as a result of the global financial crisis (GFC). There had been
a move to much more conservative balance sheets linked to a number of new issues of capital.
Gearing—as measured by net debt as a proportion of shareholders’ funds, which had run at an
average of about 30% over the past 20 years—was expected to come down to about 20% and
stay there for some time. The point was made that reducing gearing was not easy, especially for
the most indebted companies, and new equity raising would not be easy for companies with highly
leveraged balance sheets.
Source: Jeremy Grant, ‘Gearing levels set to plummet’, Financial Times, 10 February 2009. © The Financial Times Limited 2009. All rights reserved. FT and
‘Financial Times’ are trademarks of The Financial Times Ltd. Pearson Australia is responsible for providing this adaptation of the original article.
While it needs to be recognised that this article was written from a British perspective, which faced
a more recessionary environment than Australia, the trends identified were fairly universal. There
is little doubt that, since the time of the writing of this article, much has taken place that reinforces
these points. In an article written early in 2016, Paul Kelly argued that the failure of economies to
recover from the GFC had led to ‘weak growth, low or negative interest rates, rising asset prices,
more inequality and poor investment’. Interest rates are still very low, a fact that may encourage
the greater use of debt. In an article written in September 2018, Ticky Fullerton quotes Jim
Rickards, a Wall Street expert, as saying: ‘I’ve seen nothing in risk management policies, talking to
the major banks, that indicates any lessons that have been learned or any improvements have
been made.’
Sources: Paul Kelly, ‘Staying smart in dangerous post-GFC world’, The Australian, 13 April 2016. Ticky Fullerton, ‘Cries of “wolf” long ignored on Wall Street’, The
More than two years later, these fears had become a reality, as declining prices hit copper and
coal. Losses for the first half of 2015 were US$676 million, and the share price fell by nearly three-
quarters. Glencore had an estimated net debt of US$50 billion. At the time Scott Patterson and
John Miller reported that a US$10 billion reduction plan was being developed, which included the
suspension of dividends and capital raising of US$2.5 billion.
In The Weekend Australian, Stephen Bartholomeusz reported that by mid-December the debt
reduction target had been revised to US$13 billion and ‘$US8.7bn had already [been] achieved or
locked in. ... If all goes according to plan, it will have reduced its overall net debt from its peak of
almost $US50bn to about $US33bn by the end of next year.’
This was achieved and borrowings have been maintained at that level to the middle of 2018.
Reuters reporters Barbara Lewis and Arathy S. Nair recounted: ‘In the depth of the crash,
Glencore sold 50 percent of its agricultural business to two Canadian investment funds, which
helped to reduce its debts but limited some of the upside for its marketing business.’ With the
rebound in the commodities market, Glencore had its ‘strongest on record’ set of results in 2017,
and the interim results for 2018 were even better. In passing it is interesting to note that the debt
for Glencore is often given ‘net’, which means that the total borrowings are offset by a figure for
‘readily marketable inventories’.
Sources: Scott Patterson and John W. Miller, ‘Glencore pays the price for high debts, aggressive deals’, The Wall Street Journal, 3 October 2015.
Stephen Bartholomeusz, ‘Blindsided miners Glencore and Anglo rush to fix balance sheet blues’, The Weekend Australian, 12–13 December 2015.
Barbara Lewis and Arathy S. Nair, ‘Glencore hails strongest full-year results after commodity rally’, UK Reuters, 21 February 2018.
Fortescue is an example of a company that has benefited from reductions in debt. A strategy of
debt and cost reduction was developed in a tough economic period for commodities. Matt
Chambers reported that a ‘bumper first-half profit saw debt reduced by $US1.7 billion ($2.21 bn)
and a record dividend ...’ ‘Fortescue’s net gearing is now 30 per cent, well below its target of 40
per cent.’
Sources: Sarah-Jane Tasker, ‘Fortescue Metals shares soar as debts slashed’, The Australian Business Review, 29 January 2016.
Matt Chambers, ‘Fortescue paying down debts and delivering Twiggy a $207m dividend’, The Australian Business Review, 23 February 2017.
The examples included here should be seen as ongoing, and so you should find it useful as time
goes by to examine what has happened since the time of writing.
Reflection 8.4
Your friend who is running a fintech business is relaxed about debt, as current interest rates are
very low. You are less relaxed about this, as your reading about low interest is that it implies that
the economy is in poor shape. What factors should your friend consider in deciding on the amount
of debt to use? What steps should be considered to avoid running into financial strife?
An aside on personal debt
So far in the chapter we have been concerned with levels of corporate debt. However, similar concerns
have existed for several years regarding levels of government and personal (or household) debt. Don
Stammer, in his article ‘Avoid future shocks: six steps for managing rising household debt, good and bad’
(27 October 2015, The Australian, News Corp Australia), identified the size of the problem as far as
household debt is concerned.
Below is an outline of the extent of the increase in levels of household debt between 1995 and 2015:
The household debt to assets ratio almost doubled from around 15% to 30%.
The interest payments to income ratio went from about 6% in 1995 through to about 12% in 2010, to
about 9% in 2015.
The debt to income ratio increased from around 60% to approximately 150%.
Household savings were close to 10% in 2015, a figure which was as high as it had been for the past 20
years. Interest rates at that time were extremely low, which makes debt seemingly affordable, but then
has the potential to lead to a very high debt to income ratio. Even moderate increases in interest rates
can impose a burden on many households. The figure for debt to income can be justified only if we
assume that the chance of increased interest rates is extremely low.
A more recent web posting, ‘Australians’ household debt nears highest worldwide’ on 31 October 2018,
reinforces this (www.finder.com.au). Australia’s household debt is now the fourth highest in the world
behind Denmark, the Netherlands and Norway. As of 2016, the average Australia household owes
$250,000. This is split as follows: mortgages 56.3%, investor debt 36.5%, personal debt 3.1%, student
debt 2.1% and credit card debt 1.9%.
In the latter half of his article, Stammer provided some guidance for managing household debt, which is
summarised below.
Interestingly, Stammer pointed out that the average (non-financial) listed company had debt equal to 55%
of its equity value. The October 2018 web article suggested three main strategies for managing your debt:
consolidate bad debts, create a budget, and set up a regular savings account.
ASIC’s moneysmart website (https://www.moneysmart.gov.au) has a section ‘Managing Debts’ in its
‘Managing your money’ tab. It suggests the following:
The essence of these articles is that, as with corporate debt, debt when used wisely can enhance wealth.
Used excessively or thoughtlessly, on the other hand, debt can lead to significant reductions in wealth or
even financial oblivion.
Reflection 8.5
Given the importance of mortgages to Australian households in purchasing homes, how might you
determine just how large a mortgage you would be prepared to take out? How might you build a
buffer just in case interest rates rise substantially? What difference would it make to your decision
if the mortgage was for an investment property? Do you have a maximum figure in mind for the
ratio of your debt to your income?
Concept check 12
Financial gearing:
A. Is the result of borrowing from outside parties
B. Is an important factor in assessing the riskiness of a firm’s financial structure
C. Can be used to increase returns to owners
D. Can result in insolvency (e.g. GFC)
E. All of the above.
Concept check 13
Which of the following is NOT a typical measure of financial gearing?
A. Total assets to total liabilities
B. Interest cover ratio
C. Total liabilities to total owners’ equity
D. Long-term liabilities to total owners’ equity
E. None of the above (e.g. all are typical measures of gearing).
Investment ratios
LO 6 Identify the main ratios used to analyse investment performance, and apply these ratios to a
business
The following ratios have been designed to help investors assess the returns on their investment:
Dividend payout ratio=Dividends announced for the yearEarnings for the year available for dividends×100
In the case of ordinary shares, the earnings available for dividends will normally be the profit after taxation
and after any preference dividends announced during the period. This ratio is normally expressed as a
percentage.
The dividend payout ratio for Alexis Ltd for the year ended 31 March 2019 is:
Activity 8.15
Calculate the dividend payout ratio for Alexis Ltd for the year ended 31 March 2020.
The information provided by this ratio is often expressed slightly differently as the dividend cover
ratio . Here the calculation is:
Dividend cover ratio=Earnings for the year available for dividendDividend announced for the year
In the case of Alexis Ltd (for 2019), it would be 165/40=4.1 times. That is to say, the earnings available for
dividends cover the actual dividends paid by just over four times.
The letter t represents the company tax rate, and this is explained below. This ratio is also expressed as a
percentage.
The numerator of this ratio requires some explanation. In Australia, investors are subject to income tax,
with rates depending on income. Companies are also subject to income tax at the company tax rate. It is
clearly not fair that investors should pay tax on income (i.e. dividends) that has already been taxed
(company profits). To avoid double taxation, a system known as the ‘imputation credit’ system has been
adopted. Under this system, an investor who receives a dividend from a company generally also receives
a tax credit—effectively the amount of income tax that would be payable by the company. In other words,
any dividend is deemed to have been paid out of profits taxed at the company tax rate. To avoid double
taxation, a tax credit is ‘imputed’. This means that, assuming a company tax rate of 30%, a dividend of
$70 will be given a tax credit of $30. The investor will be deemed to have received gross income of $100
($70+$30) and to have paid tax of $30. The ‘gross’ dividend will be calculated by multiplying the cash
dividend by (1/(1−t)), where t is the company tax rate. Hence, if dividends received are $70, the gross
dividends will be $70×(1/(1−0.30)), assuming the tax rate is 30%, which gives $100. So far as the
individual shareholder is concerned, the tax authorities will treat the $100 as income on which 30% tax
has been paid. It will then be up to the individual shareholder to make a return. You should check
precisely what the company tax rate is for the particular business at the particular time.
Investors may wish to compare the returns from shares with the returns from other forms of investment.
As these other forms of investment are often quoted on a gross (i.e. pre-tax) basis, it is useful to ‘gross
up’ the dividend when making such comparisons. This can be done by dividing the dividend per share by
(1−t), where t is the company tax rate.
Assuming an income tax rate of 30%, the dividend yield for Alexis Ltd for the year ended March 2019 is:
Note that the share capital was issued at 50¢ per share, which means that there are 600 million shares.
The dividend per share is therefore $40 million/600 million=6.7¢ per share.
Activity 8.16
Calculate the dividend yield for Alexis for the year ended 31 March 2020.
In the case of Alexis Ltd, the earnings per share for the year ended 31 March 2019 will be as follows:
Activity 8.17
Calculate the earnings per share for Alexis Ltd for the year ended 31 March 2020.
This ratio is regarded by many investment analysts as a fundamental measure of share performance. The
trend in earnings per share over time is used to help assess the investment potential of a company’s
shares. Although total profits can rise if ordinary shareholders invest more in the company, this will not
necessarily mean that the profitability per share will rise as a result.
It is not usually very helpful to compare the earnings per share of one company with those of another.
Differences in capital structures can render any such comparison meaningless. However, like dividends
per share, it can be very useful to monitor the changes that occur in this ratio for a particular company
over time.
Price/earnings ratio
The price/earnings (P/E) ratio relates the market value of a share to the earnings per share. This ratio
can be calculated as follows:
The P/E ratio for Alexis Ltd for the year ended 31 March 2019 will be:
Price/earnings ratio=$2.5027.5¢=9.1 times
You should note that the figure for earnings per share was calculated in the preceding section.
This ratio reveals that the capital value of the share is 9.1 times higher than its current level of earnings.
The ratio is, in essence, a measure of market confidence in the future of a company. The higher the P/E
ratio, the greater the confidence in the company’s future earning power and, consequently, the more
investors are prepared to pay in relation to the earnings stream of the company.
P/E ratios are a useful guide to market confidence in the future, and therefore can be helpful when
comparing different companies. However, differences in companies’ accounting policy choices (methods)
can lead to different profit and earnings per share figures, and this can distort comparisons.
The reciprocal of the P/E ratio, expressed as a percentage (i.e. (earnings×100)/market price per share),
provides a measure of earnings yield. Hence, a share with a P/E ratio of 10 would have an earnings yield
of 10%, whereas one with a P/E ratio of 20 would have an earnings yield of only 5%.
Activity 8.18
Calculate the price/earnings ratio of Alexis Ltd for the year ended 31 March 2020.
What do you deduce from the investment ratios calculated for Alexis Ltd for 2019 and 2020?
Real World 8.7 provides some dividend payout ratios for a range of businesses.
Woolworths—payout ratio before significant items 70.3% 71.7% 70.4% 70.7% 70.7% 72%
Wesfarmers—earnings per share excluding significant items (AU¢) 196.6 216.1 209.5 254.7 245.1 206.8
dividends per share (declared) 200 200 186 223 223 278
It should be noted that the basic earnings per share in 2016 were down to 36¢ per share after
significant items
Microsoft was slow to pay dividends, not paying regular dividends in the first 16 years of its life,
but preferring to reinvest for growth. In more recent years, however, the payout ratio has
increased. The figures for recent years are given below:
2014 2015 2016 2017 2018 2019
Diluted earnings per share (US$) 2.63 1.48 2.56 3.25 2.13 5.16
Dividends per share (US$) 1.07 1.21 1.39 1.53 1.65 1.84
Dividends are paid quarterly and have always been maintained or increased.
Santos has been through an extremely difficult few years with a hostile resources segment.
Results for the company are:
Underlying earnings per share for 2014 and 2015 were 54.3¢ and 4.3¢, respectively.
BHP has also gone through a tough trading period, particularly in 2015 and 2016:
Diluted earnings per share (US¢) 258.4 35.8 (120) 110.4 69.4 159.9
Underlying basic earnings per share (US¢) 252.7 133.7 22.8 126.5 167.8 176.1
Real World 8.8 provides information about the share performance of a selection of large, well-known
businesses. This type of information is provided on a daily basis by several newspapers.
Source: https://www.asx.com.au/asx/share-price-research/company/.
Code Stock Close % change Vol High Low Yield (%) ratio
ANZ ANZ Banking 26.61 +0.68 6,689,755 29.30 24.09 6.01 12.67
HVN Harvey Norman 4.80 +1.05 3,478,530 4.84 3.34 6.88 13.83
TLS Telstra Corp 3.77 +.027 25,176,746 3.98 3.02 2.65 21.79
WOW Woolworths Ltd 43.14 +.61 1,678,776 43.71 28.21 2.36 20.92
Concept check 14
Which of the following is not a typical investment ratio?
A. Dividend payback ratio
B. Dividend yield ratio
C. Earnings per share
D. Price/earnings (P/E) ratio
E. Dividend payout ratio.
Concept check 15
Which ratio relates the market value of a share to the earnings per share?
A. Dividend yield ratio
B. Earnings per share
C. Price/earnings (P/E) ratio
D. Dividend payout ratio
E. None of the above.
Concept check 16
Which ratio measures the proportion of earnings that a company pays out to shareholders
in the form of dividends?
A. Dividend yield ratio
B. Earnings per share
C. Price/earnings (P/E) ratio
D. Dividend payout ratio
E. None of the above.
Other aspects of ratio analysis
LO 7 Identify a range of other issues relating to financial analysis, including the main limitations of
ratio analysis
Trend analysis
It is important to see whether any trends can be detected by using ratios. Key ratios can be plotted on a
graph to give a simple visual display of changes occurring over time. The trends occurring in a company
may be plotted against trends in the industry as a whole for comparison purposes. An example of trend
analysis is shown in Figure 8.4 .
trend analysis
A form of analysis that uses trends, usually graphically or by percentage analysis.
The current ratio for a particular business (XYZ Ltd) is plotted over time. On the same graph, the same
ratio for the average of businesses in the same industry is also plotted, enabling comparison to be made
between the ratio for the particular business and the industry average.
Some companies publish certain key financial ratios as part of their annual report to help users identify
important trends. These ratios may cover several years. Woolworths provides an example. In its 2018
annual report, Woolworths provided a six-page summary of performance over five years, which sets out
its overall position and provides a basis for measuring performance. The information provided covers
details of the business generally, and considerable information relating to the three major financial
statements, together with associated ratios of the type described in this chapter (although inevitably there
are some variations from the ratios calculated in this chapter).
1. The common size reports , also known as ‘vertical analysis’. Under this method, the key
magnitude in the report becomes 100 and all other subsidiary figures are expressed as a
percentage of that figure. In the income statement (statement of comprehensive income), the key
figure is normally ‘sales’. In the statement of financial position, the key figure is normally ‘total
assets’, or ‘total liabilities plus equity’. However, you can modify the key figure to match the
analysis you wish to make.
2. Trend percentage. Under this method, all figures in an allocated base year are indexed as 100
and all subsequent years’ figures are expressed as a percentage of the base year figure.
3. Percentage change, also known as ‘horizontal analysis’. Under this method, the percentage
change for the year is shown for each line item.
Index analysis is easy and can readily highlight pleasing and disturbing trends in the financial reports over
time. The best way to explain these techniques is by way of an example (see Example 8.6 ) based on a
very basic income statement.
EXAMPLE
8.6
Income statement
$ $ $
Common size
Trend percentage
2018/19 2019/20
% %
Percentage change
Financial expenses 0 0
A review of any of the above should reveal favourable and unfavourable financial trends that may warrant
further investigation.
Activity 8.19
What favourable and unfavourable trends did you observe in Example 8.6 ?
Researchers have also developed ratio-based models that claim to assess the vulnerability of a business
to takeover by another business. These areas, of course, are of interest to all those connected with the
business. In the future, it is likely that further ratio-based models will be developed to predict other
aspects of future performance.
There is also the problem of deliberate attempts to make the financial statements misleading.
Inflation
A persistent problem, in most countries, is that the financial results of businesses can be distorted as a
result of inflation . One effect of inflation is that the reported value of assets held for any length of time
may bear little relation to current values. Generally speaking, the reported value of non-current assets will
be understated in current terms during a period of inflation as they are often reported at their original cost
(less any amounts written off for depreciation). This means that comparisons, whether between
businesses or between periods, will be hindered. A difference in, say, ROCE may simply be owing to the
fact that assets shown in one of the statements of financial position being compared were acquired more
recently (ignoring the effect of depreciation on the asset values). Another effect of inflation is to distort the
measurement of profit. In the calculation of profit, sales revenue is often matched with costs incurred at
an earlier time. This is because there is often a time lag between acquiring a particular resource and
using it to help generate sales revenue. For example, inventories may well be acquired several months
before they are sold. During a period of inflation, this will mean that the expense does not reflect prices
that are current at the time of the sale. The cost of sales figure is usually based on the historic cost of the
inventories concerned. As a result, expenses will be understated in the income statement, and this, in
turn, means that profit will be overstated. The longer the average inventories turnover period, the greater
the distortion. One effect of this will be to distort the profitability ratios discussed earlier.
inflation
A tendency for a currency to lose value over time owing to increasing prices of
goods and services.
Concept check 17
Common size reports are also referred to as:
A. Trend analysis
B. Vertical analysis
C. Horizontal analysis
D. All of the above
E. None of the above.
Concept check 18
Limitations of ratio analysis include:
A. Excluded assets (e.g. customer loyalty)
B. Inflation
C. Differences between businesses
D. All of the above
E. None of the above.
SELF-ASSESSMENT QUESTION
8.1
A Ltd and B Ltd operate electrical wholesale stores in Sydney. The accounts of each company for
the year ended 30 June 2020 are as follows:
A Ltd B Ltd
Current assets
869.0 834.9
Non-current assets
447.0 601.2
Current liabilities
438.4 311.5
Non-current liabilities
A Ltd B Ltd
1,610.3 1,617.9
Less
Depreciation
146.7 430.2
The market prices of the shares in each company at the end of the year were $6.50 and $8.20,
respectively.
For each business, calculate two ratios that are concerned with each of the following
aspects:
profitability
efficiency
liquidity
gearing, and
investment (10 ratios in total).
What can you conclude from the ratios you have calculated?
This chapter has provided a broad introduction to the use of ratios in performance appraisal. In
practice, you will find that you will need to modify your approach depending on the circumstances
in which you find yourself, particularly the level and nature of your job and the kind of business you
are working in. The following examples might indicate the difference in approach.
Suppose that you are working for a department in a large retail supermarket. Performance of your
department is likely to be assessed from a much narrower perspective than might be implied in this
chapter to date. If the supermarket is part of a chain of shops, which most are, there will be
expected performance targets set at corporate level. Performance appraisal will focus on these
narrow areas. Typically, the areas examined are likely to be:
This is not to imply that the company in which you are working will not engage in a full-scale
appraisal process. Rather, it is to show that analysis takes place at different levels and different
information is analysed.
By comparison, if you are in a planning and analysis role in corporate head office, the analysis you
will engage in will typically be much broader, and may cover almost the whole range of issues.
This kind of analysis will typically require you to engage in significant benchmarking. This means
that you will have to identify companies that provide a sensible basis for comparison as to how you
are performing, which might help identify how performance can be improved. As a minimum, you
are likely to need to identify a range of companies in the same or a similar industry, of a similar
nature to your business. Benchmarks need to be provided or calculated for both the average
company and the leading company in the relevant sector. Most of the ratios used in this chapter
will be needed. A number of businesses that specialise in benchmarking exist nationally and
internationally. These businesses typically provide considerable amounts of detailed information of
an operational nature and can be a useful supplement to the ratio analysis. Examples that you
might look at include The Centre for Interfirm Comparison (UK), ANZ Business Insights and MAUS
Business Systems.
Clearly, the nature of the analysis carried out in the case of a departmental performance of a
supermarket is significantly simpler than one carried out in the case of a corporate benchmarking
process. The ratios included in this chapter aim to provide you with a substantial starting point in
your understanding of performance appraisal. As your career develops, however, the knowledge
and experience you gain will enable you to become a far more accomplished analyst, enabling you
to pick up issues well beyond those covered in this chapter.
Reflection 8.6
Assume that you are a branch manager with a retail chain of shops that sells clothes and
accessories for women. What kind of performance issues are likely to occur? What kind of ratios
might you use to measure branch performance?
Summary
In this chapter we have achieved the following objectives in the way shown.
Explain the importance of ratios in analysing financial performance, identify the Defined a ratio
possible bases for comparison, and identify the key aspects of financial Identified the range of ratios commonly used
performance and financial position that are evaluated by the use of ratios Explained the need for comparison, and identified
the main bases for comparison as past periods,
similar businesses and planned performance
Identified the key steps in financial ratio analysis
Reviewed a number of obvious lessons that can
be learned from the basic financial statements
Identify the main ratios used to analyse profitability, and apply these ratios to a Explained the following ratios:
business — return on ordinary shareholders’ funds
Identify the main ratios used to analyse efficiency regarding use of assets, and Explained the following ratios:
apply these ratios to a business — average inventories turnover period
Identify the main ratios used to analyse liquidity, and apply these ratios to a Explained the following ratios:
business — current ratio, and
Identify the main ratios used to analyse financial gearing (leverage), and apply Explained the concept of financial gearing
these ratios to a business Explained the following ratios:
— gearing ratio, and
Identify the main ratios used to analyse investment performance, and apply these Explained the following investment ratios:
ratios to a business — dividend payout ratio
— dividend yield
Identify a range of other issues relating to financial analysis, including the main Discussed and assessed:
limitations of ratio analysis — trend analysis
— inflation
Easy
8.1 LO Provide an example of a commonly used ratio. (Hint: Think of driving a car.) What makes a ratio? What makes a ratio useful?
1
8.2 LO Briefly describe each of the main categories of financial ratios. Which category of ratios is the most important in your opinion?
1 Why?
8.3 LO Complete the following sentence: ‘The gross profit margin percentage represents the proportion of ...’
2
8.4 LO What do efficiency measures indicate about a business? Describe the calculation of an efficiency measure for learning
3 accounting.
8.5 LO The current and quick (acid test) ratios are both measures of what? Which of the two ratios is a stricter test, and how does it
4 accomplish this?
8.6 LO Describe two financial gearing ratios. What aspect of a business are they attempting to portray?
5
8.7 LO Provide a brief explanation, along with an advantage and a disadvantage, for each of the four main ratios used to evaluate
6 investment performance.
8.8 LO List and briefly describe other methods that can be used for financial statement analysis.
7
Intermediate
8.9 LO Does the ROSF ratio provide a better measure of performance than the ‘bottom line’ profit value? Compare this with someone
2 telling you that they ran 5 kilometres before coming to class today.
8.10 LO Would you expect the operating profit margin to be higher or lower than the gross profit margin? What is a good operating profit
2 margin?
8.11 LO Your company’s inventory turnover has increased from 25.5 days to 28.6 days when you compare last year’s results to the
3 current year. Is this good? Discuss.
8.12 LO You are contemplating an expansion of your self-funded business with a $300,000 fixed-interest rate bank loan. Is this a good
5 idea?
8.13 LO Why does the dividend yield formula divide the dividends amount by (1−t) where t is the corporate tax rate?
6
Challenging
8.14 LO A classification of ratios that you may encounter is ‘solvency’. Where would solvency ratios fit in with the classification system
1 used in this textbook? Which term would be preferred by companies with substantial borrowings, and why?
8.15 LO Ratios that use values from both the income statement and the balance sheet require the calculation of average amounts for the
2 balance sheet amounts. Why is this done, and when will the usual method of calculating this average be inappropriate?
8.16 LO An alternative efficiency measure for the collection of credit sales is accounts receivable turnover, calculated as credit sales
3 revenue divided by average accounts receivable. This calculation seems to be the reverse of the average settlement period
calculation. Are they measuring the same thing? Explain.
8.17 LO A criticism of ratio analysis is that it provides only part of the financial picture being reviewed. What part of the picture is
7 missing?
8.18 LO You are keen to use your financial analysis skills in your new job. You want to use the price/earnings ratio as an indicator of the
6 market’s confidence in the future prospects of a particular company. Your boss has confused you by asking you to use an
earnings yield formula. You can see that he’s got things backwards—upside down actually. What’s going on?
8.19 LO Describe some limitations of the analysis of financial statements. Provide suggested remedies for each of the limitations cited.
7
8.20 LO Follow up on Real World 8.6 by updating what you know about Glencore or Fortescue.
5
8.21 LO Critically evaluate the statement that ‘financial reports are largely based on historical cost information and are therefore useful in
6 assessing the stewardship (accountability) of management, but of little use to external decision-makers when it comes to
allocating scarce resources’.
Application exercises
Easy
8.1 LO Prepare common size (vertical analysis) reports for the statement of financial position and income statement shown below.
1/7 What can you learn from this analysis?
$ $ $
Current assets
Income statements
for the year ended 30 June
2019 2020
$ $
8.2 LO 4 Complete the following table for the requested ratios and account balances.
Average total assets less current liabilities 4,200 4,400 4,700 6,000
8.4 LO An analysis of liquidity and efficiency for ABC Ltd yields the following results:
3/4 Industry average
ratio name
ratio focus
ratio formula
(c) Gearing
8.6 LO Business A and Business B are both retailers, but seem to take a different approach to this trade according to the information
1/2/3 available, which consists of a table of ratios:
8.7 LO a. Camus Company has an operating profit margin of 5% and a return on capital employed of 20%. The capital employed
3/4/5 in the business is $80 million.
What is the sales revenue for the business?
b. Clouseau Co. began trading on 1 January and, after only eight months’ trading, a fire in one of its two warehouses
destroyed all of the inventories being held there. The owner of the business reported that sales revenue and purchases
to the date of the fire were $180,000 and $160,000, respectively. Furthermore, there were still $40,000 of inventories
held in the second warehouse that were not affected by the fire. The business makes a constant gross profit margin of
40% on its sales.
What is the value of the inventories destroyed by the fire?
8.8 LO A common size analysis of the income statements of Justine Ltd is presented below:
2/5
Answer the following questions, referring to the above index analysis:
JUSTINE LTD
Income statement
Expenses 28 31 34
Profit 7 6 5
8.9 LO The following financial information is provided for Metal Recyclers Ltd.
5/6 2018 2019 2020
Taxation 45 40 51
b. Calculate the historical return on owners’ equity for 2019 and 2020, and compare this with the earnings yield.
c. Discuss any significant trends or anomalies.
Challenging
8.10 LO Conday and Co. Ltd, in operation for three years, produces antique reproduction furniture for the export market. Its most
1–7 recent set of accounts is set out below.
$’000 $’000
Current assets
Inventory 600
1,420
Non-current assets
990
Current liabilities
Taxation 95 1,145
Non-current liabilities
Shareholders’ equity
1065
Total liabilities and shareholders’ equity 2,410
$’000
Sales 2,600
Notes: The debentures are secured on the freehold land and buildings.
The company has asked an investor to invest $200,000 by purchasing 50,000 new ordinary shares at $4 each. Conday
wishes to use the funds to finance further expansion.
a. Assess Conday’s financial position and performance, and comment on any features you consider to be significant.
b. State, with reasons, whether or not the investor should invest in the company on the terms outlined.
Current assets
Cash 100 86 73 45
Non-current assets
Investments 100 95 89 79
Intangibles 100 95 90 85
Other 100 98 97 85
Convert the above analysis into a ‘percentage change’ (horizontal analysis) table.
8.12 LO You are presented with the following financial report extracts for WeRHere4U Ltd:
1–7
2020 2019 2018 2017
$ $ $ $
Income statement
Taxation 30%
Current assets
Non-current assets
Current liabilities
You should note that there are also other current assets, non-current assets and current liabilities that are not specifically
listed in the extracts shown above.
a. For the income statement section, prepare a ‘vertical analysis’ for the three years (2018–2020).
b. For the statement of financial position extract, prepare a ‘trend percentage’ analysis for the three years (2018–2020),
the base year being 2018.
c. Prepare as many ratios as possible from the available information to cover profitability, liquidity, efficiency and gearing.
d. Prepare a report indicating potential strengths and weaknesses in the management of this business, basing it on the
analysis of parts (a)–(c).
e. Identify additional information you would require to improve your analysis of this company over the period specified.
Chapter 8 Case study
Select a company for which you can obtain a recent annual report, then find the five-year summary
position which is typically provided.
Questions
1. Calculate as many useful ratios as you can, and then review these, after taking into account the
content of the financial statements themselves.
2. Review the performance and progress of the company.
3. Identify any particular issues that you have found in the process of your analysis.
CC10 E CC17 B
CC5 B CC12 E
Solutions to activities
Activity 8.1
The first part of your answer should be along the lines covered in the section on financial ratio
classifications. The second part should reflect the section headed ‘the need for comparison’. The
advantages of each method are largely related to the purpose for which the analysis is required. Past
periods provide a good basis for comparison if the analysis is aimed at assessing progress over time.
Similar businesses provide an opportunity to compare and contrast performance with a range of
competitors and to learn from others. Planned performance is likely to be really important in an internal
analysis focused on improvement and progress. It is unlikely that enough detailed figures would be made
available for a general-purpose analysis for outside stakeholders.
Activity 8.2–8.5
ROSF = 11(563 + 534)/2×100=2.0%ROCE = 47(763 + 834)/2×100=5.9%Operating profit margin = 472,681
The 2020 ROSF ratio is very poor by any standards; a bank deposit account will normally yield a better
return than this. We need to try to find out why things went so badly wrong in 2020. As we look at other
ratios, we should find some clues.
The ROCE ratio tells much the same story as ROSF; namely, a poor performance, with the return on the
assets being less than the rate that the business has to pay for most of its borrowed funds (i.e. 10% for
the loan notes).
The operating profit ratio shows a very weak performance compared with that of 2019. In 2019, for every
$1 of sales revenue an average of 10.8¢ (i.e. 10.8%) was left as operating profit, after paying the cost of
the carpets sold and other expenses of operating the business. By 2020, however, this had fallen to only
1.8¢ for every $1. It seems that the reason for the poor ROSF and ROCE ratios was partially, perhaps
wholly, a high level of expenses relative to sales revenue. The gross profit ratio should provide us with a
clue as to how the sharp decline in this ratio occurred.
The decline in the gross profit ratio means that gross profit was lower relative to sales revenue in 2020
than it had been in 2019. Bearing in mind that:
Clearly, part of the decline in the operating profit margin ratio is linked to the dramatic decline in the gross
profit margin ratio. Whereas, after paying for the carpets sold, for each $1 of sales revenue 22.1¢ was left
to cover other operating expenses in 2019, this was only 15.3¢ in 2020.
We can see that the decline in the operating profit margin was 9% (i.e. 10.8% to 1.8%), whereas that of
the gross profit margin was only 6.8% (i.e. from 22.1% to 15.3%). This can only mean that operating
expenses were greater, compared with sales revenue in 2020, than they had been in 2019. The declines
in both ROSF and ROCE were caused partly, therefore, by the business incurring higher inventories’
purchasing costs relative to sales revenue, and partly through higher operating expenses compared with
sales revenue. We would need to compare these ratios with their planned levels before we could usefully
assess the business’s success.
The analyst must now carry out some investigation to discover what caused the increases in both cost of
sales and operating expenses, relative to sales revenue, from 2019 to 2020. This will involve checking on
what has happened with sales and inventories prices over the two years. Similarly, it will involve looking
at each of the individual areas that make up operating expenses to discover which ones were responsible
for the increase, relative to sales revenue. Here, further ratios—for example, staff expenses (wages and
salaries) to sales revenue—could be calculated in an attempt to isolate the cause of the change from
2019 to 2020. In fact, as we discussed when we took an overview of the financial statements, the
increase in staffing may well account for most of the increase in operating expenses.
Activity 8.6–8.10
Average inventories turnover period=
(300 + 406)/22,272 ×365=56.7 daysAverage settlement period for trade receivables=
(240 + 273)/22,681 ×365=34.9 daysAverage settlement period for trade payables=
(261 + 354)/22,378 ×365=47.2 daysSales revenue to capital employed=2,681(763 + 834)/2=3.36 timesSales revenue per e
Maintaining the inventories turnover period at the 2019 level might be reasonable, although whether this
represents a satisfactory period can probably only be assessed by looking at the business’s planned
inventories period. The inventories turnover period for other businesses operating in carpet retailing,
particularly those regarded as the market leaders, may have been helpful in formulating the plans.
On the face of it, this reduction in the settlement period for receivables is welcome. It means that less
cash was tied up in trade receivables for each $1 of sales revenue in 2020 than in 2019. Only if the
reduction was achieved at the expense of customer goodwill or a high direct financial cost might the
desirability of the reduction be questioned. For example, the reduction may have been due to chasing
customers too vigorously or as a result of incurring higher expenses, such as discounts allowed to
customers who paid quickly.
There was an increase, between 2019 and 2020, in the average length of time that elapsed between
buying inventories and services and paying for them. On the face of it, this is beneficial, because the
business is using free finance provided by suppliers. This is not necessarily advantageous, however, if it
is leading to a loss of supplier goodwill that could have adverse consequences for Alexis Ltd.
This seems to be an improvement in the sales revenue to capital employed ratio, since in 2020 more
sales revenue was being generated for each $1 of capital employed ($3.36) than was the case in 2019
($3.20). Provided that over-trading is not an issue, and that the additional sales are generating an
acceptable profit, this is to be welcomed.
The sales revenue per employee represents a fairly significant decline and probably one that merits
further investigation. As we discussed previously, the number of employees had increased quite notably
(by about 33%) during 2020, and the analyst would probably try to discover why this had not generated
sufficient additional sales revenue to maintain the ratio at its 2019 level. It could be that the additional
employees were not appointed until late in the year ended 31 March 2020.
Activity 8.11–8.12
The current ratio for the year ended 31 March 2020 is:
The acid test ratio for the year ended 31 March 2020 is:
Although we cannot make a totally valid judgement without knowing the planned ratios, there appears to
have been a worrying decline in liquidity. This is indicated by both of these ratios. The apparent liquidity
problem may, however, be planned, short-term and linked to the expansion in non-current assets and
staffing. It may be that when the benefits of the expansion come on stream, liquidity will improve. On the
other hand, short-term claimants may become anxious when they see signs of weak liquidity. This anxiety
may lead them to press for payment, which could cause problems for Alexis Ltd.
Activity 8.13–8.14
The gearing ratio as at 31 March 2020 will be:
(300/(534 + 300))×100=36%
The interest cover ratio for the year ended 31 March 2020 is:
The gearing ratio increased significantly in 2020. This is mainly due to the substantial increase in the
contribution of long-term lenders to the financing of the business.
The interest cover ratio has declined dramatically from a position where operating profit covered interest
13.5 times in 2019, to one where operating profit covered interest only 1.5 times in 2020. This was partly
caused by the increase in borrowings in 2020, but mainly caused by the dramatic decline in profitability in
that year. The latter situation looks hazardous; only a small decline in future profitability would leave the
business with insufficient operating profit to cover the interest payments. The gearing ratio at 31 March
2020 would not necessarily be considered to be very high for a business that was trading successfully. It
is the low profitability that is the problem.
Without knowing what the business planned these ratios to be, it is not possible to reach a valid
conclusion on Alexis Ltd’s gearing.
Activity 8.15–18
The dividend payout ratio for the year ending 31 March 2020 will be:
This would normally be considered to be a very alarming increase in the ratio over the two years. Paying
a dividend of $40 million in 2020 may be very imprudent.
The dividend yield ratio for the year ending 31 March 2020 will be:
The earnings per share for the year ended 31 March 2020 will be:
The price/earnings (P/E) ratio for the year ending 31 March 2020 will be:
$1.50/1.8c = 83.3 times
Although the EPS has fallen dramatically and the dividend payment for 2020 seems very imprudent, the
share price seems to have held up remarkably well (fallen from $2.50 to $1.50). This means that dividend
yield and P/E value for 2020 look better than those for 2019. This is an anomaly of these two ratios, which
stems from using a forward-looking value (the share price) in conjunction with historic data (dividends and
earnings). Share prices are based on investors’ assessments of the business’s future. It seems with
Alexis Ltd that, at the end of 2020, the ‘market’ was not happy with the business, relative to 2019. This is
evidenced by the fact that the share price had fallen by $1 a share. On the other hand, the share price
has not fallen as much as profit for the year. It appears that investors believe that the business will
perform better in the future than it did in 2020. This may well be because they believe that the large
expansion in assets and employee numbers that occurred in 2020 will yield benefits in the future—
benefits that the business was not able to generate during 2020.
Activity 8.19
In terms of the favourable trends revealed, you may have considered:
the relative increase in cost of sales (declining gross profit margin), and
the relative increase in administration costs.
Financial accounting capstone case
It was November 2019, you recently graduated from a university and were hired by an investment fund
company as a junior analyst. Your company provides financial consulting services to clients, and the first
client given to you was Little Tummy’s Organics (hereafter ‘Little Tummy’). Tables 1 –3 provide Little
Tummy’s financial information of past three years.
Background
Little Tummy is an Australian public company that produces organic food and formula products for babies
and toddlers. The company is headquartered in Victoria, Australia, with operations in the Asia Pacific.
Started as a small family firm in rural Victoria selling baby cereals and snack foods, it grew into one of the
biggest baby formula manufacturers in Australia, occupying about 25% market share as of 2016. This is
primarily due to the booming baby food industry in recent years, mainly driven by a strong demand from
China for safe and organic baby food.
Table 1
LITTLE TUMMY’S ORGANICS AUSTRALIA LTD
Consolidated statements of financial performance
for the year ended 30 June
Earnings before net interest and tax (EBIT) 11,057.4 48,875.4 533.7
Table 2
LITTLE TUMMY’S ORGANICS AUSTRALIA LTD
Consolidated statements of financial position as at 30 June
Assets
Current assets
Non-current assets
Liabilities
Current liabilities
Non-current liabilities
Equity
Table 3
LITTLE TUMMY’S ORGANICS AUSTRALIA LTD
Consolidated statements of cash flows for the year ended 30 June
Cash and cash equivalents at the beginning of the financial year 3,990.6 28,831.5 29,065.5
Cash and cash equivalents at the end of the financial year 28,831.5 29,065.5 15,731.1
Operational issues
Before 2019, Little Tummy consistently reported an increase in annual revenue over 60%. However, it
suffered a loss in 2019. Particularly, the demand from China slowed down and Little Tummy failed to
quickly adjust the production level, which had left the company short of cash and reliant on the banks to
finance its working capital. This eventually resulted in Little Tummy’s shares being suspended from
trading on the ASX on 12 December 2018.
During this period, it emerged that the company had too much stock (the equivalent of a year’s worth of
inventory, or around $110 million) sitting in factories and warehouses. Beside overstocking, Little Tummy
was obliged to continue paying its diary supplier due to its minimum annual volume commitments with its
suppliers. Otherwise, the binding contract requires Little Tummy to pay for another $8–$10 million a year
in ‘shortfall payments’, a commitment the company would not be able to afford.
In 2018, the CEO of Little Tummy made a crucial while unfortunate decision to reduce Little Tummy’s
reliance on daigou by going direct to consumers in China via e-commerce sites such as T-Mall, JD.com,
Kaola, NetEase and VIP. But when Little Tummy started discounting on these platforms due to
overstocking, the daigou came under pressure. Suddenly their prices were not competitive compared with
the online platforms in China, and so they switched to buying other baby formula brands. That led to Little
Tummy’s market share declining from 22.3% in the first quarter of 2018, to 13.9% in the third quarter of
2018, according to data from Aztec, which looks at the number of tins scanned in supermarkets and
pharmacies across Australia.
The advice
The client is conscious that the regulatory environments for baby food companies are constantly
changing. In January 2018, the Chinese government introduced a new requirement for all foreign baby
formulas to pass SAMR (State Administration for Market Regulation) registration; Little Tummy is still
awaiting approval of its application. In January 2019, a new e-commerce law was issued in China forcing
all daigou to register as e-commerce operators and acquire licenses, which potentially will reduce the
daigou’s profit margin. Recently, the Australian government rolled out policies and imposed restrictions on
daigou purchases of baby formula.
Meanwhile, with many companies in the baby food industry now disclosing a sustainability report, the
client would like to know how the United Nation’s Sustainability Goals can be relevant to Little Tummy,
and the key areas the company need to focus on. He also would like some advice on how to get through
the hard time and recover the market share.
As a junior analyst with your company, are you able to complete the following tasks?
1. Analyse the financial reports of Little Tummy and calculate relevant ratios.
2. Evaluate and discuss which of the UN Sustainability Goals are relevant to the baby food
companies like Little Tummy, and why they are relevant.
3. Advise how regulatory requirements affect an exporter like Little Tummy and strategies for
managing associated risks.
4. Explain why the poor inventory management would affect the cash position of Little Tummy.
5. While going online is the trend for many retailing and manufacturing companies, why could it go
wrong for Little Tummy?
6. With reference to tasks 1–5, prepare written advice to the client to address their concerns.
Chapter 9 Cost–volume–profit analysis and relevant
costing
Learning objectives
When you have completed your study of this chapter, you should be able to:
LO 1 Distinguish between fixed costs and variable costs, and explain the importance of a
detailed understanding of cost behaviour
LO 2 Apply the distinction between fixed costs and variable costs to explain and apply
break-even analysis
LO 3 Explain and apply the concept of contribution and contribution margin
LO 4 Define and distinguish between relevant costs, outlay (historic) costs, and opportunity
costs
LO 5 Explain and apply the concept of relevant costing to a range of decision-making
situations.
This is the first chapter that deals with the area known as management
accounting. The chapter focuses on two aspects of management
accounting that are critical to effective decision-making. The first of these
concerns the area generally known as cost behaviour, which is basically
the relationship between volume of activity, costs and profit. Broadly, costs
can be divided between costs that are fixed, relative to the volume of
activity, and those that vary with the volume of activity. Some (semi-
variable) costs do not fall neatly into these categories, but it is possible to
break these down into fixed and variable elements. This split enables us to
develop break-even analysis, while a clear understanding of cost behaviour
helps us to make decisions and assess risk, particularly in the context of
short-term decisions.
The second main area involves a range of possible costs which are (or are
not) relevant to different decisions; the term ‘relevant costing’ is generally
applied to the application of these ideas. Not all costs (and revenues) that
appear to be linked to a business decision may actually be relevant to it. It
is important to distinguish between costs (and revenues) that are relevant
and those that are not. Failure to do this can lead to bad decisions being
made. The chapter includes a range of decisions that typically need to be
made, and identifies the appropriate costs to be included.
The behaviour of costs
LO 1 Distinguish between fixed costs and variable costs, and explain the importance of a detailed
understanding of cost behaviour
Costs incurred by a business may be classified in various useful ways, one of which is according to how
they behave in relation to changes in the volume of activity. Costs may be classified according to whether
they:
remain fixed (the same) in total when the volume of activity changes, or
vary according to the volume of activity.
These are known as a fixed cost and a variable cost , respectively. We shall see in this chapter that
understanding how much of each type of cost is involved with a particular activity can be of great value to
the decision-maker.
fixed cost
A cost that stays fixed (the same) in total when changes occur to the volume of
activity.
variable cost
A cost that varies according to the volume of activity.
Fixed costs
The way total fixed costs behave is depicted in Figure 9.1 . ‘0F’ is the amount of fixed costs, and this
stays the same irrespective of the level of activity. It is important to be clear that ‘fixed’, in this context,
means only that the total cost is not altered by changes in the level of activity.
Examples of costs that are likely to be fixed for, say, a business operating a small chain of hairdressing
salons include rent, insurance, cleaning costs and staff salaries.
Staff salaries and wages are sometimes discussed in texts as variable costs. It is useful to distinguish
between salaried and casual employees. Salaried staff tend to incur fixed costs, whereas casual staff,
who are paid only for the time they work, tend to incur variable costs. Salaried staff are generally not paid
according to their level of output, and it is not normal to sack salaried staff when there is a short-term
downturn in activity. If there is a long-term downturn in activity, or at least it looks that way to
management, redundancies may occur, with consequent fixed-cost savings. This, however, is true of all
costs. If a reduction in demand seems likely, the business may decide to close some branches and make
savings in rent. Thus, ‘fixed’ does not mean set in stone for all time; it usually means ‘fixed’ over the short
to medium term. With certain industries (e.g. mining), a variety of employment practices occur, which
means that labour still has a substantial component of cost that is variable.
There are circumstances in which the labour cost is variable (e.g. where staff are paid according to how
much output they produce), but this is unusual. Whether labour costs are fixed or variable will depend on
the particular circumstances.
Fixed costs are likely to be affected by inflation. If rent (a typical fixed cost) goes up due to inflation, this
fixed cost will increase, but not because of a change in the level of activity. So fixed costs are not the
same amount irrespective of the time period involved. They are almost always ‘time-based’; that is, they
vary with the length of time concerned. The rent charge for two months is normally twice that for one
month. Thus, fixed costs normally vary with time, but of course not with the level of output. Therefore,
when we talk of fixed costs being, say, $1,000, we must add the period concerned, say, $1,000 per
month.
Fixed costs do not stay the same irrespective of the level of output. They are usually fixed for a particular
range of output levels. Beyond a particular point, fixed costs often have to increase to allow higher levels
of output. They are often said to step up as activity levels increase. By way of example, consider the
impact of rapid growth in a hairdressing business on the cost of its rent. The rent is only fixed over a
particular range (known as the ‘relevant’ range). If the number of people wanting to have their hair cut
increases, the business would have to expand its physical size. It might do this by opening additional
branches, or by moving existing branches to larger premises nearby. It might cope with relatively minor
increases in activity by using existing space more efficiently or by setting longer opening hours. If activity
continued to expand, higher rent charges would seem inevitable. In practice, the situation would look
something like that shown in Figure 9.2 , with the cost being rent.
As the volume of activity increases from zero, the rent (a fixed cost) is unaffected. At a particular point,
the volume of activity cannot increase further without additional space being rented. The cost of renting
the additional space will cause a ‘step’ in the rent cost. The higher rent cost will continue unaffected if
volume rises further, until eventually another step point is reached.
Variable costs
These costs vary in total with the level of activity. In a manufacturing business, for example, they would
include the cost of raw materials it uses. In the case of a hairdressing business, items such as hair
products and other materials and laundry costs (e.g. towels) spring to mind. As with many types of
business activity, the variable costs of hairdressers tend to be relatively light in comparison to fixed costs;
that is, fixed costs tend to make up the bulk of total costs.
Variable costs can be represented graphically, as in Figure 9.3 . At zero level of activity, the cost is
zero. The cost increases in a straight line as activity increases.
At zero activity, there are no variable costs. However, as the volume of activity increases, so do the total
variable costs.
The straight line for variable costs on this graph implies that certain costs (the variable costs) will normally
be the same per unit of activity, irrespective of the level of activity concerned. In some cases, however,
the line is not straight, because at high levels of output economies of scale may be available. For
example, the business may be able to employ labour more efficiently with higher volumes of activity.
Similarly, the relatively large quantities of materials and services bought may enable the business to
benefit from bulk discounts and its general power in the marketplace. By way of example, we only need to
consider the economic power of the two main supermarkets in Australia, Woolworths and Coles.
In other circumstances, a high level of demand may cause a shortage of a commodity, thus pushing
prices up at the higher end of activity. To obtain more labour hours it may be necessary to pay higher
salaries or wages to attract suitable new staff, or to pay overtime premiums to encourage existing staff to
work longer hours.
In making decisions about the likely behaviour of semi-variable costs, it is common practice to use past
behaviour patterns as the base. If several cost figures are available for a range of production levels, we
can plot these on a graph and put in a line of best fit. The aim is to calculate the equation of the line:
γ=mx+c
where
γ is cost
The split into fixed costs and variable costs can be achieved in several ways. In its simplest form, the cost
line may be derived simply by drawing a line between the highest and lowest figures given, and extending
this line to the y axis. This is known as the high–low or range method. A better method is to use all of the
observations. The line of best fit can be derived from these observations. This may be done ‘by eye’ or by
statistical methods (see Example 9.1 ).
EXAMPLE
9.1
A business has the following figures for production overheads over the past five weeks:
20,000 30,500
22,000 31,000
18,000 28,500
19,000 29,000
20,000 29,800
These figures can be plotted on a graph and a line of best fit put in by eye, as shown in Figure
9.4 . When putting in a line of best fit in this way, the line is inevitably approximate and there is
scope for error.
From this graph, estimates of fixed and variable costs can be made. The fixed costs are those
associated with an output level of zero. In the graph, these are approximately $16,000. The
variable cost, which is effectively the slope of the line, can be calculated by deducting the fixed
costs of $16,000 from total costs at any level of output, and dividing it by that output. If we assume
that the right-hand cross reflects a point of the graph at which 22,000 units of output causes
$31,000 of costs, of which $16,000 is fixed, the variable costs associated with an output of 22,000
must be $15,000=$0.68 per unit of output. (The slope of the line is $15,000/22,000 units=$0.68.)
Hence, if we were to produce 24,000 units, we would expect the total costs to be around $16,000+
(24,000×$0.68)=$32,320.
Output $
Difference 4,000 $2,500 (all of which is presumed to relate to the variable element of cost)
Hence, the variable cost per unit could be calculated by dividing $2,500 by
$2,500 by 4,000 units=62.5¢.
Since at an output level of 18,000 units variable costs would be 18,000×62.5¢=$11,250, and total
costs are $28,500, fixed costs can be estimated as $17,250. Clearly, these results are slightly
different from those obtained when all five observations were used.
If more precision is required, statistical techniques (e.g. linear regression) can be used to derive a more
accurate line of best fit. Most spreadsheet packages have a function that enables this to be carried out
fairly easily. One issue that remains relates to the spread of observations used to estimate the fixed and
variable elements of cost. This probably occurred to you in Example 9.1 , when a line of best fit was put
in by eye. The range of observations in Example 9.1 was for five output levels of between 18,000 and
22,000 units. Extrapolating a line beyond this range may be dangerous, since output levels outside this
range may not be normal, and cost behaviour patterns may change quite dramatically, both above
and below what may be regarded as ‘normal’ levels of activity. This requires thought if decisions are being
made about output levels outside this normal or relevant range.
cost behaviour
The manner in which costs alter with changes in the level of activity.
Now that we have considered the nature of fixed and variable costs, we can go on to do something useful
with that knowledge.
Activity 9.1
You are given the following information for a company for two successive periods:
January February
Estimate the fixed costs and variable costs for each of the three types of cost shown.
Concept check 1
Which of the following statements is true?
A. All costs are either fixed costs or variable costs.
B. Variable costs are costs that change as conditions change.
C. Fixed costs are costs that will never change.
D. All of the above statements are false.
Concept check 2
Which of the following statements is true?
A. Understanding cost behaviour is important for both management accounting and
financial accounting.
B. A clear understanding of cost behaviour helps managers to make inferior decisions.
C. A clear understanding of cost behaviour helps managers assess risk.
D. All of the above statements are true.
Concept check 3
Which of the following statements is false?
A. Fixed costs can be graphed as a straight line starting at the origin.
B. Sales revenues can be graphed as a straight line starting at the origin.
C. Variable costs can be graphed as a straight line starting at the origin.
D. None. All are true.
Break-even analysis
LO 2 Apply the distinction between fixed costs and variable costs to explain and apply break-even
analysis
Armed with knowledge of each element of cost for a particular product or service, it is possible to make
predictions regarding total and per-unit costs at various projected levels of output. Such information can
be very useful to decision-makers. Much of the rest of this chapter will be devoted to seeing how it can be
useful, starting with break-even analysis .
break-even analysis
A way of analysing cost behaviour and revenues so as to enable the break-even
point (and other target levels of profit) to be calculated.
If, in respect of a particular activity, we know the total fixed costs for a period and the total variable cost
per unit, we can produce a graph like that in Figure 9.5 , which shows a fixed cost area. Added to this is
the variable cost, the wedge-shaped portion at the top of the graph. The uppermost line represents the
total cost at any particular level of activity. This total is the vertical distance between the graph’s
horizontal axis and the uppermost line for the particular level of activity concerned. Logically enough, the
total cost at zero activity is the amount of the fixed costs. This is because, even when nothing is going on,
the business will still be paying rent, salaries, etc., at least in the short term. The fixed cost is augmented
by the amount of the relevant variable costs as the volume of activity increases.
total cost
The sum of the variable and fixed costs of pursuing some activity.
If we superimpose on this total cost graph a line representing total revenue for each level of activity, we
obtain the graph shown in Figure 9.6 . Note that at zero level of activity (zero sales) there is zero sales
revenue. The profit (total sales revenue less total cost) at various levels of activity is the vertical distance
between the total sales line and the total cost line, at that particular level of activity. At the break-even
point there is no vertical distance between these two lines and thus there is no profit; that is, the
activity breaks even at the level of activity indicated on the horizontal axis. At activity levels below the
break-even point a loss will be incurred; above the break-even point, there will be a profit. The further
below the break-even point, the higher the loss; the further above, the higher the profit.
break-even point
A level of activity where revenue will exactly equal total cost, so there is neither
profit nor loss.
As you may imagine, deducing break-even points by graphical means is a laborious business. It may
have struck you that since the relationships in the graph are all straight-line ones, it would be easy to
calculate the break-even point.
thus:
and:
If you look back at the break-even chart (Figure 9.6 ), this looks logical. At an output of zero, the total
cost line is higher than revenue by an amount equal to the amount of the fixed costs. Because the sales
revenue per unit is greater than the variable cost per unit, the sales revenue line will gradually catch up
with the total cost line. The rate at which it will catch up depends on the relative steepness of the two
lines, and the amount that it has to catch up is the amount of the fixed costs. Bearing in mind that the
slopes of the two lines are the variable cost per unit and the selling price per unit, the above equation for
calculating b looks perfectly logical. Example 9.2 illustrates this point.
EXAMPLE
9.2
Cottage Industries Ltd makes baskets. The fixed costs of operating the workshop for a month total
$4,500. Each basket requires materials which cost $18. Each basket takes two hours to make, and
the business pays the basket-makers $27 an hour. The basket-makers are all on contracts that
specify that if they do not work, for any reason, they are not paid. The baskets are sold to a
wholesaler for $90 each.
Note that the break-even point must be expressed with respect to a period of time.
Activity 9.2
a. Can you think of reasons why the managers of a business might find it useful to know the break-
even point of some activity they are planning?
b. Cottage Industries Ltd (see Example 9.2 ) expects to sell 500 baskets a month. The business
has the opportunity to rent a basket-making machine. Doing so would increase the total fixed costs
of operating the workshop for a month to $18,000. Using the machine would reduce the labour time
to one hour per basket. The basket-makers would still be paid $27 an hour.
How much profit would the business make each month from selling baskets:
assuming that the business does not rent the basket-making machine?
assuming that the machine is rented?
The difference between the actual output and the break-even volume is known as the margin of
safety , and provides an indication of the risks involved. We will consider this factor in more detail later
in this chapter. We shall take a closer look at the relationship between fixed costs, variable costs and
break-even, and the advice we might give the management of Cottage Industries Ltd after we have
considered the notion of ‘contribution’.
margin of safety
The extent to which the planned level of output or sales lies above the break-even
point.
The concepts discussed above may, of course, need to be slightly modified to reflect the nature of the
business. This is especially true for businesses that carry passengers or freight, where the extent to which
capacity is utilised becomes critical. Real World 9.1 illustrates this.
In some industries (e.g. airlines) the idea of a ‘load factor’ is commonly found. This is normally
defined as the actual level of activity, as a percentage of capacity. For example, Regional Express
(REX) had a load factor of 52.6% in June 2015, which increased through the next three years to
64.7% in June 2018, before falling back to 61.8% in 2019. REX also provides a load factor for the
year to date and a comparison with the same period in previous years. Over the period 2016 to
2018, profit before tax went from $4.3 million to $22.1 million. Use of a load factor indicates a real
awareness of the concepts and ideas discussed in the sections on break-even analysis and
margin of safety.
By 2018 the average load factor in the airline business was 81.7%.
The highest was achieved by Ryanair at 94.7% in 2017. Michael Goldstein, writing in Forbes,
reports that in 2017 load factors of 90% or better were recorded by four other airlines. In the lead,
with an average 92.8% capacity, was India’s Spicejet. Close behind were Europe’s easyJet
(92.4%) and WizzAir (91%), then Air Asia with a 90.9% occupancy rate, and Australia’s Tigerair at
88.7%. All of the top 30 airlines had a load factor higher than the average figure. ‘[I]n general, the
lower the load factor, the lower the profit,’ although Emirates had a lower than average load factor
(77.2%) but remains extremely profitable.
Qantas shows its revenue seat factor in its annual reports. Figures for the period 2015 to 2019
increased consistently year on year, from 79.1% in 2015 to 84.2% in 2019.
The revenue seat factor is calculated by dividing the available seat kilometres by the passenger
seat kilometres.
While it would be useful to know the break-even seat factor, the figures given above for Qantas
suggest increased efficiency over time.
Sources: REX, Investor Relations—Operating Statistics; Qantas Annual Report 2019. Michael Goldstein, ‘Meet the most crowded airlines: load factor hits all-time
Reflection 9.1
The figures shown above will clearly be of significance to accountants and senior management.
How useful might they be if you were a marketing manager?
Concept check 4
Which of the following statements is false?
A. Break-even analysis provides calculations of break-even levels of sales volume
where total revenues are equal to total costs.
B. Fixed costs may change in the long term.
C. As activity increases, so does total cost, but only because variable costs decrease.
D. The margin of safety is the extent to which the planned level of output or sales lies
above the break-even point.
Concept check 5
Which of the following statements about break-even charts is false?
A. The sloping line starting at zero represents the sales revenue at various volumes of
activity.
B. The point at which the sales revenue line catches up with the sloping total cost line is
the break-even point.
C. Below this point a loss is made; above it, a profit.
D. A break-even chart provides a good method for calculating a break-even point.
Concept check 6
Which of the following would decrease a firm’s break-even point?
A. A decrease in the expected sales volume
B. A decrease in selling price
C. An increase in fixed costs
D. A decrease in variable cost per unit of a product.
Contribution
LO 3 Explain and apply the concept of contribution and contribution margin
The bottom part of the break-even formula (Sales revenue per unit−Variable costs per unit) is known as
the contribution per unit . Thus, for the basket-making activity (Activity 9.2 ), without the machine
the contribution per unit is $18 (90−(18+54)), and with the machine it is $45 (90−(18+27)). This can be
quite a useful figure to know in a decision-making context. It is known as contribution because it
contributes to meeting the fixed costs, and once these are covered it then contributes to profit. The
variable cost per unit is also known as the marginal cost ; that is, the additional cost of making one
more basket.
marginal cost
The addition to total cost which will be incurred by making/providing one more unit
of output.
Figure 9.7 clearly shows how contribution grows as volume grows. The vertical distance between the
sales revenue line and the variable cost line measures the amount of contribution at that level of output.
Note that no profit is made until the contribution covers the amount of the fixed costs.
Break-even and profit–volume charts (see the next section) provide a useful picture of the relationship
between costs, volume and profit. However, unless the charts are drawn with great care, the results will
not be as accurate as they should be. Mathematical techniques can be used to determine which break-
even point or level of output is required for a prescribed amount of profit. The broad principles are outlined
below.
Contribution per unit is calculated by deducting the variable costs per unit from the selling price per unit.
Each unit of contribution goes towards fixed costs initially, then to profits. This means that the break-even
point can be calculated by solving the following equation.
Another way of looking at this is to ask the question: how many lots of contribution per unit need to be
obtained to cover the fixed costs? Example 9.3 shows how the concept of contribution can be used.
EXAMPLE
9.3
The following are details of planned sales and costs of a business for a period.
Sales 10,000 units @ $6 each $60,000
From the information above, the break-even point can be calculated as follows:
Since the fixed costs were $15,000, the break-even point can be calculated as follows:
15,0002.50=6,000 units
As the business plans to sell 10,000 units, the margin of safety is 4,000 units.
It is also easy to calculate the level of sales necessary to make a prescribed level of profit, say
$5,000. In order to make such a profit, we have to recover the amount of the fixed costs plus the
amount of profit desired. Hence, using the above example, we can obtain the level of sales needed
to make a profit of $5,000 as follows:
Fixed costs+profitContribution per unit=Level of sales needed to achieve the desired profit
that is:
$15,000+$5,000$2.50=8,000 units
A variation of the above approach is the use of the contribution margin ratio . This is the contribution
per unit expressed as a percentage of sales price per unit. Alternatively, it can be calculated as the total
contribution margin divided by total sales revenue, expressed as a percentage.
The sloping line is profit (loss) plotted against activity. As activity increases, so does total contribution
(sales revenue less variable costs). At zero activity there are no contributions, so there will be a loss
equal in amount to the fixed costs.
The PV chart is obtained by plotting loss or profit against the volume of activity. The slope of the graph is
equal to the contribution per unit, since each additional unit sold decreases the loss, or increases the
profit, by the contribution per unit (sales revenue per unit less the variable cost per unit). At zero level of
activity, there are no contributions, so there is a loss equal to the amount of the fixed costs. As the level of
activity increases, the amount of the loss gradually decreases until the break-even point is reached.
Beyond the break-even point, profits increase as activity increases.
It may have occurred to you that the PV chart does not tell us anything not shown by the break-even
chart. However, the information is perhaps more easily absorbed from this chart. This is particularly true
of the profit at any level of volume. This information is provided by the break-even chart as the vertical
distance between the total cost and total sales revenue lines. The PV chart, in effect, combines the total
sales revenue and total variable cost lines, which means that profit (or loss) is actually plotted.
How does this help in choosing between the options? While individual attitudes to risk determine which
strategy to adopt, most people would prefer the strategy of not renting the machine since the margin of
safety between the expected level of activity and the break-even point is much greater. The margin of
safety gives the extent to which the planned level of output or sales lies above the break-even point.
The relative margins of safety are directly linked to the relationship between the selling price per basket,
the variable costs per basket and the fixed costs per month. Without the machine, the contribution (selling
price less variable costs) per basket is $18. With the machine, it is $45. Without the machine, the fixed
costs are $4,500 a month; with the machine, they are $18,000. This means that with the machine the
contributions have more fixed costs to ‘overcome’ or recover before the activity becomes profitable. On
the other hand, the rate at which the contributions can overcome or recover fixed costs is higher with the
machine, because variable costs are lower. This means that one more, or one less, basket sold has a
greater impact on profit than it does if the machine were not rented.
Real World 9.2 shows how, once the break-even is known, the margin of safety can be calculated, and
how these figures can assist in decision-making and performance evaluation.
Unfortunately, very few airlines actually publish their break-even levels, with Ryanair (a well-known
European budget airline) being one of the few to do so.
The importance of achieving good levels of activity is clear from this. The difference between the
load factor and the break-even level represents the margin of safety. We can see that in each year
the load factor has been significantly more than the break-even point. This has resulted in
substantial operating profits. The surge in Ryanair’s profit since 2015 has been linked to the
business adopting a more customer-friendly approach.
Source: Based on information contained in Ryanair Holding plc Annual Report 2019 (p. 58).
The relationship between fixed costs and variable costs is known as operating gearing . An activity
with relatively high fixed costs compared with its variable costs is said to have high operating gearing.
operating gearing
The relationship between the total fixed costs and the total variable costs for
some activity.
Thus, Cottage Industries Ltd is more highly operationally geared with the machine than it would be
without it. Renting the machine quite dramatically increases the level of operating gearing because it
causes an increase in fixed costs, but at the same time it leads to a reduction in the variable costs per
basket. The reason that the word ‘gearing’ is used in this context is that, as with intermeshing gear wheels
of different circumferences, a movement in one of the factors (volume of output) causes a more-than-
proportionate movement in the other (profit). The word ‘leverage’ is also used. We can illustrate this with
Cottage Industries Ltd’s basket-making activities:
$ $ $ $ $ $ $ $
*
Contributions 5,400 9,000 18,000 27,000 13,500 22,500 45,000 67,500
Less fixed costs 4,500 4,500 4,500 4,500 18,000 18,000 18,000 18,000
*
$18 per basket without the machine and $45 per basket with it.
Note that without the machine (low operating gearing), a doubling of the output from 500 to 1,000 brings a
trebling of the profit. With the machine (high operating gearing), doubling output causes profit to rise by
six times. At a lower volume (300), high operating gearing is associated with a loss, whereas, in this
example, lower operating gearing is still associated with a profit, albeit small.
The effect of financial gearing was represented by Figure 8.3 (page 350). The same principle applies
to operating gearing. An amount of rotation by the larger gear wheel (representing volume of output)
causes a larger amount of rotation by the smaller wheel (representing profit).
In general, activities that are capital-intensive tend to be more highly operationally geared, since renting
or owning capital equipment gives rise to fixed costs and can also give rise to lower variable costs.
Real World 9.3 provides examples of the importance of understanding operating gearing.
Jimmy Choo plc, like most wholesale/retail businesses, has a high proportion of fixed costs, such
as premises occupancy costs, employee costs, plant depreciation and motor vehicle running costs.
Source: Information from: Jimmy Choo plc, 2016 Annual report, www.jimmychooplc.com.
Greggs, like most retailers, has a high proportion of fixed costs, such as premises occupancy
costs, salaries and wages, plant depreciation, motor vehicle running costs and training. The very
strong growth in the early years was primarily due to the company’s continued search for
efficiencies in its cost base and a significant program of investment in better processes and
systems. The operating profit margin went up over the first two years but has since stabilised.
Source: Greggs plc, annual reports 2015, 2016, 2017 and 2018.
Class discussion points
1. Explain how Greggs obtained such profit growth relative to sales.
2. Is this rate of profit growth sustainable?
Reflection 9.2
Our young restaurateur Lucas, from earlier chapters, is now firmly entrenched in the local and
regional areas. His eight restaurants are open five nights a week, from Wednesday to Sunday. He
is looking at expanding the business and is considering two options:
1. Non-linear relationships. The normal approach to break-even analysis assumes that the
relationships between sales revenues, variable costs and volume are strictly straight-line ones. In
real life this is unlikely, due to economies of scale, dis-economies of scale (relating to labour and
other goods and services), and the need for price reductions in order to achieve higher volumes of
sales. However, most businesses operate within quite a narrow range of volume activity, and within
these ranges the impact on non-linearity tends to be quite small.
2. Stepped fixed costs. Most fixed costs are not fixed over all volumes of activity. They tend to be
‘stepped’ in the way depicted in Figure 9.3 on page 387. This means that, in practical
circumstances, great care must be taken in making assumptions about fixed costs. The problem is
heightened because most activities will probably involve fixed costs of various types (rent,
supervisory salaries, administration costs), all of which are likely to have steps at different points.
3. Multi-product businesses. Most businesses do not do just one thing. This is a problem for break-
even analysis, since it raises problems regarding the effect of additional sales of one product or
service on sales of another of the business’s products or services. There is also the problem of
identifying the fixed costs of one particular activity. Fixed costs, such as rent, tend to relate to more
than one activity; for example, two activities may be carried out in the same rented premises.
There are ways of dividing fixed costs between activities, but these tend to be arbitrary, which calls
the value of the break-even analysis into question.
Despite some problems with the notions of break-even analysis, it seems to be widely used. The media
frequently refer to the break-even position for businesses and Real World 9.4 provides some examples
of this, and of the need to be aware of the relationship between volume and profit.
Clem 7
A range of articles appeared regarding the Clem 7 tunnel, an under-river tunnel in Brisbane that
was designed to alleviate traffic congestion in this rapidly growing city. Unfortunately, the tunnel
has been a financial disaster for its investors.
Five months after its opening in 2010, the tunnel was being used by about 27,000 cars a day. The
toll was cut to $2. Forecasts had suggested that 60,000 vehicles a day would use the tunnel within
a month of its opening, and 90,000 after about six months. On 25 February 2011, the owners,
RiverCity Motorways, placed the entire group into voluntary liquidation, with the main reason given
being that the low levels of traffic were unable to support the debt incurred to build the tunnel. In
December 2013 Queensland Motorways, operator of the Gateway and Logan motorways, took
over tolling and operation, and in July 2014 Queensland Motorways was acquired by a consortium
led by toll-road operator Transurban.
Source: Wikipedia.org/wiki/Clem_Jones_Tunnel.
Taking off
Malaysian Airways, which has failed to reach its break-even since 2010, aimed to break even by
the end of 2017, and be profitable by 2018. The ways in which this was planned to be achieved
brings into focus the relationship between cost, volume of activity and profit.
To make the position worse, the airline suffered two disasters during 2014 that had a serious
adverse effect on the business’s profitability. By 2017, they have had four chief executive officers
(CEOs) in less than three years.
In 2015, the business had appointed a new CEO with the aim of returning the company to a
profitable situation. To achieve this, the new CEO planned to:
Unfortunately, that CEO left the company and a new CEO was appointed, a former director of
Ryanair. He planned to lower costs and improve profits by:
renegotiating some key contracts, including some of those with airports and fuel suppliers
using more fuel-efficient aircraft, like the Airbus 350, and
boosting passenger numbers through promotional campaigns.
This CEO went back to Ryanair after quite a short time, and a new CEO was appointed, this time
from within. In October 2017, CNN’s Sherisse Pham was able to report ‘aggressive cost cuts’ over
recent years, which included 6,000 jobs being lost, and focusing on Asia with most of its long-haul
routes being discontinued.
Sources: Based on P. McGee & A. Parker, ‘Disaster-plagued Malaysian Airways seeks break even by 2018’, ft.com, 1 June 2015. FT and ‘Financial Times’ are
Information taken from: Bilqis Bahari, ‘MAS targets profit by 2018, brand improvement’, New Straits Time, 17 January 2017.
Sherisse Pham, ‘Malaysia Airlines just lost another CEO after string of departures’, CNNmoney, 18 October 2017.
Real World 9.5 provides an illustration of the importance of businesses in the oil industry knowing their
costs and break-even positions.
Atif Kubursi reported in The Conversation: ‘The marginal cost (the cost of producing an additional
barrel of oil) is lowest in Saudi Arabia at US$8.98 per barrel, the highest in the UK at US$44.33. In
Canada, it’s $26.24.’ In 2013, the benchmark price of oil ‘exceeded US$133 per barrel’.
Crude oil prices fell from around US$80 a barrel in mid-2014 to the mid-US$30s a barrel in early
2016, at which time prices were at a 12-year low. This was very close to the break-even cost for
some OPEC (Organization of the Petroleum Exporting Countries) member countries. For example,
Market Realist reports that Angola had an estimated break-even cost of about US$35.40, while
Nigeria had a figure of US$31.60 (November 2015 estimates) based on capital and operational
expenditure. Other estimates of break-even prices included US$29 per barrel for onshore reserves
in the Middle East, US$57 per barrel for ultra-deep water, US$52.50 per barrel for the United
Kingdom, and US$62 per barrel for North American shale. The cheapest oil to produce was in
Kuwait at US$8.50 per barrel.
For high-cost companies/countries, these figures raise considerable issues, such as whether shale
production is worth continuing while prices are so low. In a highly price-competitive market, a
detailed understanding of the cost structures of each business and those of their competitors
would be essential.
The market picked up, and for most of 2017 the price of West Texas Intermediate crude was
between US$40 and US$55 per barrel, and for 2018 US$60–US$70 per barrel, before slumping
again to $42.50. At the end of January 2019, it was around US$50 per barrel.
A volatile market price makes decisions about future investment difficult, and so a knowledge of
break-even prices is important. On Oilprice.com, Tsvetana Paraskova reported: ‘According to JP
Morgan estimates, the break-even oil price for BP is $46 a barrel, for Total its $55, for Shell $58,
for Equinor $48, and for Eni $59.’ Judging from recent comments of Big Oil’s top executives, she
concluded, ‘$50 a barrel seems to be the watershed for most oil majors’. Most of the projects
planned have considerably lower break-even prices.
Another element of the break-even debate for oil relates to what is known as the fiscal break-even,
which has been explored by Ashutosh Shyam in a 2018 article in the India Times. Many of the big
oil producers use income from their oil production to fund their own economies, which in turn has
social and political implications. Countries such as Saudi Arabia, Venezuela and Russia need oil
prices to be high enough to fund many social and other governmental activities. The fiscal break-
even figure is the price at which the revenues earned enable the desired government/social
expenditure to be achievable, as well as covering production costs. Venezuela has the highest
fiscal break-even price at $216 per barrel, while Saudi Arabia and Russia have figures of $88 and
$53, respectively.
Sources: Atif Kubursi, ‘Understanding the rollercoaster ride of oil prices’, The Conversation, 29 June 2018.
Rabindra Samanta, ‘Crude is near the break-even cost for some OPEC members’, marketrealist.com, 9 December 2015.
Gordon Kristopher, ‘Crude oil’s total cost of production impacts major oil producers’, marketrealist.com, 13 January 2016.
Tsvetana Paraskova, ‘Oil prices crash, but oil majors aren’t panicking’, Oilprice.com, 16 November 2018.
Ashutosh Shyam, ‘Producer’s fiscal break-even a key factor in setting oil prices’, India Times, 24 December 2018.
Reflection 9.3
You are the manager of a small mining company. Times are tough and the mine is making a loss.
How might you respond?
Activity 9.3
A business sold 10,000 units in 2017 at $100 each. Variable costs were $60 each, while fixed costs
totalled $250,000.
The business expects variable costs to increase by 5% in 2018 and fixed costs to increase by 10%.
Because of current market conditions, the selling price will not be increased in line with inflation, but will
increase to $102 per unit. The business expects to sell 10,000 units in 2018. What are the expected
break-even points and the profits for each of the two years?
Clearly, in Activity 9.3 the impact of inflationary increases in costs, when there is no equivalent
increase in selling price (a situation frequently found in times of recession), is considerable, both in terms
of profits and the break-even point.
Use of spreadsheets
It is worth noting that it is often worthwhile to prepare a break-even chart or some sort of profit profile
under various assumptions. A spreadsheet provides a useful starting point. As long as the spreadsheet is
set out appropriately, it is relatively easy to develop a profit profile over a range of activity levels, together
with a range of charts. These include a break-even chart and a profit–volume chart. Also, the input
variables can be changed to enable the impact of a range of different assumptions to be clearly identified.
In the kind of analysis used in Activity 9.3 , for example, it may be useful to consider building a
spreadsheet model into which price rises can be put, so that results can be ascertained under a variety of
different assumptions about cost/revenue behaviour (sensitivity analysis). As already noted, regression is
easily done using a spreadsheet.
SELF-ASSESSMENT QUESTION
9.1
The following information concerns a business for the past three months
Assets $
Contribution 120,000
Loss 30,000
The managers of the business are now considering what to do about this loss. They hope to make
a profit of $30,000 in the next three months, and the following proposals have been made:
a. the level of sales needed to make a profit of $30,000, assuming that none of the three
proposals is adopted
b. the break-even point under this assumption
c. the level of sales needed, for each of these proposals, to generate the required profit,
and
d. the impact each proposal will have on the break-even point.
Assume that revenues and costs will remain the same in the next three months, other than those
for the three proposals.
We noted in the previous section that cost behaviour is not always linear. The implication of this is that
break-even charts and the analysis of relationships between costs, volume and profits, of the type
discussed so far in the chapter, become far more complex. An example of a break-even chart modified to
include some of the above cost behaviour patterns is shown in Figure 9.9 . Profit profiles using
spreadsheets probably represent a more effective way of dealing with these patterns, although the
spreadsheets are inevitably more complex than would be the case for the examples used to date.
Real World 9.6 provides evidence concerning the extent to which managers use break-even analysis.
Ernst and Young surveyed nearly 2,000 US businesses about their management accounting
practices. These tended to be larger businesses, of which about 40% were manufacturers and
about 16% financial services; the remainder were across a range of other industries.
The survey revealed that 62% use break-even analysis extensively, with a further 22% considering
using the technique in the future.
The survey is now pretty old (it was conducted in 2003) and covers only larger businesses. It
should, therefore, be treated with caution. Nevertheless, it may provide some indication of what is
current practice in the United States and elsewhere in the developed world.
A major 2009 study on management accounting practice found that between 35% and 50% of all
companies surveyed used variable or marginal costing.
A more recent, UK-based survey of the practices of 11 small and medium-sized businesses found
a marked tendency to use break-even analysis. Interestingly, this study found that cost–volume–
profit analysis was used by both small and medium-sized firms, but small firms tended to use an
informal approach (knowledge of fixed costs and how much sales revenue was needed to cover
them), while medium firms used a more formal approach (‘calculating break-even points under
alternative scenarios and formally modelling the impact of changes in the marketing mix or cost
structure on break-even, margin of safety and target profit’).
Chartered Institute of Management Accountants (CIMA), Management Accounting Tools for Today and Tomorrow (CIMA, London, 2009).
Michael Lucas, Malcolm Prowle and Glynn Lowth, Management accounting practices of (UK) small-medium-sized enterprises (SMEs), 9(4) (Chartered Institute of
Reflection 9.4
How might our young restaurateur Lucas use the idea of break-even analysis, for the whole of his
business or parts of it?
Concept check 7
Which of the following statements about contribution or contribution margin is false?
A. Contribution per unit, divided into the fixed costs, gives the break-even point.
B. For volumes below the break-even level, contribution represents what’s left over from
each sale to help pay for fixed costs.
C. For volumes above the break-even point, contribution contributes to profit.
D. No false statements. All are true.
Concept check 8
Which of the following would increase contribution margin per unit?
A. A decrease in the expected sales volume
B. An increase in selling price
C. A decrease in fixed costs
D. An increase in total variable costs.
Concept check 9
Which of the following statements about profit–volume charts is true?
A. Profit–volume charts provide more information than break-even charts.
B. The slope of the profit line is the same as the slope of the revenue line on the break-
even chart.
C. The slope of the profit line is the same as the slope of the total cost line on the break-
even chart.
D. No true statements. All are false.
Relevant cost, outlay cost and opportunity cost
LO 4 Define and distinguish between relevant costs, outlay (historic) costs, and opportunity costs
Cost represents the amount sacrificed to achieve a particular business objective. Measuring cost may
seem, at first sight, to be a straightforward process: it is simply the amount paid for the item of goods
being supplied or the service being provided. When measuring cost for decision-making purposes,
however, things are not quite that simple. Example 9.4 illustrates why this is the case.
cost
The amount of resources, usually measured in monetary terms, sacrificed to
achieve a particular objective.
EXAMPLE
9.4
You own a motor car which you bought for $10,000 cash at an auction—a price which was well
below the list price. You have just been offered $12,000 for the car. What do you consider the cost
to be?
Up to now, when we have been preparing historical accounts, the answer is straightforward. The
cost is what we paid for the car—$10,000. However, by retaining the car, you are sacrificing the
opportunity to sell the car to receive cash of $12,000. Thus, the real sacrifice, or cost, incurred by
keeping the car for your own use is $12,000.
Any decision that is made with respect to the car’s future should logically take account of this figure. This
cost is known as the opportunity cost , since it is the value of the opportunity foregone in order to
pursue the other course of action—which is to retain the car. In this case, the opportunity cost is also
likely to be the most relevant cost .
opportunity cost
The cost of the best alternative strategy.
relevant cost
The cost which is relevant to any particular decision.
Historic cost can be seen as being useful for measuring performance in the past, but the fact that it is the
result of past decisions does not mean that it is of any significance per se in future decisions. We need to
clearly identify just what costs are relevant for any particular decision that needs to be made. What part
would the fact that the purchase price was $10,000 play in your response to an offer of $11,000 for the
car? Probably nothing. You would compare the offer of $11,000 with the earlier offer of $12,000 and reject
it, unless there were other non-financial factors in play.
Historic costs are past costs, and are also known as sunk costs . The money has been spent, whether
wisely or not, and there is nothing you can do about it. So it ceases to be of direct relevance to the
decision. This is not to say that if you have made a bad decision (say, paid $20,000 for a car that you find
is only worth $10,000) that you won’t experience anger and anguish. But it’s done—move on.
sunk cost
A cost that has already been incurred and, as such, is not relevant to future
decisions.
Having said this, the past decision to buy the car in Example 9.4 does mean that we are in a position
to exercise choice as to what we do with the car. Also—and this is a really important point to note—
knowledge of historic costs and past trends can be extremely useful in assessing future costs, which are
relevant. Indeed, past experience may be a major factor in assessing whether or not the offer of $12,000
for the car in Example 9.4 is actually a genuine offer, or just an attempt to assess firmness of price.
Opportunity costs are rarely taken into account in financial accounting, as they do not involve any out-of-
pocket expenditure. They are normally only calculated where they are relevant to a particular
management decision. Historic costs, on the other hand, do involve out-of-pocket expenditure and are
recorded. They are used in preparing the annual financial statements, such as the statement of financial
position and the income statement. This is logical, however, since these statements are intended to be
accounts of what has actually happened and are drawn up after the event.
Overall, to be relevant to a particular decision, a cost must satisfy all three of the following criteria:
1. It must relate to the objectives of the business. Businesses exist primarily to increase their
owners’ (shareholders’) wealth. Thus, to be relevant to a particular decision, a cost must relate to
this wealth objective.
2. It must be a future cost. Past costs cannot be relevant to decisions being made about the future.
3. It must vary with the decision. Only costs (and revenues) that differ between outcomes are
relevant. Take, for example, a haulage company that has decided to buy a new truck, but remains
undecided as to just which make or model to buy. The load capacity, fuel costs and maintenance
costs are different for each truck. These potential revenues and costs are all relevant items. The
truck will require a driver, who will need to be employed, but a suitably qualified driver could drive
either truck for the same wage. Thus, the cost of employing the driver will be irrelevant to the
decision as to which truck to buy, as the cost is the same whichever truck is chosen. This is
despite the fact that this cost is a future one.
Care needs to be taken with this particular issue. If the decision was not about the choice of truck, but
rather whether or not to operate an additional truck, the cost of employing a driver would be relevant. The
cost of the driver would now be a cost that would vary with the decision made.
Figure 9.10 shows a decision flow diagram for deciding which costs are relevant.
Figure 9.10 Decision flow diagram for identifying relevant costs and revenues
To be relevant to a particular decision, a cost or revenue must satisfy all three criteria.
Note that in Activity 9.4 the original cost of the car is irrelevant for reasons that have already been
discussed. It is the opportunity cost of the car that concerns us. The cost of the new engine is relevant
because, if the work is done, the garage will have to pay $600 for the engine; but will pay nothing if the
job is not done. The $600 is an example of a future outlay cost .
Activity 9.4
a. A garage business has an old car that it bought several months ago. The car needs a replacement
engine before it can be driven. It is possible to buy a reconditioned engine for $600. This would
take seven hours to fit by a mechanic who is paid $30 an hour. At present the garage is short of
work, but the owners are reluctant to lay off any mechanics or even to cut down their basic working
week, because skilled labour is difficult to find and an upturn in repair work is expected soon.
The garage paid $6,000 to buy the car. Without the engine it could be sold for an estimated
$7,000. What is the minimum price at which the garage should sell the car with a reconditioned
engine fitted?
b. Assume exactly the same circumstances as in (a) above, except that the garage is quite busy at
the moment. If a mechanic is to be put on the engine-replacement job, it will mean that other work
that the mechanic could have done during the seven hours—all of which could be charged to a
customer—will not be undertaken. The garage’s labour charge is $60 an hour, although the
mechanic is paid only $30 an hour.
What is the minimum price at which the garage should sell the car, with a reconditioned engine
fitted, under these altered circumstances?
outlay cost
A cost that involves the spending of money or some other transfer of assets.
The labour cost is irrelevant for part (a) because the same cost will be incurred whether the mechanic
undertakes the engine-replacement work or not. This is because the mechanic is being paid to do nothing
if this job is not undertaken; thus the additional labour cost arising from this job is zero. For section (b) a
charge for labour has been added to obtain the minimum price. There, the relevant labour cost is that
which the garage will have to sacrifice in making the time available to undertake the engine-replacement
job. While the mechanic is working on this job, the garage is losing the opportunity to do work for which a
customer would pay $420. Note that the $30 an hour mechanic’s wage is still not relevant. The mechanic
will be paid $30 an hour irrespective of whether it is the engine-replacement work or some other job that
is undertaken.
It should be emphasised that the garage will not seek to sell the car with its reconditioned engine for
$7,600 in the situation outlined in section (a) and $8,020 in section (b); it will attempt to charge as much
as possible for it. However, any price above these figures will make the garage better off financially than it
would be by not undertaking the engine replacement.
Concept check 10
Which of the following statements about opportunity costs is true?
A. Opportunity cost is the cost of the opportunity foregone in order to pursue a course of
action.
B. Opportunity cost is the cost of the best alternative strategy.
C. Opportunity costs will increase the cost of a particular decision.
D. All of the above are true.
Concept check 11
In order for a cost to be relevant to a particular decision, the following criteria must be
satisfied.
A. It must relate to the objectives of the business, be an objective past cost, and must
vary with the decision.
B. It must relate to the objective of the business, be a future cost, and must vary with
the decision.
C. It must relate to the objective of the business, be a sunk cost, and must vary with the
decision.
D. All costs are relevant.
Reflection 9.5
James is in the building business, and spends much of his time buying property (usually in quite
poor condition), doing it up, and then selling it. He recently bought a small property for $250,000,
spent $50,000 on improvements, and sold it for $350,000. Do you think this gives him a
reasonable return?
Marginal analysis/relevant costing
LO 5 Explain and apply the concept of relevant costing to a range of decision-making situations
When we are trying to decide between two or more possible courses of action and where economic costs
and benefits are the decision-making criteria, only costs that vary with the decision should be included in
the decision analysis. For example, a householder who wants a house decorated asks two decorators to
price the job. One of them will do the work for $2,000, the other one wants $2,400; in both cases on the
basis that the householder will supply the materials. Both decorators will probably do an equally good job.
The materials will cost $700 whoever does the work. Assuming that the householder prefers the lower
cost, the two contractors’ prices will be compared and a decision made on that basis. The cost of the
materials is irrelevant because it will be the same in each case. It is only possible to distinguish rationally
between courses of action on the basis of the differences between them.
For many decisions involving relatively small variations from existing practice or relatively limited periods
of time, fixed costs are not relevant to the decision because they will be the same, because either:
Suppose that a business that occupies its own premises suffers a downturn in demand for its service and
realises it could carry on operating from smaller, cheaper premises. Does this mean that the business
would sell its old premises and move to the new site overnight? Clearly not. For one thing, it is seldom
possible to find a buyer for premises at very short notice, and it may be difficult to move premises quickly
if, say, delicate equipment has to be moved. Apart from these constraints, management may feel that if
the downturn is not permanent and trade revives, such a move would become a disadvantage.
The business’s premises may illustrate an area of one of the more inflexible types of cost, but most fixed
costs tend to be broadly similar in this context. We shall now consider some decision-making areas where
fixed costs can be regarded as irrelevant, and analyse decisions in those areas:
The fact that the decisions we are considering here are short-term ones means that the wealth-
enhancement goal will be promoted by pursuing a policy that aims to generate as many net cash inflows
as possible.
As with all management decisions, in marginal analysis only costs and revenues that vary with the
decision are considered. This means that fixed costs can usually be ignored. This is because marginal
analysis is usually applied to minor alterations in the level of activity. It tends to be true, therefore, that the
variable cost per unit will be equal to the marginal cost, which is the additional cost of producing one more
unit of output. There may be times, however, when producing one more unit will involve a step in the fixed
cost. If this occurs, the marginal cost is not just the variable cost; it will include the increment, or step, in
the fixed cost as well.
EXAMPLE
9.5
Cottage Industries Ltd (Example 9.2 , page 391) has spare capacity: it has spare basket-
makers. An overseas retail chain has made an order for 300 baskets at a price of $81 each.
Without considering any wider issues, should the business accept the order?
Since the fixed costs will be incurred in any case, they are not relevant to this decision. All we need
to do is to see whether the price offered will yield a contribution. If it will, the business will be better
off by accepting the contract than by refusing it. We know that the variable costs per basket total
$72; thus, each basket will yield a contribution of $9 (i.e. $81−72): $2,700 in all. Whatever else
may be happening to the business, it will be $2,700 better off by taking this contract than by
refusing it.
There are other factors that are either difficult or impossible to quantify, but are nevertheless still likely to
affect a final decision. For Cottage Industries, these may include the following:
The possibility that spare capacity will be ‘sold off’ cheaply when there is another potential customer
offering a higher price, by which time the capacity will be fully committed. The likelihood of this
occurring is a matter of commercial judgement.
The possibility of losing customer goodwill by selling the same product at different prices. Offering
different prices to customers in different countries may overcome such a problem.
If the business is going to suffer continually from being unable to sell its full production potential at the
‘regular’ price, it may be better in the long run to reduce capacity and make fixed-cost savings. Using
the spare capacity to produce marginal benefits may not overcome this problem.
On a more positive note, the business may see this as a way of breaking into the overseas market,
which it may not achieve by charging its regular price.
The most efficient use of scarce resources
We tend to think that market size is operating the brake on output. That is, the ability of a business to sell
is likely to limit production, rather than sales being limited by its ability to produce. In some cases,
however, circumstances arise that limit the amount that can be produced, which in turn limits sales.
Limited production might stem from a shortage of any production factor—labour, raw materials, space,
machinery, etc. The most profitable combination of products occurs when the contribution per unit of the
limiting factor is maximised. Example 9.6 illustrates how this is done.
limiting factor
Some aspect of the business (e.g. lack of sales demand) that will stop it from
achieving its objectives to the maximum extent.
EXAMPLE
9.6
A business provides three different services, as follows:
Within reason, the market will take as many units of each service as available, but the ability to
provide the service is limited by the availability of skilled labour. Fixed costs are not affected by the
choice of service provided, because all three services use the same production facilities. What is
the most profitable service, given the limited number of labour hours available?
The most profitable service is AX109 because it generates a contribution of $66.67 (i.e. $200/3)
per hour. The other two generate only $50.00 each per hour ($250/5 and $300/6).
Your first reaction may have been that the business should provide service AX220 only, because
this is the one that yields the highest contribution per unit sold. If so, you are mistakenly thinking
that the ability to sell is the limiting factor. If you are not convinced by the above analysis, take an
imaginary number of available labour hours and ask yourself what is the maximum contribution
(and, therefore, profit) that could be made by providing each service exclusively. Bear in mind that
there is no shortage of anything else, including market demand, just a shortage of labour.
Activity 9.5
a. A business makes three different products, as follows:
Product (code name) B14 B17 B22
Fixed costs are not affected by the choice of product, because all three products use the same
machine. Machine time is limited to 148 hours a week. Which combination of products should be
manufactured if the business is to produce the highest profit?
b. What steps could lead to a higher level of contribution?
c. What maximum price would the business logically be prepared to pay to have the remaining B14s
machined by a subcontractor, assuming that no fixed or variable costs would be saved by not
machining in-house? Would there be a different maximum if we were considering the B22s?
Sometimes just part of a product is subcontracted. For example, the producer may have an appliance
component made by another manufacturer. In principle, there is hardly any limit to the scope of make or
buy decisions. Virtually any part, component or service required for the main product or service, or even
the main product or service itself, could be subjected to a make or buy decision. So, for example, a
company’s personnel function, normally performed in-house, could be subcontracted. At the same time,
electrical power, usually provided by an outside electrical utility business, could be generated in-house.
EXAMPLE
9.7
Jones Ltd needs a component for one of its products. It can have the component made by a
subcontractor, who will charge $20 a piece. The business can produce the components internally
for total variable costs of $15 each. Jones Ltd has spare capacity. Should it subcontract or produce
the component in-house?
The answer is that Jones Ltd should produce the component itself, since the variable cost of
subcontracting is greater by $5 than the variable cost of internal manufacture.
Should the business have no spare capacity, it would be necessary to incorporate the opportunity
cost of any time spent working on the component. This would be typically based on the loss of
contribution from the time transferred from normal activity to work on the component.
At a more general level, there are a number of factors, other than the immediately financially quantifiable,
that need further consideration. The two most important are:
expertise and specialisation—most businesses can do virtually everything in-house, but few have (or
want to acquire) the necessary skills and facilities; for example, although most businesses could
generate their own electricity, their management teams tend to think that this is better done by a
specialist.
SELF-ASSESSMENT QUESTION
9.2
a. Shah Ltd needs a component for one of its products. It can have the component made by a
subcontractor, who will charge $20 for each component. The business can produce the
components internally for total variable costs of $15 per component. Shah Ltd has no spare
capacity, so it can produce the component internally only by reducing its output of another
product. While it is making each component, it will lose contributions of $12 from this other
product. Should the component be subcontracted or produced internally?
b. Khan Ltd can make three products (A, B and C) using the same machines. Various
estimates for next year have been made as follows:
A B C
Product $ $ $
Fixed overhead costs for the next year are expected to total $400,000.
i. If the business made only product A next year, how many units would it need to make to
break even? (Assume for this part of the question that there is no effective limit to market
size and production capacity.)
ii. If the business has maximum machine capacity for next year of 10,000 hours, in which
order of preference would the three products come?
iii. The maximum market for next year for the three products is as follows:
Product A 3,000 units
What quantities of which product should the business make next year, and how much profit would
this be expected to yield?
Closing or continuing a section or department
It is quite common for businesses to account separately for each department or section to try to assess
the relative effectiveness of each one.
EXAMPLE
9.8
Goodsports Ltd is a retail shop that operates through three departments, all in the same premises.
The three departments occupy roughly equal areas of the premises. The trading results for the
year just ended showed the following:
Profit/(loss) 52 41 20 (9)
It seems that if the general clothes department closed, the business would be more profitable by
$9,000 a year, assuming last year’s performance to be a reasonable indication of future
performance.
When the costs are analysed between those that are variable and those that are fixed, however,
the following results are obtained:
Contribution 190 87 66 37
Profit/(loss) 52 41 20 (9)
From this analysis it is obvious that closing the general clothes department, without any other
developments, would make the business worse off by $37,000 (the department’s contribution). The
department should not be closed, because it makes a positive contribution. The fixed costs would
continue whether the department closed or not. As the above analysis shows, distinguishing
between variable and fixed costs can make the picture a great deal clearer.
Other developments that might need to be considered include the following:
Expanding the other departments or replacing the general clothes department with a
completely new activity. This would make sense only if the space currently occupied by the
general clothes department could generate contributions totalling at least $37,000 a year.
Subletting the space occupied by the general clothes department. Once again, this would need
to generate a net figure of $37,000 a year to make it more financially beneficial than keeping
the department open.
There may be advantages in keeping the department open even if it generated no contribution
(assuming no other use for the space). This is because customers attracted to the general
clothing range may then shop at one of the other departments. By the same token, a sub-
tenant business might attract customers to the shop (or drive them away).
Closely aligned with the make or buy decision and the decision of continuing or closing a department or a
section is the relatively recent practice of outsourcing production or services, or moving part of the
business activities offshore. Real World 9.7 provides information on reasons for the growth in
outsourcing, and of the trends regarding the kind of areas outsourced.
Outsourcing globally has been estimated by microsourcing.com to have grown from US$45.6
billion in 2000 to US$88.9 billion in 2015. Jesus Lopez has identified the main reasons for
outsourcing as: reduction or control of costs (44%); access to IT resources (34%); freeing up of
internal resources (31%); better customer focus (28%); enabling reorganisation or transformation
(22%); acceleration of projects (15%); access to management expertise not available internally
(15%); and reduced time to market (9%). And, as microsourcing says, outsourcing seems to be a
global phenomenon.
Deloitte prepares a regular survey on outsourcing. The 2018 survey suggests some important
changes in what is being outsourced, and corporate attitudes to it, and uses the term ‘disruptive
outsourcing’ to indicate the direction in which the sector is moving. ‘In the past, organizations
typically used outsourcing to improve back-office operations through cost reduction and
performance improvement’ (p. 2). Disruptive outsourcing enables competitive advantage by
moving change forward using technology. These solutions are seen as having the potential to
revolutionise the way business is done.
The main industries using this new type of outsourcing are: technology, media and
communications (29%); financial services (25%); consumer (18%); and energy, resources and
industrials (12%).
The survey found that most respondents recognise that they needed to change their strategy.
There was a recognition that they need to think about continual innovation to obtain competitive
advantage ‘by transforming the way organisations operate, and making them more agile, efficient,
and effective’ (p. 4). The survey found that the primary motivation for adopting the cloud was to
catalyse IT innovation. Cost reduction was not a primary objective. One-third of respondents were
prepared to accept a cost increase if they could improve performance.
Deloitte’s position can be summarised thus: ‘Traditional outsourcing is dead. Long live disruptive
outsourcing.’
Jesus Lopez, ‘What is outsourcing? What does it mean for companies?’, medium.com, 25 August 2017.
Deloitte Development LLC, Traditional Outsourcing is Dead. Long Live Disruptive Outsourcing. The Deloitte Global Outsourcing Survey 2018.
Reflection 9.6
What kind of areas might Lucas, our restaurateur, or Tim, our agricultural engineer from the case
in Chapter 6 , or our fintech entrepreneur from Chapter 4 , outsource in order to obtain or
retain a comparative advantage?
Concept check 12
A business, which has current spare capacity, has the chance to break into a foreign
market. It currently sells its main product at $125 each. It has worked out that it could make
money in the new market as long as it could sell the product for at least $85. Which of the
following are reasons why the business might choose not to sell at this reduced price?
A. The spare capacity, which is limited, may be better used for other, as yet unidentified,
opportunities.
B. Loss of goodwill once domestic customers get to know of different pricing regimes
overseas.
C. Rather than continuing to run with spare capacity, the business might be better off
reducing its capacity.
D. All of the above.
Concept check 13
Which of the following statements relating to relevant costing is true?
A. When deciding on the most profitable combination of products, maximisation of the
contribution per unit of limiting factor is the way to go.
B. There are clear limits to the scope that a business has regarding the make or buy
decision.
C. When considering whether a department should be retained or closed, it is important
to identify relevant costs in detail, including a share of fixed overheads.
D. The general problems of subcontracting mean that subcontracting is usually not a
good idea.
Consider a decision to install an LPG conversion system in your vehicle. You have a large older
car, which uses about 12 litres of unleaded fuel per 100 kilometres. An LPG conversion system will
cost you about $2,800 to install. LPG consumption is estimated at about 14 litres per 100
kilometres. Costs of normal unleaded fuel are expected to be around $1.50 per litre, and for LPG
about 80¢ per litre. How might you approach this decision?
You probably will need to estimate your annual average use of the vehicle in terms of kilometres
covered. What if you are not sure? One way is to calculate the minimum kilometres of usage that
you will need to do to recover the cost of the installation. To do this, you need to work out the fuel
cost savings. These are, per 100 kilometres:
How many kilometres need to be covered to recover the installation costs? If every 100 kilometres
recovers $6.80, we can calculate the kilometres needed to recover the cost by dividing the
installation costs by 6.80 and multiplying the result by 100.
$2,800×100/6.8=41,176 kilometres
This suggests that if you drive an average of 25,000 kilometres a year, you will recover the costs in
well under two years. If your usage is much higher, the returns are much higher. Again, there are
assumptions made in these calculations which may not be valid, such as those regarding fuel
costs and an implicit assumption that servicing costs will be no different with an LPG conversion
system added. So if you are going to investigate the possibility of installing an LPG conversion
system, you need to ask rather more detailed questions regarding costs than we have considered
here.
Another factor needs mentioning at this stage. Everything we have done to date assumes that
money has no time value. The concept of the time value of money is dealt with in Chapter 12 .
You might like to reconsider this box after you have read Chapter 12 , as there are further
factors that might have an impact on your decisions.
Finally, consider the example of make or buy in a family context. You want your garden to have a
solid swing set for use by your family. You have looked at what is available, and found that the
best buy will cost you $500. You wonder whether you might build something similar. You estimate
that the materials will cost about $260. How do you then factor in your labour time? You might just
love doing things like this and not even think about the opportunity cost of your labour. You might
be completely impractical and think that the building would take you several weekends, say 20
hours (probably plus a few hours from friends). The money saved by building amounts to $240, so
if it takes you 20 hours to build, you are pricing your labour at $12 per hour. If you are very busy
and currently earning at an hourly rate well in excess of $12 per hour, you might simply say it’s not
worth your time. Many people make this choice, often implicitly. If you have good skills in this area
and think that you can do the job in about six hours, the effective hourly rate is $240/6=$40. This
starts to look like a good hourly rate. Very few people explicitly go through these sorts of
calculations, but often make a judgement that it is simply not worth trying to do things like this
themselves. At the other end of the spectrum is the person who wants to do something special, not
to say unique, who will give almost no thought to the material costs and time involved.
Reflection 9.7
Gardening, home repairs, renovations and dressmaking are all activities that you can do yourself,
or have them done for payment. How do you choose which, or how much, of each of these to do
for yourself?
Summary
In this chapter we have achieved the following objectives in the way shown.
Distinguish between fixed costs and variable costs, and explain the Explained the nature of fixed and variable costs
importance of a detailed understanding of cost behaviour Analysed costs and separated the elements of semi-
variable costs into fixed and variable
Identified problems such as non-linearity, stepped costs
and multi-product businesses
Illustrated through the chapter the importance of a
detailed understanding of cost behaviour
Apply the distinction between fixed costs and variable costs to explain and Illustrated and prepared a break-even chart
apply break-even analysis Calculated a break-even point
Illustrated the uses to which break-even analysis can be
put
Illustrated the concept of margin of safety
Explained the concept of operating gearing
Explain and apply the concept of contribution and contribution margin Explained and illustrated the concept of contribution
Applied the concept of contribution to specific situations
Identified ways in which spreadsheets can help in
decision-making
Used both historic and forecast figures
Illustrated more complex relationships
Define and distinguish between relevant costs, outlay (historic) costs, and Defined and explained relevant costs and opportunity
opportunity costs costs
Illustrated that historic costs are not usually relevant for
decision-making
Provided a decision flow diagram to assist in
determining relevance
Explain and apply the concept of relevant costing to a range of decision- Explained the concept
making situations Applied it to a number of situations
— special contracts
Easy
9.1 LO Use a mobile phone payment contract to illustrate the concept of fixed and variable costs.
1
9.2 LO Your accounting study buddy tells you that he has learned that the break-even point is the sales volume where total sales
2 revenue will be equal to the total variable costs at that sales volume. Clarify the break-even concept for your friend. Is there a
particular instance where his calculation would provide the correct result?
9.3 LO After the first 10 minutes of watching a ‘spur of the moment decision’ movie, you knew you’d made a bad decision and were
4 going to hate it. And you were right, but you sat through the whole movie to ‘get your money’s worth’. What type of cost was your
movie ticket? What decision logic did you ignore by staying for the whole movie?
9.4 LO Provide examples from your life as a student for each of the different types of cost. Explain how each of your examples fits the
4 criteria for that cost.
9.5 LO What features must a cost possess for it to be considered relevant to a decision?
5
Intermediate
9.6 LO 3 Explain the meaning of ‘contribution’, and discuss its usefulness.
9.8 LO 3 Contribution represents the unit selling price less the unit variable cost. How does it relate to the concept of operating
gearing?
9.9 LO 5 In the case of a scarce resource, management should strive to maximise the contribution per unit of the limiting factor. Explain
this statement.
9.10 LO 1 Why is an understanding of cost behaviour (e.g. fixed costs, variable costs, etc.) important? Will such understanding be more
important for financial accounting or for management accounting?
9.11 LO 3 Why do we bother with break-even analysis? A business is formed to earn profit, not just to not make a loss (e.g. break even).
Discuss.
9.12 LO 4 If historical costs are irrelevant for decision-making, why do we spend so much time analysing them?
9.13 LO 5 Some students and businesses follow the policy of ignoring fixed costs when faced with a decision. Will this result in correct
decisions being made? When will it fail?
9.14 LO 2 Assume you plan to run a café on your university campus. What kinds of costs are considered fixed for a café? What kinds of
costs are considered to be variable costs?
Challenging
9.15 LO 1 Describe some of the challenges encountered by the accountant in determining cost behaviour.
9.16 LO 2 Use break-even or cost–profit–volume (CVP) analysis to illustrate the concept of risk.
9.17 LO 3 Break-even/CVP analysis seems to be a great tool. Does it have any weaknesses?
9.18 LO 4 Many business decisions will have opportunity costs that should be considered in the decision process. Discuss how these
opportunity costs are related to each of the following concepts:
a. excess or spare capacity
b. historical costs
c. sunk costs
d. relevant costs
e. outlay costs
f. incremental costs
g. out-of-pocket costs, and
h. marginal costs.
9.19 LO 4/5 Why might a business logically continue to make a product when it could be acquired externally at a cheaper total unit
price?
9.20 LO 5 In relation to a manufacturing business, explain how you would address the following limiting factor situations:
a. sales demand
b. raw materials
c. skilled labour
d. machine time
e. inwards delivery, and
f. selling price (regulated).
9.21 LO 2/5 What strategies could be used by a hotel business that continually fails to achieve the break-even point (typically expressed
as an occupancy rate)?
9.22 LO 4/5 Why, in making outsourcing decisions, does the business’s capacity need to be taken into account?
9.23 LO 2/3 How do you think the technology advancement, such as the artificial intelligence and automation, might affect the operating
gearing of businesses?
Application exercises
Easy
9.1 LO 1 A company manufactures a single product. The total cost of making 2,000 units is $30,000 and the total cost of making 3,000
units is $40,000. Within this range of activity:
9.2 LO 2/3 A company provides the following financial data related to a single product:
Calculate:
9.3 LO 1/3 a. A company’s break-even point is 5,500 units per annum. The unit selling price is $86 and the unit variable cost is $53.
i. What is the contribution margin ratio (%)?
ii. What are the annual fixed costs?
b. A company makes a single product, which sells for $24 per unit. Fixed costs are $32,000 per month, and the
contribution margin is 0.30 (30%). Sales for the month were $132,000.
i. What is the contribution per unit ($)?
ii. What is the break-even point in sales dollars?
iii. What is the margin of safety in sales units?
9.4 LO 1/2 a. The following information on sales revenue and wages expense was collected over a six-month period:
Sales Wages
February 150 97
Using the high–low method, determine the formula for calculating wages expense within the relevant range.
b. The total manufacturing cost for two levels of activity is given below:
Level 1 Level 2
Assuming the variable cost per unit and the total fixed costs remain constant over the relevant range and time period,
compute the total fixed cost.
9.5 LO 2/3 a. A company can sell its products for $15 each. The variable costs of each product are $10. Fixed costs are $20,000.
Find:
i. the break-even sales volume
ii. the sales volume needed to make a profit of $25,000
b. Lannion & Co provides and markets a standard cleaning service. Summarised results for the past two months reveal
the following:
October November
There were no price changes of any description during these two months.
Intermediate
9.6 LO 1/2 Brown and Co. makes and sells a single product line. Summarised results for the past two months reveal the following:
May June
$ $
There were no price changes of any description during these two months. Deduce the break-even point (in units of the
service) for Brown and Co. (Hint: If there were no price changes over the two months, what is the only possible reason for the
sales revenue and expenses figures being different from one month to the next?)
9.7 LO 2 You are given this data for a company for two successive periods.
Period 6 Period 7
All production is sold for $100 per unit. Estimate the fixed costs and break-even point.
It is now proposed to introduce a machine whereby fixed costs will rise by $116,000 and variable costs will fall by $10 per
unit. Estimate:
a. W Ltd wishes to attain a before-tax profit equal to 20% of sales revenue. Variable costs are 60% of sales, and fixed
costs are $360,000. Calculate the dollar amount of sales necessary for achieving the profit goal.
b. X Ltd incurs variable costs of $24 per unit for a product that has a selling price of $36. If the break-even point is
$84,000 of annual sales, what are the company’s annual fixed costs?
c. Y Ltd has annual fixed costs of $76,000. The variable costs are $5 per unit and the break-even point is 8,000 units.
What is the selling price per unit?
d. Z Ltd has a product that sells for $73 and is produced at a variable cost of $59 per unit. The variable costs can be
reduced by 25% by installing a new piece of equipment. Installing the new equipment will increase fixed costs from the
present level of $120,000 to $170,000. Calculate the present break-even point and the new break-even point if the
equipment is installed.
Challenging
9.9. LO 1- During the past three-month period, B Ltd showed a net loss of $20,000, and the directors are holding a meeting to discuss
5 what action to take. Each director has a proposal to submit, and you have been invited to present figures showing the result
of each proposal. The one matter on which all the directors agree is a profit target of $40,000 for the next period. You have
the following information for the last period and for the period immediately preceding it:
Last period Preceding period
Both of the above outputs were within the normal range of activity. It is estimated, however, that if the output exceeds 12,000
units, the variable costs will increase by $10 for each unit in excess of 12,000. The following proposals are put forward:
1. Improve packaging of the product at a cost of $2.50 per unit in an effort to increase sales.
2. Launch an advertising campaign costing $20,000 in an effort to increase sales.
3. Reduce the selling price by $2.50 per unit.
4. Buy more efficient machinery to reduce the variable costs per unit by $10. Fixed costs at present include $40,000 per
annum depreciation in respect of the machinery to be replaced.
a. Show how the figures for the fixed and variable costs could be calculated.
b. Assuming that the variable costs were $50 per unit and the fixed costs were $200,000, show the increases in
sales necessary under each of the first three proposals to achieve the profit target.
c. Show the amount that could be invested in new machinery under proposal 4, assuming that depreciation of
20% per annum will be provided and that output will remain at 9,000 units. Ignore inflation.
9.10 LO 5 Walker Ltd has declared the following for the year to 31 May 2020:
$’000
Direct materials 2%
An order has been received from abroad, at a price that is 20% lower than the domestic price, for 12,500 units to be supplied
during the year. The order must be accepted in its entirety or rejected. Home demand is unlikely to change. Three options are
being considered:
Advise management on the most profitable option, and calculate the net profit to be expected.
9.11 LO 5 A company makes three products, A, B and C. All three products require the use of two types of machine, cutting machines
and assembling machines. Estimates for next year include the following:
Time required per unit on cutting machines (hours) 1.0 1.0 0.5
Time required per unit on assembling machines (hours) 0.5 1.0 0.5
Fixed overhead costs for next year are expected to total $42,000. It is the company’s policy for each unit of production to
absorb these in proportion to its total variable costs.
The company has cutting machine capacity of 5,000 hours per annum and assembling machine capacity of 8,000 hours per
annum.
a. State, with supporting workings, which products in which quantities the company should plan to make next year on the
basis of the above information.
b. State the maximum price per product that it would be worth the company paying a subcontractor to carry out that part
of the work that could not be done internally.
9.12 LO 5 The management of your company is concerned about its inability to obtain enough fully trained labour to enable it to meet its
present budget projection.
Product $ $ $ $
Direct costs
The amount of labour likely to be available amounts to $20,000. You have been asked to prepare a statement ensuring that
at least 50% of the budgeted sales are achieved for each product and the balance of labour used to produce the greatest
profit.
a. Prepare a statement showing the greatest profit available from the limited amount of skilled labour available, within the
constraint stated.
b. Provide an explanation of the method you have used.
c. Provide an indication of any other factors that need to be considered.
Chapter 9 Case study
$ $ $
Sales 640,000
Cost of sales
Factory
Material (280,000)
Labour (96,000)
(492,000)
Selling
Commission (64,000)
(114,000)
Administration
(30,000)
(636,000)
The budgeted profit is not satisfactory and there are various proposals for how the position could be
improved.
1. The managing director would like to know the position if selling prices were increased by 7.5% and
an additional $40,000 was spent on advertising to maintain the present budgeted output.
2. The production director feels the answer is an increased output. The sales director states that he
could have the factory working at 100% capacity if he were allowed to reduce selling prices by 5%.
He wishes to know what profit would be gained under these conditions and at what level of output
the company would break even.
3. The marketing director is opposed to proposal 2. She considers that more should be spent on
sales promotion. She estimates that a sales promotion costing $15,000 would result in sales of
400,000 units per annum. She wishes to know what profit this would achieve, and the maximum
amount she could spend to achieve the desired sales level without reducing profit below the
$4,000 budgeted.
4. The sales director also reports that a European distributor is quite willing to take 100,000 units per
annum, provided a reasonable selling price can be agreed. The quality required, however, would
involve increased factory variable costs of 12.5¢ per unit, and the company would pay half the
distribution costs (estimated to total $30,000 per annum). No sales commission would, however,
be payable. What is the minimum price at which the proposal could be accepted? What factors
should be taken into account to determine the finally agreed price?
Questions
1. Calculate the break-even point on the basis of the budgeted figures.
2. Prepare statements answering all of the points raised, and comment on each one.
3. Identify the behavioural factors that are likely to be driving each of the proposals, and consider how
you might deal with these.
Activity 9.1
Using the high–low method, the figures can be calculated as follows:
Materials $4,000/4,000=$1
Labour $1,500/4,000=37.5 ¢
Overheads $500/4,000=12.5 ¢
At an output level of 20,000 units this implies total variable costs of:
The difference between these figures and the total figures for each type of cost will give an estimate of fixed costs, as follows:
Materials nil
Labour $2,500
Overheads $7,500
These figures could then be used to carry out cost–profit–volume analysis and to prepare charts, basing the figure for variable costs per
unit on an estimated $1.50, and basing the figure for fixed costs on an estimated $10,000.
Activity 9.2
Being able to deduce the break-even point is useful for comparing the planned or expected level of
activity with the break-even point, and for determining the riskiness of the activity. Operating only just
above the required level of activity to break even may indicate that it is a risky venture, since only a small
fall from the planned level of activity could lead to a loss.
$ $ $ $
Less
(500×1×$27) 13,500
40,500 40,500
= Fixed costs/(Sales revenue per unit – Variable costs per unit)=$12,000/[$60–(12+18)]=400 baskets per month
The break-even point without the machine is 250 baskets per month (see Example 9.2 , page 391).
There seems to be nothing to choose between the two manufacturing strategies regarding profit at the
estimated sales volume. There is, however, a distinct difference between the two strategies regarding the
break-even point. Without the machine, the actual level of sales could fall by half of what is expected
(from 500 to 250) before the business would fail to make a profit. With the machine, a 20% fall (from 500
to 400) would be enough to cause the business to fail to make a profit. On the other hand, for each
additional basket sold above the estimated 500, an additional profit of only $18 (i.e. $90−18−54) would be
made without the machine, whereas $45 (i.e. $90−18−27) would be made with the machine.
Activity 9.3
2020 2021
Activity 9.4
a. The minimum price is the amount required to cover the relevant costs of the job. At this price, the
business will make neither a profit nor a loss. Any price that is lower than this amount will mean
that the wealth of the business is reduced. Thus, the minimum price is:
$
Opportunity cost of the car 7,000
Total 7,600
Total 8,020
Activity 9.5
Product B14 B17 B22
Therefore:
Produce
148 hours
a. This leaves the market demand unsatisfied for a further three units of product B14 and 30 units of
product B22.
b. Some possibilities for improving matters are as follows:
Contemplate obtaining additional machine time by acquiring a new machine, subcontracting the
machining to another business, or perhaps squeezing a few more hours per week out of the
business’s own machine. Perhaps two or more of these strategies could be combined.
Redesign the products in a way that requires less time per unit on the machine.
Increase the price per unit of the three products. This may dampen demand, but the existing
demand cannot be met at present, and it may be more profitable, in the long run, to make a
greater contribution on each unit sold than to take one of the other courses of action to
overcome the problem.
c. If the remaining three B14s were subcontracted at no cost, the business could earn a contribution
of $150 per unit, which it could not do otherwise. For any price up to $150 per unit, therefore, it
would be worth paying a subcontractor to do the machining. Naturally, the business would prefer to
pay as little as possible, but anything up to $150 would still make it worthwhile to subcontract the
machining. This would not be true of the B22s because they have a different contribution per unit;
$110 would be the relevant figure in their case.
Chapter 10 Full costing
Learning objectives
When you have completed your study of this chapter, you should be able to:
LO 1 Explain the nature of full costing, and the reasons why this information is useful to
managers
LO 2 Deduce the full cost of a unit of output in a single or multi-product (or -service)
environment, differentiate between direct and indirect costs, and discuss the problem of
charging overheads to jobs in a multi-product (multi-service) environment
LO 3 Explain the advantages of segmenting overheads, and use this approach to apply
overheads on a departmental basis
LO 4 Explain the principles of activity-based costing (ABC), apply cost drivers, and compare
ABC with the traditional system of total absorption costing
LO 5 Identify and explain the main uses of full cost information, and the main criticisms of
full costing, and apply the concepts of relevant costing and full costing appropriately to
several decision-making situations.
With full costing we are not concerned with variable costs, but with all of the costs involved with
achieving some objective; for example, making a particular product. The logic of full costing is that all of
the costs of running a particular facility—say, a factory—are part of the cost of that factory’s output. For
example, the rent may be a cost that will not alter merely because we make one more unit of production,
but if the factory was not rented there would be nowhere for production to take place, so rent is an
important element of the cost of each unit of output.
full costing
Deducing the total direct and indirect (overhead) costs of pursuing some objective
or activity of the business.
Full cost is the total amount of resources, usually measured in monetary terms, sacrificed to achieve a
particular objective. It takes account of all of the resources sacrificed to achieve the objective. Thus, if the
objective was to supply a customer with a service or a product, the cost of the delivery of the service or
product to the customer’s premises would normally be included as part of the full cost. To derive the full
cost figure, we must accumulate the costs incurred and then assign them to the particular product or
service.
full cost
The total amount of resources, usually measured in monetary terms, sacrificed to
achieve a particular objective.
We saw in Chapter 1 that the only point in providing management accounting information is to improve
the quality of managers’ decisions. There are four main areas where information relating to the full cost of
a business’s products or services may help serve this purpose. These are:
1. Pricing and output decisions. Having full cost information can help managers make decisions on
the price to charge customers for the business’s products or services. Full cost information, along
with relevant information concerning prices, can also be used to determine the number of units of
products or services to be produced.
2. Exercising control. Determining the full cost of a product or service is often a useful starting point
for exercising cost control. Where the reported full cost figure is considered too high, for example,
individual elements of the full cost may then be examined to see whether there are opportunities
for savings. This may lead to re-engineering the production process, finding new sources of supply
and so on. Also, budgets and plans are often expressed in full-cost terms. Budgets are typically
used to help managers exercise control by comparing planned (budgeted) performance with actual
performance. We shall pick up this point in Chapter 11 .
3. Assessing relative efficiency. Full cost information can help compare the cost of carrying out an
activity in a particular way, or at a particular place, with its cost if carried out in a different way or
place. A motor car manufacturer, for example, may wish to compare the cost of building a
particular model of car in one manufacturing plant, rather than in another. This could help in
deciding where to locate future production.
4. Assessing performance. We have seen that profit is an important measure of business
performance. To measure the profit arising from a particular product or service, the sales revenue
that it generates should be compared with the costs consumed in generating that revenue.
(Usually, this cost is based on the full cost of whatever is sold.) This can help in assessing past
decisions. It can also help in guiding future decisions, such as continuing with, or abandoning, the
particular product or service.
To work through the main principles, Example 10.1 provides a useful starting point.
EXAMPLE
10.1
The University of Cambridge calculated that for the academic year 2014/15 the average cost of
educating an undergraduate student was £18,000.
Source: John Morgan, ‘Cambridge’s “Cost of education” rises to £18K per student’, Times Higher Education Supplement, 8 September 2016.
This figure represents the full cost of carrying out this activity. This immediately begs the question
as to what this figure should include. Does it simply include the cost of the salaries earned by
academics during the time spent in lectures, seminars and tutorials, or does it include other things?
If other costs are to be included, what are they? Would they include, for example, a charge for the
costs of time spent by academics in:
Would there be a charge for administrative staff carrying out teaching-support activities, such as:
timetabling
preparing prospectuses
student counselling, and
careers advice?
Would there be a charge for the use of university facilities, such as:
the library
lecture halls, and
laboratories and workshops?
If the cost of such items is not to be included, is the figure of £18,000 potentially misleading? If, on
the other hand, the cost of these items is to be included, how can an appropriate charge be
determined? Addressing questions such as these is the focus of this chapter.
Reflection 10.1
How might the full cost of a steak meal in the city-centre restaurant run by Lucas, our restaurateur,
be calculated? Is this useful information?
In the sections that follow, we shall begin by considering how to derive the full cost of a unit of output for a
business providing a single product or service. We then go on to see how the full cost of a unit of output
may be determined for a business providing a range of products or services.
Activity 10.1
How important do you consider a knowledge of full cost is likely to be in pricing decisions?
Concept check 1
Which of the following could be considered a cost object?
A. The company
B. A customer
C. A line of products
D. An employee
E. All of the above.
Concept check 2
Full cost information is important for several reasons. Which of the following is NOT an
important reason for calculating full costs?
A. Short-term pricing decisions
B. Long-term pricing decisions
C. Calculation of the break-even point
D. Determining finished goods inventory values
E. Calculating the cost of goods sold.
Concept check 3
Which of the following would NOT be included in determining full cost?
A. Variable costs
B. Direct costs
C. Fixed costs
D. Infrastructure costs
E. None of the above (each is part of the full cost).
Deriving full costs in a single or multi-product or -
service operation
LO 2 Deduce the full cost of a unit of output in a single or multi-product (or -service) environment,
differentiate between direct and indirect costs, and discuss the problem of charging overheads to jobs
in a multi-product (multi-service) environment
Single-product businesses
The simplest case for which to deduce the full cost per unit occurs when the business has only one
product line or service; that is, each unit of its product or service is identical. Here it is simply a question of
adding up all of the costs of production incurred in the period (e.g. materials, labour, rent, fuel and power)
and dividing this total by the total number of units of output for the period. This is illustrated in Example
10.2 . This approach is referred to as process costing.
EXAMPLE
10.2
Rustic Breweries Ltd has just one product, a bitter beer marketed as Old Rustic, and last month
the company produced 40,000 litres of it. The costs incurred were as follows:
Labour 30,000
Ingredients 10,000
Fuel 5,000
The full cost per litre of producing Old Rustic is found simply by taking all of the costs and dividing
the total by the number of litres brewed:
While the full cost can be found in this case quite simply by adding all of the costs and dividing by the
number of litres produced, in practice it is not so easy to decide exactly how much cost was incurred. In
the case of Rustic Breweries Ltd, for example, how is the cost of depreciation deduced? It is almost
certainly an estimate, and so the appropriateness of its inclusion is open to question. Should we use the
‘relevant’ cost of the raw materials (almost certainly the replacement cost) or the actual price paid for the
materials used? If it is worth calculating the cost per litre, it must be because this information will be used
for some decision-making purpose, so the replacement cost is probably more logical. In practice,
however, it seems that historic costs are more often used to deduce full costs. It is not clear why this
should be the case.
There can also be problems in deciding precisely how many units of output there were. Brewing beer is
not a very fast process, so there is likely to be some beer still being brewed at any given moment. This
means that part of the costs incurred last month involved some ‘work-in-progress’ beer at the end of the
month, and is not therefore included in the output quantity of 40,000 litres. Similarly, part of the 40,000
litres was started and incurred costs in the month before last, yet the full 40,000 litres were used in our
calculation of the cost per litre. Work-in-progress is not a serious problem, but some adjustment for the
value of opening and closing stocks for the period must be taken into account to keep the full cost
information reliable.
The approach to full costing that is usually taken with identical, or near-identical, units of output is often
referred to as process costing .
process costing
A technique for deriving the full cost per unit of output, where the units of output
are exactly the same or very similar, or it is reasonable to treat them as being so.
Activity 10.2
Can you think of at least two types of industry where process costing may apply?
Multi-product operations
In many situations in which full costing is used, the output units of the product or service are not identical,
and so the approach we used with litres of Old Rustic in Example 10.1 would not be suitable. For
example, whereas customers would expect to pay the same price for each litre of their preferred type of
beer, few people would expect to pay a garage the same price for each car repair regardless of its
complexity or size. So, while it is reasonable to price litres of beer equally because the litres are identical,
it is not acceptable to price widely different car repairs equally.
Direct and indirect costs
When the units of output are not identical, we normally separate costs into two categories:
Direct costs are costs that can be fairly easily identified (or traced to) specific cost units. That is to say,
the effect of the cost can be measured for each particular unit of output. A cost unit is simply a unit of
whatever is having its cost determined—usually one unit of service or a manufactured unit. The main
examples of direct costs are direct materials and direct labour. In costing a motor car repair by a garage,
both the cost of spare parts used in the repair and the cost of the mechanic’s time would be direct costs.
Collecting direct costs is a simple matter of having a cost recording system that can capture the cost of
direct materials used on each job, and the cost of direct workers, based on the hours worked and the rate
of pay. Usually, direct workers are required to record how long was spent on each job. Thus, the
mechanic doing the job would record the length of time worked on the car. The pay rates should be
available. It is simply then a matter of multiplying the number of hours spent on a job by the relevant rate
of pay. The stores staff would normally be required to keep a record of the cost of parts and materials
used on each job. A job sheet will normally be prepared—probably on a computer—for each individual
job. The quality of the information generated will rely on staff faithfully recording all elements of direct
labour and materials applied to the job.
direct costs
Costs that can be identified with specific cost units, to the extent that the effect of
the cost can be measured in respect of each particular unit of output.
cost unit
The object for which the cost is being deduced, usually an individual product.
Indirect costs (or overheads) are all other product/service costs; that is, those that cannot be directly
measured for each particular unit of output. Thus, the rent of the garage premises would be an indirect
cost of a motor repair.
indirect costs (or overheads)
All costs except direct costs; that is, those that cannot be directly measured in
respect of each particular unit of output.
With both of these types of cost we include both production and non-production costs (such as marketing
costs) as appropriate.
We shall use the terms ‘indirect costs’ and ‘overheads’ interchangeably for the rest of this book.
Overheads are sometimes known as common costs because they are common to all aspects of the
production unit (e.g. factory or department) for the period. Real World 10.1 provides some guidance
regarding the relative weighting of direct and indirect costs found in practice.
common costs
See indirect costs.
A survey of 176 UK businesses operating in various industries, all with annual sales revenue of
more than £50 million, was conducted by Al-Omiri and Drury. They discovered that the full cost of
the businesses’ output, on average, is split between direct and indirect costs as follows:
All businesses 69 31
Manufacturing businesses 75 25
For the manufacturers, the 75% direct cost was, on average, made up of 52% for direct materials,
14% direct labour and 9% other direct costs.
Source: Mohammed Al-Omiri and Colin Drury (2007), ‘A survey of factors influencing the choice of product costing systems in UK organisations’, Management
Reflection 10.2
Tim, our agricultural engineer, has found that repairing heavy agricultural equipment is currently
providing the majority of his business. What kind of split into direct and indirect costs might he
expect?
Job costing
The term job costing describes the way we identify the full cost per unit of output (job) when the units
of output differ. To cost (i.e. to deduce the full cost of) a particular unit of output (job) we usually ascribe
all possible direct costs to the job that, by the definition of ‘direct costs’, can be done. We then seek to
‘charge’ each unit of output with a fair share of indirect costs, as shown in Figure 10.1 . Put another
way, cost units (products) absorb overheads. This leads to full costing also being known as absorption
costing .
Figure 10.1 The relationship between direct costs and indirect costs
The full cost of any particular job is the sum of those costs that can be measured specifically in respect of
the job (direct costs), and a share of those costs that create an environment in which production (of an
object or service) can take place, but which do not relate specifically to any particular job (overheads).
job costing
A technique for identifying the full cost per unit of outputs, where outputs are not
similar.
absorption costing
A method of costing in which a ‘fair share’ of manufacturing/service provision
overhead is included when calculating the cost of a particular product or service.
Note that whether a cost is a direct one or an indirect one depends on the item being costed. People tend
to refer to overheads without stating what the cost unit or object is; this is incorrect. In order to explain
how this works, consider Example 10.3 .
EXAMPLE
10.3
Sparky Ltd employs a number of electricians, doing a range of work for its customers, from minor
repairs to installing complete wiring systems in new houses.
Into which category—direct or indirect—would each of the following costs fall for a particular job
done by Sparky Ltd:
Only the electrician’s wages earned while working on the particular job and the cost of the actual
materials used on the job are direct costs. This is because it is possible to measure how much time
(and, therefore, labour cost) was spent on the particular job, and it is possible to measure how
many materials were used in the job.
All of the other costs are general costs of running the business, and as such must form part of the
full cost of doing the job, but cannot be directly measured in respect of the particular job.
Naturally, a cost unit that is defined broadly (e.g. operating Sparky Ltd for a month) tends to have a higher
proportion of its costs identified as direct than more narrowly defined units do (such as a particular
customer job, e.g. rewiring). As we shall see shortly, this makes costing broader cost units rather more
straightforward than costing narrower ones, since direct costs are easier to deal with.
This might seem to imply some relationship between fixed, variable, direct and indirect costs. More
specifically, some people mistakenly believe that variable costs and direct costs are the same, and that
fixed costs and overheads are the same. This is incorrect.
The notion of fixed and variable costs is concerned entirely with the behaviour of costs in the face of
changes to the volume of output. Directness of costs is entirely concerned with collecting together the
elements that make up full cost—that is, with the extent to which costs can be measured directly in
respect of particular units of output or jobs. These are entirely different concepts. Although there may be a
tendency for fixed costs to be overheads and for variable costs to be direct costs, there is no automatic
link and there are many exceptions to this tendency. For example, most operations have variable
overheads. Also, labour—a major element of direct cost in most production contexts—is usually a fixed
cost, certainly over the short term.
To summarise this point, total cost is the sum of direct and indirect costs. It is also the sum of fixed and
variable costs. These two facts are independent of one another. Thus, a particular cost may, for example,
be fixed relative to the level of output, on the one hand, and be either direct or indirect on the other.
Indirect costs of any activity form part of the cost of each unit of output. By definition, however, they
cannot be directly related to individual cost units. This raises a major practical issue: how are indirect
costs to be apportioned to individual cost units?
The next step is the difficult one. How might the cost of running the factory, which is a cost of all
production, be apportioned (shared) between individual products that are not similar in size and/or
complexity of manufacture? The issue is the calculation of an overhead absorption (recovery) rate
that is appropriate. One possibility is to share this overhead cost equally between each cost unit produced
in the period. Few of us would propose this method unless the cost units were almost identical in terms of
the extent to which they had ‘benefited’ from the overheads. If we do not propose equal shares, we must
identify something observable and measurable about the cost units that seems to provide a reasonable
basis for distinguishing between one cost unit and the next in this context.
In practice, time—measured by direct labour hours —is usually the most popular basis. It must be
stressed, however, that this is not the ‘correct’ way and certainly not the only way. We could, for example,
use the relative size of products as measured by weight or by relative material cost. Possibly we could
use the relative lengths of time that each unit of output was worked on by machines.
Electrician Plumber
Materials Materials
Weather-proof switch Stormwater bend
*
Usually identifying the number of hours worked on the job
In both of these examples, the materials used have been clearly tracked and relate directly to the
job done—hence, they can reasonably be classified as direct costs which the customer can clearly
see have resulted in a cost that needs to be passed on. The only doubtful issue relates to the last
materials item under the electrician—namely, connectors, cable clips and screws. These are small
items of materials that are almost certainly not directly related to the actual use, but represent a bit
of a guess regarding something that is not very costly anyway.
When we turn to labour, the number of hours worked is clearly identified, enabling the customer to
check to see whether the amount of time charged is reasonable. But what about the hourly rate?
Recent rates charged are typically $60–$90 per hour. Does this mean that a plumber charging $60
per hour for his labour will have an income in the order of $120,000 per annum (assuming a 40-
hour working week, 50 weeks a year)?
The answer is certainly not. Plumbers and electricians typically have overheads, covering such
things as depreciation of vehicles and equipment, telephone costs, book-keeping costs and so on.
The time charged does not typically include travel between jobs and other downtime. These
overhead costs need to be totalled and charged in some way.
In businesses of this type, with a lot of quite different jobs, the easiest way of doing this is to make
an estimate of the total overhead costs, and of the estimated number of hours to be charged to
customers, calculate the average overhead cost per direct labour hour, and add this to the hourly
wage that the tradesperson wishes to be able to pay him- or herself.
If the annual overheads of an electrician were estimated to be $30,000, and the number of hours
expected to be charged to the customer (not the same as the number of hours spent working)
were 1,500 (which implies about 30 hours per week of chargeable time), the overhead recovery
rate per direct labour hour would be $20.
This implies that the tradesperson would earn a wage (assuming a charge-out rate of $60 per
hour) of only $40 per hour, for 30 hours per week, which gives a weekly figure of $1,200.
Assuming a 50-week working year, this translates to an annual income of $60,000.
It should be clear that even in relatively straightforward businesses of this type, overhead control
and recovery is an essential part of the business, and that recovery using a charge based on direct
labour hours is a very easy and effective way forward.
Accounting and You provides an example of the typical way in which you are billed for electrical or
plumbing work done. It provides an opportunity for you to understand the usual issues, albeit from a
different perspective.
Activity 10.3
A garage owner wishes to know the direct cost of each job (car repair) that is carried out. How could
information on the direct costs (labour and materials) for a particular job be collected?
The kind of businesses referred to in Accounting and You is relatively simple, with few indirect costs.
Once offices are set up, there are a whole range of other costs that will be incurred that make the
situation more complex. Consider, for example, the work of a solicitor’s or accountant’s practice. The use
of the same kind of basis for charging clients (usually known as ‘billable hours’) as used in Accounting
and You is possible, but there are far more overheads to be covered, and the degree of complexity of the
work is going to be far more varied.
Reflection 10.3
While working out the cost of doing a particular job is useful, the resulting figure is not necessarily,
or even usually, the best guide to how a particular job might be priced. You are managing a
financial services business, and you work out the cost of each job. What kind of issues might arise
relating to both the calculation of the number of hours used and the basis on which the price is
actually set? Just what kind of behavioural issues relating to the customer might arise in the
process? By way of illustration, consider the price that you might charge to a pedantic, fastidious
person for advisory work that you would like to continue to do in the future.
EXAMPLE
10.4
Johnson Ltd has overheads of $60,000 each month. Each month 2,500 direct labour hours are
worked and charged to units of output (the business’s products). A particular job uses direct
materials costing $238. Direct labour worked on the job is 15 hours, and the wage rate is $25 an
hour. Overheads are charged to jobs on a direct labour hour basis. What is the full cost of the job?
First, let us establish the ‘overhead recovery rate’—that is, the rate at which jobs will be charged
with overheads. This is $24 (i.e. $60,000/2,500) per direct labour hour.
613
973
Note that the number of labour hours (15 hours) appears twice in deducing the full cost: once to
deduce the direct labour cost, and a second time to deduce the overheads to be charged to the
job. These are really two separate issues, although they are both based on the same number of
labour hours.
Note also that if all jobs completed during the month are assigned overheads in a similar manner,
all $60,000 of overheads will be charged to the jobs between them. Jobs that involve a lot of direct
labour will be assigned a large share of overheads, and those that involve little direct labour will be
assigned a small share of overheads.
The main reasons why direct labour hours are regarded as the most logical basis for sharing overheads
between cost units are as suggested below.
Large jobs should logically attract large amounts of overheads because they are likely to have been
rendered more ‘service’ by the overheads than small jobs. The length of time that they are worked on
by direct labour may be seen as a rough and ready way of measuring relative size, although there are
other means of doing this (e.g. relative physical size).
Most overheads are related to time. Rent, heating, lighting, depreciation, supervisors’ and managers’
salaries, and loan interest, which are all typical overheads, are all more or less time-based. That is to
say, the overhead cost for one week tends to be about half that for a similar two-week period. Thus, it
seems logical to use time as a basis of apportioning overheads to jobs, because this takes account of
the length of time the units of output benefited from the ‘service’ rendered by the overheads.
Direct labour hours can be measured for each job. They are normally measured to deduce the direct
labour element of cost in any case. Thus, in the real world it is practical to apply a direct labour hour
basis of dealing with overheads.
However, it cannot be emphasised enough that there is no ‘correct’ way to apportion overheads to jobs.
Overheads—by definition being indirect costs—do not naturally relate to individual jobs. If, nevertheless,
we wish to take account of the fact that overheads are part of the cost of all jobs, we must find some
acceptable way of including a share of the total overheads in each job. If a particular means of doing this
is accepted by those who are affected by the full cost deduced as a result, then the method is as good as
any other method. Accounting is only concerned with providing useful information to decision-makers. In
practice, the method generally considered to be the most useful is the direct labour hour method.
Activity 10.4
Marine Supplier Ltd’s range of work includes making sails for small sailing boats on a made-to-measure
basis.
The following costs are expected to be incurred by the company during next month:
The company has received an inquiry about a sail that is estimated to take 12 direct labour hours to
make, and to require 20 square metres of sailcloth costing $6 per square metre.
The company normally uses a direct labour hour basis of charging overheads to individual jobs.
Figure 10.2 shows the process for applying overheads and direct costs to the sail that was the subject
of Activity 10.4 .
Figure 10.2 How the full cost of the sail is derived by Marine Suppliers Ltd
The full cost is made up of the sail’s (job’s) ‘fair’ share of the overheads, plus the direct cost element that
is measured specifically in relation to that particular sail.
Most people would probably feel that the nature of the overheads should influence the choice of the basis
of charging the overhead to jobs. If the operation is a capital-intensive one where the overheads are
dominated by those relating to machinery (e.g. depreciation, machine maintenance, power), machine
hours might be favoured. Otherwise, direct labour hours might be preferred.
One of these bases might seem preferable to the other one because it apportions either a higher or a
lower amount of overheads to a particular job. This would be irrational, however. Since the total
overheads are the same irrespective of the method of charging the total to individual jobs, a method that
gives a higher share of overheads to one particular job must give a lower share to the remaining jobs.
There is one cake of fixed size. If one person is to be given a relatively large slice, the other people must
receive smaller slices. To illustrate further this issue of apportioning overheads, consider Example
10.5 .
EXAMPLE
10.5
A business expects to incur overheads totalling $20,000 next month. The total direct labour time
worked is expected to be 1,600 hours, and machines are expected to operate for a total of 1,000
hours. During the month the business expects to do just two large jobs, outlined as follows:
Job 1 Job 2
Let us now examine how much overhead will be charged to each job if overheads are to be
charged on:
Job 1 $12.50×800=$10,000
Job 2 $12.50×800=$10,000
Job 1 $20.00×700=$14,000
Job 2 $20.00×300=$6,000
It is clear from this that the total of overheads charged to jobs is the same whichever method is
used. So, whereas the machine hour basis gives job 1 a higher share than the direct labour hour
method does, the opposite is true for job 2.
It is not practical to charge overheads on one basis to one job and on another basis to the other job. This
is because either total overheads will not be fully charged to the jobs, or the jobs will be overcharged with
overheads. For example, if we combined the direct labour hour method for job 1 ($10,000) and the
machine hour basis for job 2 ($6,000), only $16,000 of a total of $20,000 of overheads would be charged
to jobs. As a result, the objective of full costing, which is to charge all overheads to jobs done, will not be
achieved. In this particular case, if selling prices are based on full costs, the business may not charge
prices high enough to cover all of its costs.
Figure 10.3 shows the effect of different bases of charging overheads to jobs 1 and 2.
Figure 10.3 The effect of different bases of charging overheads to jobs in Example 10.5
The share of the total overheads for the month charged to jobs can differ significantly depending on the
basis used.
Real World 10.2 briefly describes the impact of the size of a business on their approach to assigning
overheads, and also provides some insight into the basis of overhead recovery in practice.
These findings might be expected given the differences between SMEs and larger businesses in
resourcing levels, and also, perhaps, in levels of financial awareness among managers.
Source: John A. Brierley (2011), ‘A comparison of the product costing practices of large and small- to medium-sized enterprises: a survey of British manufacturing
Fifteen per cent of respondents used a ‘production-time based overhead rate’. This is presumably
something like a machine hour rate.
Although this survey applied only to manufacturing businesses, in the absence of other information
it provides some impression of what happens in practice.
Source: Based on information taken from Christopher J. Cowton, Colin Drury and John A. Brierley (2007), ‘Product costing practices in different manufacturing
Concept check 4
The direct costs of repairs to your car would include:
A. Parts used in the repair
B. Labourer’s time spent working on your car
C. Receptionist’s time spent with you
D. A and B only
E. All of the above.
Concept check 5
Which of the following statements is false?
A. Most overheads are not related to time.
B. Overhead costs are the same as common costs and indirect costs.
C. Overhead costs are commonly recovered using direct labour hours.
D. There is no one correct way to share overheads between cost objects.
E. None of the statements are false.
Concept check 6
The use of direct labour hours for charging overheads to jobs will do a good job of
apportioning overhead for which of the following?
A. A capital-intensive operation
B. An airline
C. A labour-intensive operation
D. An internet service provider
E. None of the above.
Segmenting the overheads
LO 3 Explain the advantages of segmenting overheads, and use this approach to apply overheads on
a departmental basis
As we have just seen, charging the same overheads to different jobs on different bases is not possible. It
is possible, however, to charge one part of the overheads on one basis and another part, or other parts,
on another basis, as illustrated in Example 10.6 .
EXAMPLE
10.6
Taking the same business from Example 10.5 , suppose that on closer analysis we find that of
the expected overheads totalling $20,000 next month, $8,000 relates to machines (depreciation,
maintenance, rent of the space occupied by the machines, etc.) and the rest to more general
overheads. The other business details are exactly the same as before.
It makes sense for the machine-related overheads to be charged to jobs on a machine hour basis,
and the remaining overheads to be charged on a direct labour hour basis. These are calculated as
shown below.
Job 1 Job 2
$ $
$7.50×800 6,000
$7.50×800 6,000
$8.00×700 5,600
$8.00×300 2,400
Total $11,600 $8,400
We can see from this that the total expected overheads figure of $20,000 is charged in total.
Segmenting the overheads in this way may well be seen to provide a better basis of charging overheads
to jobs. This is quite commonly done in practice, usually by dividing a business into separate ‘areas’ for
costing purposes, and charging overheads differently from one area to the next, according to the nature of
the work done there.
Size and complexity. Many businesses are too large and complex to run as a single unit, and it is
more practical to run them as a series of relatively independent units, each with its own manager.
Expertise. Each department normally has its own specific activity and is managed by a specialist.
Accountability. Each department can have its own accounting records for assessing its performance.
This can encourage staff motivation.
Many businesses deal with charging overheads to cost units on a department-by-department basis, with
the idea that it allows a fairer means of charging overheads. In many cases, it does not greatly improve
the fairness of the resulting full costs or gain other benefits, but it is probably not an expensive exercise to
apply overheads on a departmental basis. Since costs are collected department by department for other
purposes (particularly control), to apply overheads department by department is relatively simple.
We shall now look at how the departmental approach to deriving full cost works in a service-industry
context, in Example 10.7 .
EXAMPLE
10.7
Autosparkle Ltd offers a motor vehicle paint-respray service that ranges from painting a small part
of a sedan car, usually after a minor accident, to a complete respray of a double-decker bus. Each
job starts life in the Preparation Department, where the vehicle is prepared for the Paintshop. In
the Preparation Department, the job is done directly by workers, mostly with them taking direct
materials from stores and treating the old paintwork to prepare the vehicle for respraying. Thus, the
job will be charged with direct materials, direct labour and with a share of the Preparation
Department’s overheads. The job then passes into the Paintshop Department, already valued at
the costs that it picked up in the Preparation Department.
In the Paintshop, the staff draw direct materials from the stores and workers respray the job with a
sophisticated spraying apparatus and by hand. So, in the Paintshop, the job is charged with direct
materials, direct labour plus a share of that department’s overheads. The job now passes to the
Finishing Department, valued at the cost of the materials, labour and overheads accumulated in
the first two departments.
In the Finishing Department, jobs are cleaned and polished ready for the customer. Further direct
labour, and in some cases materials are added, and the job picks up a share of that department’s
overheads. The job, now complete, passes back to the customer.
Figure 10.4 shows how this process works for a particular job. The basis of charging overheads
to jobs (e.g. direct labour hours) might be the same for all three departments or it might differ from
one department to another. Spraying apparatus costs might dominate the Paintshop costs, so
overheads might well be charged to jobs on a machine hour basis. The other two departments
would probably be labour-intensive, so direct labour hours might seem appropriate there.
As the particular paint job passes through the three departments where, as work is carried out on
it, the job ‘gathers’ costs of various types.
The passage of the job through the departments can be compared with a snowball rolling across snow.
As it passes, it picks up more and more snow.
Where cost determination is dealt with departmentally, each department is known as a cost centre .
This can be defined as a particular physical area or some activity or function for which the cost is
separately identified. Charging direct costs to jobs, in a departmental system, uses the same principles as
where the whole business is one single cost centre. It is simply a matter of keeping a record of:
the number of hours of direct labour worked on the particular job and the grade of labour, assuming
that there are different grades with different rates of pay
the cost of the direct materials taken from stores and applied to the job, and
any other direct costs (e.g. subcontracted work) involved with the job.
cost centre
Some area, object, person or activity for which costs are separately collected.
It is obviously necessary to identify the production overheads of the entire organisation on a departmental
basis. This means that the total overheads of the business must be divided between the departments, so
that the sum of the departmental overheads equals the overheads for the entire business. By charging all
of their overheads to jobs, between them the departments will charge all of the overheads of the business
to jobs.
Real World 10.3 provides an indication of the number of different cost centres that businesses tend to
use in practice.
It is usual for businesses to have several cost centres. A survey by Colin Drury and Mike Tayles of
186 larger UK businesses involved in various activities revealed the information shown in the
figure.
We can see that 86% of the businesses surveyed had six or more cost centres, and that 36% of
businesses had more than 20 cost centres. Although not shown on the diagram, 3% of the
businesses surveyed had a single cost centre (i.e. a business-wide or overall overhead rate was
used). Clearly, businesses that deal with overheads on a business-wide basis are relatively rare.
Source: Based on information taken from Colin Drury and Mike Tayles (2006), ‘Profitability analysis in UK organizations: an exploratory study’, British Accounting
Reflection 10.4
Lucas, our restaurateur, has asked your advice. He wants to know the amount of profit for each of
his restaurants. He has asked what cost centres he might need, and how he might apportion
overheads to them. He is also thinking of offering, in a couple of his most attractive locations, a
facility for weddings and the associated receptions. He is concerned as to how much to charge for
this new activity.
In Example 10.1 we saw a figure being produced for the cost of educating an undergraduate student at
Cambridge University. This single figure does not capture the complications of the variety of courses run
by a typical university. Real World 10.4 illustrates the need for segmentation and the need to consider
just what causes overheads.
Real world 10.4
Uni course costs vary
In December 2016 the Australian Department of Education and Training produced a report, Cost of
Delivery of Higher Education, prepared by Deloitte Access Economics. The report analysed
department costs across 17 universities, and the full range of undergraduate courses. Reported
costs varied widely, ranging from $10,000 to $70,000. It should be clear to you that different
courses will have different direct costs, but also will use different parts of the infrastructure and
incur different shares of the overheads. Detailed figures can, therefore, only be prepared using the
segmented approach covered above.
Factors that were seen as possibly influencing costs were identified as follows (p. 51):
Proportion of casual staff Proportion of external students Investment in student learning experience and teaching quality
Keep these in mind for the next section, when the items on this list have the potential to become
cost drivers for the cost of undergraduate degree programs.
Source: Deloitte Access Economics, Cost of Delivery of Higher Education: Australian Government Department of Education and Training. Final Report, December
Reflection 10.5
You have just come from a party at which the subject of HECS costs came up. You have been
somewhat irritated by a young doctor who was quite vocal in complaining about the higher cost of
his medical qualification, compared with the cost of your business degree, and that of a friend’s IT
degree. Explain to him why there is such a difference in the costs of the three programs.
Batch costing
The production of many types of goods and services, particularly goods, involves a batch of identical or
nearly identical units of output, but each batch is distinctly different from other batches. For example, a
theatre may put on a production whose nature, and therefore costs, is very different from those of other
productions. However, ignoring differences in the choice of seating, all of the individual units of output (i.e.
tickets to the play) are identical.
In these circumstances, a system known as batch costing is used, in which we normally deduce the
cost per ticket by a job costing approach (taking account of direct and indirect costs, etc.) to find the cost
of mounting the production, and then simply divide this by the number of tickets expected to be sold to
find the cost per ticket. Batch costing is used in a variety of industries, including clothing, manufacturing,
engineering component manufacturing, tyre manufacturing, bakery goods and footwear production.
batch costing
A technique for identifying full cost, where the production of many types of goods
and services, particularly goods, involves producing a batch of identical or nearly
identical units of output, but where each batch is distinctly different from other
batches.
Activity 10.5
Consider the following businesses:
– Pharmaceutical manufacturer
– Sugar refiner
– Picture framer
– Private hospital
– Coal mining
– Architect’s office
– Cement manufacturer
Try to identify for each business which form of full costing (job, process or batch costing) is likely to be
most appropriate.
Concept check 7
Which of the following statements is false?
A. The amount of overhead charged to individual jobs can be quite different depending
on the allocation method.
B. The total cost of overhead changes with the allocation method.
C. In a business with multiple cost centres it is reasonable to use both machine hours
and direct labour hours in the allocation method.
D. It makes sense for machine-related overheads to be charged to jobs on a machine
hour basis.
E. None of the above is false. All are true.
Concept check 8
Which of the following statements is true?
A. Proper segmentation of overheads will reduce the overall overhead cost.
B. Segmentation of overheads simplifies the costing process (e.g. fewer calculations).
C. Multiple allocation rates are required if overheads are segmented.
D. All of the above are true.
E. None of the above is true. All are false.
Concept check 9
Which of the following statements is false?
A. Overhead recovery rates are generally calculated at the beginning of the accounting
period.
B. Businesses which deal with overheads on a business-wide basis are relatively
common.
C. The sale of output at full cost should result in the business earning a zero profit.
D. Batch costing is a hybrid of process and job costing.
E. None of the above is false. All are true.
Activity-based costing (ABC)
LO 4 Explain the principles of activity-based costing (ABC), apply cost drivers, and compare ABC with
the traditional system of total absorption costing
Direct labour-intensive and direct labour-paced production. Labour was at the heart of production.
Machinery at that time was used to support the direct labour, and the speed of production was dictated
by direct labour.
A low level of overheads relative to direct costs. Little was spent on power, personnel services,
machinery (therefore, low depreciation charges) and other areas typical of the overheads of modern
businesses.
A relatively uncompetitive market. Transport difficulties limited industrial production worldwide, and
customers’ lack of knowledge of competitors’ prices meant that businesses could prosper without
being too scientific in pricing their output. Typically, they could simply add a margin for profit to arrive
at the selling price (cost plus pricing). Customers would have tended to accept the products the
supplier had to offer, rather than demand exactly what they wanted.
Since overheads represented a pretty small element of total costs, it was acceptable and practical to deal
with overheads in a fairly arbitrary manner. Not too much effort was devoted to controlling the cost of
overheads, because the rewards of better control were relatively small, certainly compared with the
rewards from controlling direct labour and material costs. It was also reasonable to charge overheads to
individual jobs on a direct labour hour basis. Most of the overheads were incurred directly in the support
of direct labour: providing direct workers with a place to work, and heating and lighting that workplace,
employing people to supervise the direct workers, etc. All production was done by direct workers, perhaps
aided by machinery. At that time, service industries were a relatively unimportant part of the economy and
would have largely consisted of self-employed individuals. These individuals would probably have been
uninterested in trying to do more than work out a rough daily/hourly rate for their time and try to base
prices on this.
Capital-intensive and machine-paced production. Machines are at the heart of production. Most
labour supports the efforts of machines—for example, technically maintaining them—and the speed of
production is dictated by machines. According to evidence provided in Real World 10.1 (page 431),
direct labour accounts on average for just 14% of UK manufacturers’ total cost.
A high level of overheads relative to direct costs. Modern industry is characterised by very high
depreciation, servicing and power costs. There are also high costs of a nature scarcely envisaged in
the early days of industrial production, such as personnel and staff welfare costs. At the same time,
there are very low, perhaps no, direct labour costs. Although the cost of direct materials often remains
an important element of total cost, more efficient production tends to reduce waste, and therefore
material cost, again tending to make overheads more dominant. Again according to Real World
10.1 , overheads account for 25% of manufacturers’ total cost and 51% of service sector total cost.
A highly competitive international market. Production and service provision, much of it highly
sophisticated, is carried out worldwide. Transport, including fast airfreight, is relatively cheap. Fax,
telephone and particularly the internet ensure that potential customers can quickly and cheaply know
the prices of a range of suppliers. The market is, therefore, likely to be highly price-competitive.
Customers also increasingly demand products custom-made to their own requirements. This means
that businesses need to know their costs with a greater degree of accuracy than they did in the past.
Businesses also need to take a considered and informed approach to pricing their output.
In most developed countries, service industries now dominate the economy, employing the great majority
of the workforce and producing most of the value of productive output. Although there are many self-
employed individuals supplying services, many service providers are vast businesses, such as banks,
insurance companies and cinema operators. For most of these larger service providers, the organisation
of activities closely resembles modern manufacturing activity. They, too, are characterised by high capital
intensity, overheads dominating direct costs and a competitive international market.
In the past, the traditional approach to determining product costs worked reasonably well, mainly because
overhead recovery rates (the rate at which overheads are absorbed by jobs) were typically of a much
lower value for each labour hour than the actual rate paid to direct workers as wages or salaries. It is now
becoming increasingly common for overhead recovery rates to be a multiple of the hourly rate of pay
because overheads are much more significant.
When production is dominated by direct labour paid $40 an hour, it might be reasonable to have a
recovery rate of $10 an hour. When, however, direct labour plays a relatively small part in production, to
have overhead recovery rates in excess of $100 per direct labour hour is likely to lead to very arbitrary
costing. Just a small change in the amount of direct labour worked on a job could massively affect the
cost deduced, not because the direct worker is massively well paid, but simply because this is the way it
has always been done—overheads not particularly related to labour are charged on a direct labour hour
basis.
An alternative approach to full costing
Historically, businesses have been content to accept that overheads exist and to deal with them, for
costing purposes, in as practical a way as possible. However, the whole question of overheads—what
causes them and how they are charged to jobs—has become more important thanks to the changes in
the business environment discussed above. There is now a growing realisation that overheads do not just
happen, they must be caused by something. To illustrate this point, consider Example 10.8 .
EXAMPLE
10.8
Modern Producers Ltd has, like virtually all manufacturers, a separate storage area for finished
goods. The costs of running the stores include a share of the factory rent and other establishment
costs, such as heating and lighting. They also include the salaries of the staff in charge of the
inventory, and the cost of financing the stored inventory.
The business has two product lines, product A and product B. Product A tends to be made in small
batches, and so low levels of finished goods inventories are held. The business prides itself on its
ability to supply product B in relatively large quantities instantly, so much of the stores is filled with
finished stocks of product B ready to be dispatched immediately an order is received.
Traditionally, the whole cost of operating the stores has been treated as a general overhead and
included in the total of overheads that is charged to jobs, probably on a direct labour hour basis.
This means that when assessing the cost of products A and B, the cost of operating the stores has
fallen on them according to the number of direct labour hours worked on each one. In fact, most of
the stores’ cost should be charged to product B, since this product causes (and benefits) from the
stores’ cost much more than product A does.
Failure to account more precisely for the costs of running the stores is masking the fact that
product B is not as profitable as it seems; it may even be causing losses due to the relatively high
cost of storing it. So far much of this cost has been charged to product A, even though product A
incurs little of the cost. This product absorbs the stores’ costs (in its production costs) in proportion
to the direct labour hour content, a factor which has nothing to do with storage.
There is a basic philosophical difference between the traditional and the ABC approaches. The traditional
approach views overheads as rendering a service to cost units, the cost of which must be charged to
those units. ABC, on the other hand, views overheads as being caused by activities. Since it is the cost
units that cause these activities, it is therefore the cost units that must be charged with the costs that they
cause.
With the traditional approach, overheads are apportioned to product cost centres. Each product cost
centre then derives an overhead recovery rate, typically overhead per direct labour hour. Overheads are
then applied to units of output according to how many direct labour hours were worked on them.
With ABC, the overheads are analysed into cost pools, with one cost pool for each cost-driving activity.
The overheads are then charged to units of output through activity cost-driver rates. These rates are an
attempt to represent the extent to which each particular cost unit is believed to cause the particular part of
the overheads.
Cost pools are much the same as cost centres, except that each cost pool is linked to a particular activity
(operating the stores in Example 10.8 ), rather than being more general, as is the case with cost
centres in traditional job (or product) costing.
Directly linking the cost of all support activities (i.e. activities that cause overheads) to particular products
or services potentially provides a more realistic, and more finely measured, account of the overhead cost
element for a particular product or service.
For a manufacturing business, these support activities may include materials ordering, materials handling,
storage, inspection and so on. In fact, ABC is probably even more relevant to service industries because,
in the absence of a direct materials element, a service business’s total cost is likely to be largely made up
of overheads. Real World 10.5 (p. 449) provides evidence that ABC has been adopted more readily by
businesses that sell services rather than products.
UPS then took functional costs and mapped them to products based on the activities that the
products drive. This was linked to extensive work measurement and package movement detail to
measure product cost. For example, airfeed cost is based on aircraft type, distance flown and
number of flight segments.
Insights from the ABC system also support other areas: performance measurement; planning and
forecasting; cost reduction efforts; pricing; administration; and customer performance
measurement.
Source: Christopher Pfaffinger, ‘UPS—activity based costing system’, March 2014, https://prezi.com/-gu2lykjjdg9/ups-activity-based-costing-system.
‘Data sourcing: extraction of data from other business systems e.g. General Ledger, Payroll
Cost processing: the actual calculation of data, and
Reporting: the actual costs of activities and products’ (p. 13).
‘Resource Module: the resources used in processing products and services, including for
example, staff, vehicles machinery, property costs etc.;
Activity Module: the activities undertaken by the business including, for example, mail
processing and delivery;
Product Module: the outputs (products) of the business activities, including, for example, first
class letters’ (p. 14).
The resources used up are attributed to activities using resource drivers. Resource drivers
‘represent a meaningful basis for attributing the costs incurred to the activities that consumed
these resources’ (p. 14). ‘Resource drivers fall into five categories, namely, operational staff hours,
vehicle hours, machine hours, accommodation square metres and direct to activities’ (p. 31). Each
of these categories has a range of detailed resource drivers.
The activity costs are attributed to products using activity drivers. An activity driver is a meaningful
basis for attributing the activity cost to the products that were handled by that activity (e.g. sorting
letters).
The outputs of the model are used to support internal decision-making and external reporting.
Royal Mail has a number of business processes detailed across approximately 500 activities. The
volume of mail is obviously a major driver of costs.
Sources: Royal Mail Group Ltd (2015), Regulatory Financial Statements 2014/15 (July). Royal Mail, ABC Costing Manual 2017–18.
All products and services are charged appropriately with the costs of the enterprise.
Activity-based costing is used as the appropriate cost allocation methodology. Resources (cost
inputs) perform activities (the doing things). Activities are used by products and services.
Direct attribution of costs to products is conducted, wherever possible.
Sound allocation rules based on the best available data are employed where direct attribution
is not possible.
Source: Australian Competition and Consumer Commission, ‘Australia Post price notification for its “ordinary” letter service’, February 2014. © Commonwealth of
Australia.
Ultimately, the aim of ABC is to recover overheads in a way that more accurately reflects the way in which
overhead costs change with changes in activity. The opaque nature of overheads has traditionally
rendered them more difficult to control than the much more obvious direct labour and material costs. If
analysis of overheads can identify the cost drivers, one can ask whether the activity that is driving the cost
is necessary at all, and whether the cost justifies the benefit. In Example 10.8 , it may be a good
marketing ploy that product B can be supplied immediately from stock, but this incurs a cost that should
be recognised and assessed against the benefit.
Advocates of ABC argue that most overheads can be analysed and cost drivers identified. If this is true,
then it is possible to examine more closely the costs that are caused activity by activity. As a result, fairer
and more accurate product costs can be identified, and costs can be controlled more effectively.
To implement a system of ABC, managers must begin by carefully examining the business’s operations.
They will need to identify:
each of the various support activities involved in the process of making products or providing services
the costs to be attributed to each support activity, and
the factors that cause a change in the costs of each support activity—that is, the cost drivers .
cost drivers
Activities that cause costs.
Identifying the cost drivers is a vital element of a successful ABC system. They have a cause-and-effect
relationship with activity costs, and so are used as a basis for attaching activity costs to a particular
product or service. This point is discussed further in the next section.
1. An overhead cost pool to be established for each activity. Thus, Modern Producers Ltd, the
business in Example 10.8 , will create a cost pool for operating the finished goods store. There
will be just one cost pool for each separate cost driver.
cost pool
The sum of the overhead costs that are seen as being caused by the same
cost driver.
2. The total cost associated with each support activity to be allocated to the relevant cost pool.
3. The total cost in each pool to then be charged to output (products A and B, in the case of Example
10.8 ), using the relevant cost driver.
Step 3 (above) involves dividing the amount in each cost pool by the estimated total usage of the cost
driver to derive a cost per unit of the cost driver. This unit cost figure is then multiplied by the number of
units of the cost driver used by a particular product, or service, to determine the amount of overhead cost
to be attached to it (or absorbed by it).
EXAMPLE
10.9
The accountant at Modern Producers Ltd (see Example 10.8 ) has estimated that the costs of
running the finished goods store for next year will be $90,000. This will be the amount allocated to
the ‘finished goods stores’ cost pool.
It is estimated that each unit of product A will spend an average of one week in the stores before
being sold. With product B, the equivalent period is four weeks. Both products are of roughly
similar size and have very similar storage needs. It is felt, therefore, that the period spent in the
stores (‘product weeks’) is the cost driver.
Next year, 50,000 units of product A and 25,000 of product B are expected to pass through the
stores. The estimated total usage of the cost driver will be the total number of product weeks that
the products will be in the stores. For next year, this will be:
150,000
The cost per unit of cost driver is the total cost of the stores divided by the number of ‘product
weeks’ as calculated above. That is:
To determine the cost to be attached to a particular unit of product, the figure of $0.60 must be
multiplied by the number of ‘product weeks’ that a product stays in the finished goods store. Thus,
each unit of product A will be charged with $0.60 for finished stores costs and each unit of product
B with $2.40 (i.e. $0.60×4).
Benefits of ABC
Through the direct tracing of overheads to products in the way described, ABC seeks to establish a more
accurate cost for each unit of product or service. This should help managers in assessing product
profitability and in making decisions concerning pricing and the appropriate product mix. Other benefits,
however, may also flow from adopting an ABC approach. By identifying the various support activities’
costs and analysing what causes them to change, managers should gain a better understanding of the
business. This, in turn, should help them in controlling overheads and improving efficiency. It should also
help them in forward-planning. They may, for example, be in a better position to assess the likely effect of
new products and processes on activities and costs.
Real World 10.5 provides an example of a service industry which has taken ABC on board
comprehensively.
Real World 10.6 provides a brief summary of trends in a major service industry from traditional
overhead recovery to the use of ABC.
The UK National Health Service (NHS) calculates the cost of various medical and surgical
procedures that it undertakes for its patients. In determining the costs of a procedure requiring time
in hospital as an in- patient, the NHS identifies the cost of the particular procedure (e.g. a knee
replacement operation). To this it adds a share of the hospital overheads to cover the cost of the
patient’s stay in hospital.
Until relatively recently, total ward overheads for a period were absorbed by dividing them by the
number of ‘bed days’ throughout the hospital, to establish a ‘bed-day rate’. A bed day is one
patient spending one day occupying a bed in the hospital. The total cost of a particular patient’s
treatment was then calculated as:
the cost of the procedure+(the number of days the patient spent in hospital x the bed-day rate)
The direct labour hour basis of absorption was not used. The bed-day rate was, however, an
alternative, logical, time-based approach.
Source: NHS, Better care better value indicators, NHS England, 15 May 2014.
In 2010, a report was written by Christopher S. Chapman and Anja Kern, Costing in the National
Health Service: From Reporting to Managing. The Department of Health had just recommended
that Acute Hospital Trusts adopt Patient-Level Information and Costing Systems (PLICS). The
majority had done so. Consequently: ‘Effective analysis of activity and resource consumption is
being developed as part of PLICS.’ In the past a top-down cost calculation method had been used,
known as reference costing, ‘with the main objective of calculating a national tariff’. The result was
that overheads were seen as ‘an inevitable and unmanageable burden for all’. Conversely, PLICS
‘calculates costs at the level of the patient episode, thus allowing the more meaningful linking of
costs to clinical data’. ‘The effective implementation of PLICS ... requires a fundamental shift in the
analysis of cost behaviour. Rather than a top-down allocation, costs should be traced so that they
can be actively managed.’ More attention needed to be placed on activity-based costing. To be
effective PLICS requires that ‘cost data constructively informs clinical decision making: taking the
step from reporting to managing’. Activity analysis is seen as facilitating better identification of
direct costs.
The report recognises that there is a long way to go, and that many organisations will take some
time to change. It emphasises the ‘importance of building up cost data around actual physical
activities i.e. work that people do’. An analysis of an operating theatre is used to show how cost
pools can be set up for different types of surgery—orthopaedic, cardiac, and eye surgery—then
uses the total number of minutes in surgery for each of the pools to arrive at three separate costs
per surgery minute. Cause and effect relationships can be usefully identified. One possibility for the
theatre was to analyse the activity and drivers per surgery session with the following drivers being
used by one hospital in the trust.
Activity of the A standard charge for providing anaesthetics is applied for the anaesthetic nurse, distinguishing whether it is a
anaesthetic general or a local anaesthetic.
nurse
Activity of the A standard charge for providing anaesthetics is applied for the anaesthetic physician, distinguishing whether it
anaesthetic is a general or a local anaesthetic.*
physician
Anaesthetic Charge for anaesthetic drugs is based on a weighting of the length of time the patient is anaesthetised. This
drugs time takes into account from entering the anaesthetic room until entering the recovery room. This assumes that
consumption of these drugs is well correlated with time.
Activity of the Costs for the surgical nurse are charged on the basis of the session schedule. The time taken into account is
nurse for the knife to skin until closure. The model charges a rate according to the number of staff present. It does not
performing the take into account actual staff costs (e.g. differentiate between agency and full-time staff on the day).
surgery
Activity of the Costs for clinicians are charged according to the clinician planning schedule of programmed activities. The time
physician for taken into account is knife to skin until closure. The system takes into account actual staff costs for seniors with
performing the a standard rate for juniors.
surgery
Consumable Currently this is done on the basis of itemised lists of consumables by procedure. This system will be replaced
items during in the near future by a new bar-coding device capturing the actual consumption of consumables for each
surgery patient.
Overhead A charge is applied for management administration, training, catering and others on the basis of charged time.
activity
*
This assumes that the length of time for the activity does not vary greatly between patients or
procedures. Clearly, ABC is important for PLICS. PLICS has been associated with considerable
improvements in the NHS.
Source: Christopher S. Chapman and Anja Kern, Costing in the National Health Service: From Reporting to Managing’ (Chartered Institute of Management
NHS Improvement, ‘Quick start guide for the healthcare costing standards’, ‘The approved costing guidance 2018—what you need to know and what you need to
do’, ‘Healthcare standards for England: information requirements and costing processes’.
Reflection 10.6
If you were on the medical staff of an NHS hospital using ABC of the type discussed above, would
you see this as something that gets in the way of improving the health of your patients, as
potentially useful, or as a necessary part of the management process? What do you see as the
most important behavioural issues in encouraging medical staff to come on board?
Activity 10.6
Your company manufactures two products, A and B. In one month, some 200 of A were produced and
1,000 of B. Overheads were incurred amounting to $250,000. Main activities and cost drivers have been
identified as follows:
250,000
SELF-ASSESSMENT QUESTION
10.1
Psilis Ltd makes a product in two qualities, called ‘Basic’ and ‘Super’. The business is able to sell
these products at a price that gives a standard profit mark-up of 25% of full cost. Full cost is
derived using a traditional batch costing approach.
To derive the full cost for each product, overheads are absorbed on the basis of direct labour
hours. The costs are as follows:
Basic $ Super $
Direct material 15 20
Based on experience over recent years, in the forthcoming year the business expects to make and
sell 40,000 Basics and 10,000 Supers.
Recently, the business’s management accountant has undertaken an exercise to try to identify
activities and cost drivers in an attempt to be able to deal with the overheads on a more precise
basis than had been possible before. This exercise has revealed the following analysis of the
annual overheads:
Total 1,000
The management accountant explained the analysis of the $1 million overheads as follows:
The two products are made in relatively small batches, so that the amount of the finished
product held in inventories is negligible. The Supers are made in particularly small batches
because the market demand for this product is relatively low. Each time a new batch is
produced, the machines have to be reset by skilled staff. Resetting for Basic production occurs
about 20 times a year and for Supers about 80 times: about 100 times in total. The cost of
employing the machine-setting staff is about $280,000 a year. It is clear that the more set-ups
that occur, the higher the total set-up costs; in other words, the number of set-ups is the factor
that drives set-up costs.
All production has to be inspected for quality, and this costs about $220,000 a year. The higher
specifications of the Supers mean that there is more chance that there will be quality problems.
Thus the Supers are inspected in total 1,500 times annually, whereas the Basics only need
about 500 inspections. The number of inspections is the factor that drives these costs.
Sales order processing (dealing with customers’ orders, from receiving the original order to
dispatching the products) costs about $240,000 a year. Despite the larger amount of Basic
production, there are only 1,500 sales orders each year because the Basics are sold to
wholesalers in relatively large-sized orders. The Supers are sold mainly direct to the public by
mail order, usually in very small-sized orders. It is believed that the number of orders drives the
costs of processing orders.
a. Deduce the full cost of each of the two products on the basis used at present, and from
these deduce the current selling price.
b. Deduce the full cost of each product on an ABC basis, taking account of the management
accountant’s recent investigations.
c. What conclusions do you draw? What advice would you offer the management of the
business?
Criticisms of ABC
Critics of ABC argue that, in the analysis of overheads, setting up an ABC system and trying to identify
cost drivers is very time-consuming and costly, and that the benefit of doing so, in terms of more accurate
costing and the potential for cost control, does not justify the cost. Furthermore, where the products
produced are quite similar, the finer measurements provided by ABC may not lead to strikingly different
outcomes than under the traditional approach. ABC is also criticised for the same reason that full costing
generally is criticised: it does not provide very relevant information for decision-making. This point will be
addressed shortly.
Despite such criticisms, ABC has gained some popularity in practice, although not as much as its
advocates might have expected. However, even if ABC-derived product costs were not really helpful (and
many would argue that they are helpful), identifying the activities that cause the costs may still be well
worth doing. As was pointed out above, knowing what drives the costs may make cost control and
performance evaluation more effective. Real World 10.7 provides some information regarding the
actual use of ABC and related methods.
Generally, it must be said that while absorption costing is widely used, ABC costing is not as
widely used as we might expect.
In a South Australian context, David Forsaith and colleagues (2003) found that activity-based
costing was used by only just over 31% of businesses surveyed. Interestingly, the figures for the
use of absorption costing were just over 32%.
A more recent survey published in 2005, which covered 528 businesses that were all members of
BetterManagement, a division of SAS, the world’s largest private software business, showed that
34% were actively using ABC, 20% were piloting ABC and 32% were considering using it. The
survey covered various industries with a wide international spread. However, these figures varied
significantly according to size and industry. In general, it was found that the greater the size of the
business, the more likely it was to use ABC. It was also found that communications and financial
services appear to have embraced ABC more enthusiastically than other industries identified. For
communications, over 50% of the largest companies were active, compared with 24% for smaller
companies. In financial services, 58% were using ABC, compared with 24% in manufacturing and
34% overall.
Mohammed Al-Omiri and Colin Drury (2007) took their analysis a step further by looking at the factors that tend to characterise
businesses that adopt ABC. They found that businesses that used ABC tended to be:
large
sophisticated, in terms of using advanced management accounting techniques generally
in an intensely competitive market for their products
operating in a service industry, particularly in the financial services.
(It is interesting that the postal service—see Real World 10.5 —closely fits this description.)
A range of studies over the years have continually found that considerable use is still made of the
traditional absorption techniques. One, by Dugdale and colleagues, commented: ‘Old methods
have not died, they are still taught, examined and used.’
Sources: Mohammed Al-Omini and Colin Drury (2007), ‘A survey of factors influencing the choice of product costing systems in UK organisations’, Management
BetterManagement (2005), ‘Activity based costing: how ABC is used in the organization’, September.
Chartered Institute of Management Accountants (CIMA), Management Accounting Tools for Today and Tomorrow (CIMA, London, 2009), <http://
www.cimaglobal.com/Documents/Thought_leadership_docs/CIMA%20Tools%20and%20Techniques%2030-11-09%20PDF.pdf>.
David Dugdale, T. Colwyn Jones and Stephen Green, Contemporary Management Accounting Practices in UK Manufacturing (CIMA Publishing, Oxford, 2005).
David Forsaith, Carol Tilt and Maria Xydias-Lobo, The Future of Management Accounting: A South Australian Perspective. Flinders University School of Commerce
Michael Lucas, Malcolm Prowle and Glynn Lowth, Management Accounting Practices of (UK) Small-Medium-Sized Enterprises (SMEs) (Chartered Institute of
Concept check 10
Which of the following statements is false?
A. Traditional costing systems typically use a single overhead cost pool, with allocation
of costs on a direct labour basis.
B. Traditional costing systems provide satisfactory costing for some companies.
C. Activity-based costing systems would be beneficial for most companies.
D. Activity-based costing systems are more complicated than traditional systems.
E. None of the above are false. All are true.
Concept check 11
Activity-based costing is a response to which of the following?
A. The move towards capital-intensive businesses
B. The move towards machine-based production and robotics
C. The higher proportion of indirect costs for today’s companies
D. The move towards production and sale of multiple products (i.e. the demise of the
single product manufacturer)
E. All of the above.
Concept check 12
Activity-based costing encompasses all of the following, except for:
A. Each of the ABC cost pools has the same or similar allocation basis.
B. ABC views indirect costs as being caused by activities.
C. Cost pools are essentially the same as cost centres.
D. ABC’s intent is to charge for overheads in the manner in which overheads change
with changes in activity.
E. All of the above are true.
Uses and criticisms of full costing
LO 5 Identify and explain the main uses of full cost information, and the main criticisms of full costing,
and apply the concepts of relevant costing and full costing appropriately to several decision-making
situations
1. For pricing purposes. In some industries and circumstances, full costs are used as the basis of
pricing. Here the full cost is deduced and a percentage is added on for profit. This is known as
cost plus pricing . Garages carrying out vehicle repairs provide an example of this. Solicitors
and accountants doing work for clients often use this approach as well. Very few suppliers are in a
position to set prices on a cost-plus basis, however. A supplier in a competitive market usually has
to accept the market price—that is, most suppliers are ‘price takers’ not ‘price makers’.
It should be noted that both the Australian Accounting Standard AASB 102: Inventories and the
International Accounting Standard IAS 2: Inventories require that all inventories, including work-in-
progress, be valued at full cost of manufacture in the published financial reports. This demands the use of
full costing. As a result, businesses that have work-in-progress or finished goods at the end of their
financial periods apply full costing for income measurement purposes. (This will include the many service
providers that tend to have work-in-progress.) You should note that, for the purposes of financial
reporting, only the full cost of manufacturing is included in the valuation of inventory. Marketing, selling
and delivery costs are not included in this figure. These costs will usually be included in the calculation of
full cost for cost plus pricing purposes. Of course, we still must remember the basic rule—value inventory
at the lower of cost and net realisable value—in this case the lower of full cost and net realisable value.
EXAMPLE
10.10
PDH Ltd, a small firm of building contractors, has, on your advice, prepared a budget for the next
year and is aiming to increase output in an effort to improve profits. The actual results for last year
have been finalised, and both sets of figures are given below.
Direct costs
(1,200) (1,500)
400 540
Administration and general overheads (280) (330)
The company has been asked to tender for a contract at a time when work is scarce and staff may
otherwise have to be laid off. In addition, the output to date is well below the level hoped for, being
nearer to last year’s actual than this year’s budget. Because of this, the CEO has prepared his
quotation by using an overhead recovery rate based on actual proportions achieved last year. The
quotation is given below:
$’000
Direct costs
Materials 150
Labour 60
210
245
294
You ascertain that the materials have been priced at cost and include the following:
1. Special window frames which cost $8,000, but are now unlikely to be used and have a
disposal value of $3,000. Alternatively, they could be converted for use on this contract at a
labour cost of $2,000; otherwise, frames costing $7,000 must be purchased.
2. Timber which cost $10,000, but would now cost $18,000 to replace.
In order for you to be able to consider this, it is necessary that you understand the system of
overhead recovery implicit in the quotation and the basis on which the quotation was prepared.
Knowing this might lead you to revise the quotation.
The problem with the figures shown is that they reflect the assumption that overheads will be
based on some kind of average—quite arbitrary—sharing of overheads. Actual overhead costs
may be quite different. A revised quotation should be prepared to reflect expected costs.
A further factor is that the contract has come at a time of low demand, so there will be no
opportunity cost—lost contribution—for labour. The company is short of work and may have to lay
off labour. Under these circumstances, any job that makes a contribution has to be considered
carefully. The contribution of the job being tendered for can be calculated by comparing the
relevant cost (as shown below) with the price quoted. The revised statement should be something
like:
$’000 $’000
Materials 150
Less
the cost of windows which have a lower opportunity cost plus the opportunity cost of the windows used. Either: (8)
Timber
The opportunity cost of using the material, which had cost $10,000 but which would cost $18,000 to replace, is 8
$18,000, so the increased cost ($10,000 is already included) is
Labour—actual cost 60
215
Determining how the various overheads behave is difficult, but worth consideration. In the figures
shown above, it is presumed that the overheads will not change just by taking on this job, so there
are no relevant cost increases. In practice, this may not be the case, and so a sound
understanding of how costs behave is essential. Any price in excess of this would leave the
business better off by taking on the contract.
The original quotation reflects the kind of price that should be charged if PDH Ltd is to be fairly
confident of recovering its overheads and making a profit. This confidence is justified only if total
revenues and general cost levels are in line with the budget. In a time of low demand, the
probability of being able to recover the overheads is seriously reduced. Trying to recover
overheads in a competitive market might prove impossible. The decision comes down to what the
market will bear in price, and how much the job is needed by PDH Ltd. In a case like this, the
reality is that taking on the contract at any price above $215,000 will minimise loss rather than
avoid losses altogether.
Clearly, when making decisions of a non-routine nature, great care must be taken. Advocates of full
costing would argue that it provides an informative long-run average cost. This is often an important
aspect of any decision, but in some cases, as in Example 10.10 and Activity 10.7 , other relevant
factors apply.
Activity 10.7
Contractors Ltd expects to have spare capacity in the coming year. It has been offered a contract that will
take a year to complete, at a fixed price of $250,000. The accountant has prepared the following figures
and advises rejecting the contract.
$ $
Direct costs
Materials
60,000
Labour
Supervisor 68,000
172,000
Overheads
Depreciation 15,000
Deficit 78,900
1. Twenty-five tonnes of material X is already in stock. It originally cost $800 per tonne. At present,
material X can be bought and sold for $900 per tonne. Apart from this contract, it is of no other use
to the company.
2. One hundred and fifty tonnes of material Y is in stock. It originally cost $120 per tonne, and further
supplies are unobtainable. The company originally intended to use the whole 150 tonnes on
another contract. However, for the other contract it is possible to use a substitute that costs $90
per tonne but requires processing that will cost $50 of labour per tonne to make it suitable for use.
3. Two skilled workers would be required for the contract at a weekly wage of $1,000 each. One of
these could be transferred from another department where they are doing work that could be done
by a semi-skilled worker at a rate of $800 per week. The other worker would have to be recruited
and would require two weeks’ training before work on the contract begins.
4. The supervisor wants to retire at the end of this year on a company pension of $36,000 a year, but
can be persuaded to stay on for another year. This would not affect his ultimate annual pension.
5. The contract would require the use of a machine bought three years ago for $150,000, now being
depreciated on a straight-line basis over 10 years. If not used on this contract, the machine could
be hired out for the year at a rate of $200 per week.
6. The company has budgeted for the following total overheads, excluding depreciation, during the
following year:
$450,000
The budgeted direct labour cost for the entire company for the year is $900,000, excluding this contract.
The company uses a full costing approach, and overheads are recovered on the basis of 50% of direct
labour cost.
If the contract is accepted, total variable overheads are expected to increase by $10,000 because of
increased power costs and administrative costs.
1. Explain the rationale of full costing, and the system of overhead recovery implicit in the
accountant’s figures.
2. Revise the above statement and state whether the contract should be accepted. Explain fully your
statement and its assumptions.
3. Explain any differences between your statement and that of the accountant.
Concept check 13
Which of the following statements is false?
A. Full costing is criticised for its reliance on past costs.
B. Full costing is criticised for its use of arbitrary overhead allocation.
C. Full cost information is required for ‘cost plus pricing’.
D. Australian accounting standards require full costing for inventory costing.
E. None of the above. All are true.
Concept check 14
When considering relevant costs and full costing, which of the following statements is false?
A. Full costing is useful for indicating the kind of recovery rate needed for long-term
survival and prosperity.
B. The relatively arbitrary nature of overhead allocation poses problems for the use of
full costing in decision-making.
C. Use of ABC systems reduces the degree of arbitrariness.
D. Use of ABC systems eliminates the problem of arbitrariness.
E. In decision-making care must be taken to identify all relevant costs, not just full cost.
Summary
In this chapter we have achieved the following objectives in the way shown.
Explain the nature of full costing, and the reasons why this Illustrated that many, perhaps most, businesses seek to identify the
information is useful to managers total or full cost of pursuing some objective, typically of a unit of
output or service
Explained that this information is useful for pricing and output
decisions, exercising control, assessing relative efficiency and
assessing performance
Deduce the full cost of a unit of output in a single or multi- (or - Illustrated and calculated full cost
service) environment, differentiate between direct and indirect Illustrated that where all units of goods or services produced by a
costs, and discuss the problem of charging overheads to jobs in a business are identical, this tends to be fairly straightforward—a
multi-product (multi-service) environment case of simply finding the total cost for a period and dividing by the
number of units of output for the same period
Identified the issues relating to multi-product or multi-service
environments
Explained and differentiated between direct and indirect costs
Explained and illustrated the nature of overheads
Explained and illustrated how it is necessary to add to the direct
costs a share of the overheads according to some formula, a
process known as ‘overhead recovery’ or ‘overhead absorption’
Calculated and applied overhead recovery rates
Identified direct labour hours as a popular (but not the sole) basis
of sharing overheads
Noted that costing individual cost units in this way is known as ‘job
costing’
Explained and illustrated the different outcomes when different
rates are applied
Explain the advantages of segmenting overheads, and use this Illustrated ways of segmenting the overheads
approach to apply overheads on a departmental basis Illustrated and applied ways of dealing with overheads on a
departmental basis
Explain the principles of activity-based costing (ABC), apply cost Noted that there is some arbitrariness in the choice between
drivers, and compare ABC with the traditional system of total overhead recovery rates
absorption costing Introduced and explained the idea of activity-based costing, a
method widely recommended as providing a more focused
approach to applying overheads to jobs, by identifying ‘cost drivers’
or activities that incur overhead costs
Explained the notion of cost drivers
Identified the main criticisms of activity-based costing
Identify and explain the main uses of full cost information, and the
main criticisms of full costing, and apply the concepts of relevant Identified the main uses of full costing: for pricing and income
costing and full costing appropriately to several decision-making measurement
situations Illustrated the uses of full costing
Identified research findings regarding the use of full costing
techniques in practice
Recognised that full costing is also widely criticised for not
providing very helpful or relevant information
Explained the limitations of full costing
Illustrated ways in which full costing can mislead or be
inappropriately used
Explained, illustrated and applied the concept of relevant costing to
a range of situations
Examined some decision-making situations where full costing
approaches can mislead, and where the concept of relevant
costing needs to come to the fore
Discussion questions
Easy
10.1 LO 1/2 Distinguish between:
job costing
process costing
batch costing.
10.2 LO 1 What costs would be included in the full cost of a box of cereal for a corner grocery store that offers free delivery within 1
kilometre of the store? Why would this information be useful to the manager of the store?
10.3 LO 2 When asked whether he wanted his pizza cut into 10 or 12 pieces, the financial accountant replied: ‘Ten pieces please. I
couldn’t possibly eat 12.’ Discuss from an overhead allocation viewpoint.
10.4 LO 1/2 Which of the following businesses would be likely to use job costing, and which would use process costing or batch costing?
a. A firm of solicitors
b. A manufacturer of soft drinks
c. A car producer
d. A landscape gardener
e. A paint producer
Intermediate
10.6 LO 1 Bodgers Ltd operates a job costing system. Towards the end of each financial year, the overhead recovery rate (the rate at
which overheads will be charged to jobs) is established for the upcoming year.
a. Why does the company bother to predetermine the recovery rate in this way?
b. What steps will be involved in predetermining the rate?
c. What problems might arise with using a predetermined rate?
10.7 LO 2 How do you decide whether a cost is classified as direct or indirect? Can the classification of a cost as direct or indirect
change within an organisation?
10.8 LO 1– How might two accountants come up with two different figures for costs of the same product? What problems does this
4 cause for the managers using the figures provided?
10.9 LO 3 This chapter discusses ‘segmenting’ the overheads. What is meant by this term? How does this help in allocating
overheads to individual jobs or services?
10.10 LO 1– Identify and discuss the changes in manufacturing that have created potential problems for traditional manufacturing
5 overhead allocation.
10.11 LO 3 What is batch costing, and how does it apply to aspects of both job costing and process costing?
10.12 LO 4 What factors should you consider in deciding on whether you should implement an ABC system in your organisation?
10.13 LO 5 Buisman Company holds 500 kilograms of Material X42 left over from its purchase at $10 per kilogram for a special
contract. Buisman could sell the 500 kilograms for $12 per kilogram and can currently purchase more X42 at $11 per
kilogram. What is the relevant cost of using the 500 kilograms stock of X42 on Job99?
10.14 LO 1– Discuss the relative merits and demerits of absorption costing and relevant costing. Describe the kind of circumstances in
5 which each might be appropriate to use.
Challenging
10.15 LO What sort of timeframe does the full costing concept use?
1
10.16 LO Are you likely to be overcharged or undercharged by a garage that charges for its car repairs using process costing?
2
10.17 LO What is one key factor that we have ignored in the determination of the cost driver for a particular item? (Hint: What is the
4 logical extension of simple regression?)
10.18 LO One of the criticisms of full costing is that very few companies are in a position to set prices on a cost-plus basis. They have to
5 accept the market price. What use is cost information to companies that are ‘price takers’?
10.19 LO Given that ABC should give more accurate estimates of costs, it can be argued that it is surprising that it is not more widely
4 used. Do you agree? What reasons can you think of that might prevent widespread use?
10.20 LO Research shows that the direct labour hour basis of overhead absorption by cost units (products) is the most popular basis in
2–5 practice. Is it a logical basis? Explain your answer.
10.21 LO In broad terms identify the kind of costs that will be incurred, and discuss the balance between direct and indirect costs, for the
2 following types of business:
10.23 LO Do you think computerised accounting systems might help to improve the adoption of the ABC in small and medium-sized
4 businesses?
Application exercises
Easy
10.1 LO 2 Gatton Foods Ltd manufactures a range of canned meat. Below is a selection of the costs accumulated by its accounting
department. Assuming the cost object is the product, classify each of these costs as direct or indirect. Also classify each
cost as variable or fixed in respect of its expected reaction to changes in volume of production.
10.2 LO 1/2 PDH Ltd uses a predetermined overhead rate in applying overheads to product costs, using direct labour costs for cost
centre A and machine hours for cost centre B. The following details the estimated forecasts for 2020.
A B
10.3 LO 2 Earth Renewal specialises in advising public bodies about recent environmental regulations. It uses a job costing system. It
uses a predetermined overhead recovery rate calculated as a percentage of expected direct labour costs. The budget for
the next year is shown below:
Rent $100,000
A local water company is inviting tenders for a project that is in the area of expertise of Earth Renewal. It is estimated that
the project will require 400 hours of work by professional members of the firm.
a. What is the direct hourly rate for Earth Renewal, and what is the overhead recovery rate?
b. Calculate the cost of the job being tendered for.
c. If the firm wishes to make a profit of 25% of the job’s cost, how much should the tender amount to?
10.4 LO 4 The accountant for Progressive Pty Ltd is developing an ABC system for costing its product. He has determined six
overhead cost pools, each of which has a specific, unique cost driver. Recovery of his hard drive after his PC crashed has
provided the data below.
The first cost pool is shown below as an example. Match the most appropriate cost driver from the first table to each of the
five remaining cost pools in the second table. Calculate the ABC application rate for each pool, and indicate the application
basis you have used for that cost pool.
No. of staff 40
Cost pool Budget cost Cost driver volume Application rate Application basis per financial transaction
Assembly $200,000
Purchasing 30,000
Finishing $100,000
Marketing $120,000
10.5 LO 2 You run an IT consulting firm, which uses a job costing scheme. The firm keeps track of direct costs per client job relating to
direct labour, licensing costs and travel. Overheads are allocated on the basis of a predetermined rate calculated as a
percentage of direct labour costs.
The budget for the year, which provided the basis for the overhead recovery rate, included the following information:
Extracts from two clients’ records, each relating to a single job, are shown below:
A B
Intermediate
10.6 LO 2– Specbuild is in the business of making garden studios. It focuses on two types—the first is relatively basic, while the second
5 is significantly more sophisticated. It is looking at its overheads with a view to ensuring that each type is charged with an
appropriate amount of overheads. The business is considering moving from a system in which it recovers overheads on a
direct labour hour basis to one that will use activity-based costing. You have been asked to provide comments on just two
parts of the overheads, relating to the materials purchasing and stores overhead, and the materials handling and delivery
costs, in order to ascertain whether it is worth further investigating activity-based costing.
Basic Sophisticated
Cost drivers
Purchasing and stores—purchase orders per studio 15 60
Use these figures to calculate what share of the overheads would be assigned to each type of studio using traditional
overhead recovery rates based on direct labour hours, and one using activity-based costing, assuming that the cost drivers
are as shown above.
Comment on the differences, and identify the main issues that need to be focused on in the decision.
10.7 LO 2– Gina Ltd uses a predetermined overhead rate in applying overheads to product costs, using direct labour costs for cost
5 centre A and machine hours for cost centre B. The following details the forecasts prepared for 2020 on which the overhead
rates are to be based:
A B
Nuforma is one of the products manufactured by Gina in a process that involves the two cost centres A and B. The following
data relate to the resources used to make the product during 2020:
A B
Machine hours 63 45
10.8 LO 2– Pieman Products Ltd makes road trailers to customers’ precise specifications. The following are predictions of costs and
5 labour and machine time during the forthcoming year, which is about to start:
A customer has asked the company to build a trailer for transporting a racing motorcycle to races. It is estimated that this will
require materials and components costing $2,500. It will take 200 direct labour hours to do the job, of which 50 will involve
the use of machinery. Deduce a logical cost for the job and explain your basis of dealing with overheads.
Challenging
10.9 LO 2–5 The following estimates of total costs are made for a business for the year:
Profit 72,000
Sales 792,000
From these figures it was decided that the overhead recovery rates and profit loadings would be as follows:
At the end of the first month it became clear that an error had been made in the budget—$50,000 of the labour had been
included as direct labour when, in fact, it was an indirect production cost.
Show the effect of the mistake by setting out the figures in the way shown above for a job for which the direct materials
cost was estimated to be $6,000 and direct labour $4,000, using:
Illustrate the concept of relevant costs, and the dangers of using full costing, by reference to the following job:
Price $20,000
10.10 LO 1/2/3 Sparta Ltd is an engineering business doing work for its customers to their particular requirements and specifications. It
determines the full cost of each job taking a ‘job costing’ approach, accounting for overheads on a departmental basis. It
bases its prices to customers on this full cost figure. The business has two departments: a Machining Department, where
each job starts, and a Fitting Department, which completes all of the jobs. Machining Department overheads are charged
to jobs on a machine hour basis, and those of the Fitting Department on a direct labour hour basis. The budgeted
information for upcoming year is as follows:
Direct labour $400,000 ($300,000 allocated to the Machining Department and $100,000 to the Fitting
Department; all direct workers are paid $20 per hour)
Indirect $100,000 (apportioned to the departments in proportion to the direct labour cost)
labour
a. Prepare a statement showing the budgeted overheads for next year, analysed between the two departments. Use
three columns: one for the total figure for each type of overhead, and one column for each of the two departments,
where each type of overhead is analysed between the two departments. Each column should also show the total
of overheads for the year.
b. Derive the appropriate rate for charging overheads of each department to jobs (i.e. a separate rate for each
department).
c. Sparta Ltd has been asked by a customer to quote for a job that will, if it goes ahead, be done early next year. The
job is expected to require direct materials costing $1,200, 50 hours of machining time, 10 hours of Machining
Department direct labour and 40 hours of Fitting Department direct labour. Sparta Ltd charges a profit loading of
20% to the full cost of jobs to determine the selling price.
Show workings to derive the proposed selling price for this job.
10.11 LO 4 Retroclean Ltd sells vacuum cleaners to three major retail outlet stores. The following gives their sales and service
information.
Sales returns
Number of items 50 13 30
Standard 40 30 50
Urgent 10 45 30
Retroclean Ltd uses activity-based costing, and the following costs apply:
From these costs, assuming a mark-up of 50% on manufacturing cost, what is the contribution of each retailer?
10.12 LO 5 Moles–Cyer Ltd, a large business, operates on a departmental basis. Each department is responsible for manufacturing
one product, and the budget for the next year for one of them is shown below.
Less costs
Material A 22 880
Material B 5 200
Labour 28 1,120
75 3,000
Loss 1,200
On the basis of this budget, the accountant argues that the department should be closed. The CEO asks you for an
independent assessment. You ascertain the following:
1. The company has enough material A in stock to produce 40,000 units of output. This material cannot be sold. If
not used in the year, it will have to be destroyed at a cost of $75,000.
2. Enough material B is in stock to produce 20,000 units. This originally cost $10 per unit but has been written down
to $5 per unit, the current replacement cost. If not used on this job, it will be used in another department as a
substitute for a part costing $3 per unit, or scrapped for $2.50 per unit.
3. Most variable overheads vary with output. However, the variable overhead rate includes supervisory labour, and
the supervisor, who is paid $40,000 a year, is needed only as long as the department exists. If the department is
closed, the supervisor will be retired on a pension of $15,000 a year. The rate also includes depreciation of
$100,000 a year, based on historic cost. The machinery will be sold if the department closes. It currently has a
sale value of $450,000, but after producing the 40,000 units it will realise only about $50,000.
4. The fixed overhead recovery rate is made up of allocated rent, rates and general expenses, all of which are
unaffected by any decision regarding the department.
5. Management has already decided on the selling price, and has decided that the department will produce 40,000
units next year, or close.
a. If you think it necessary, redraft the accountant’s statement. Explain your amendments and state your
assumptions clearly.
b. Advise the CEO on both the financial and more general factors that should influence the final decision.
Chapter 10 Case study
Materials—wooden mouldings 2
—plastic mouldings 1
—fixings 1
Additional costs will be incurred relating to supervision and maintenance, variable overheads,
administration and distribution. Further investigation of costs reveals the following:
1. Toymakers has 2,000 wooden mouldings already in stock. These had cost $5 each. If not used on
the MacBain, they can be used on an alternative product in place of mouldings which would cost
$2.50 each. New mouldings would cost $6 each in the first year and $6.50 each in the second.
2. Five thousand plastic mouldings are in stock. These had cost $7.50 each. They have no alternative
use and, if not used on the MacBain, they would probably be destroyed at a cost of $500. Further
mouldings can be purchased for $5 each. No price increases are expected over the next two
years.
3. Fixings used are of a type also used on other products. Enough are in stock to produce 3,000
MacBains. They had cost $1.50 each. Further fixings are available at a price of $2.50 each.
4. The labour force currently consists of 20 staff on direct production work and three on supervision
and maintenance. Production workers are currently working on short time, for only 30 hours per
week, and are paid $15 per hour. The three supervision and maintenance staff are fully employed,
and an additional supervisor will be required if the MacBain is to be produced. These three staff
are currently paid $40,000 per annum each. One of the current supervisors is due to retire shortly,
on a pension of $20,000 per annum. He has offered to stay on for another year if it will help the
situation. If he does, he will be paid his normal salary. There will be no effect on his future pension.
A pay rise of 10% is expected at the beginning of the second year.
5. Variable overheads are expected to amount to $2.50 per MacBain. The new toy would require new
machinery costing $110,000. This will probably last for five years, after which it will have a disposal
value of about $10,000. Disposal values at the end of each of the first two years are estimated to
be $60,000 and $40,000, respectively. Administration costs are expected to rise by about $2,500
per annum if the MacBain is made, although administration overheads are usually recovered on
the basis of 10% on direct costs. Distribution of Toymakers’ products currently costs $250,000 in
total for each year. This is shared out in proportion to direct costs, using a 10% loading, although
the company thinks it can manage to distribute the MacBains by employing additional part-time
drivers at a cost of $15,000 a year, and by running the trucks for longer periods. Additional vehicle
costs will be $10,000 each year. This decision will, in turn, mean replacing one of the trucks—that
is, a year from now at a cost of $25,000. Replacement was originally planned for two years from
now. Toymakers can obtain funds from the bank for capital expenditure of this type at 15% per
annum.
Questions
1. Set out a statement for each of the next two years of possible production showing the costs and
revenues you consider relevant to the decision under consideration. State your assumptions and/or
explain the basis of your figures.
2. Make a recommendation as to whether Toymakers Ltd should proceed with the MacBains, and
briefly identify any other information that would be useful.
Activity 10.1
Ultimately, price will be determined by supply and demand factors. However, any new production or
service is only likely to occur if there is a very good prospect of obtaining a price that covers the full cost,
together with an appropriate profit margin. Obviously, short-term events can occur that might prevent this,
but in the long term this must occur in order for the business to continue with a particular product or
service.
Activity 10.2
Suitable industries are likely to include: paint manufacturing; chemical processing; oil extraction; plastic
manufacturing; paper manufacturing; brick manufacturing; beverages; and semiconductor chips
Activity 10.3
Usually, direct workers are required to record how long was spent on each job; thus, the mechanic doing
the job would record the length of time spent worked on the car. The pay rates should be available. It is
simply then a matter of multiplying the number of hours spent on a job by the relevant rate of pay. The
stores staff would normally be required to keep a record of the cost of parts used on each job.
Activity 10.4
First, it is necessary to identify the indirect costs and total them as follows:
Depreciation 9,000
(Note: This list does not include the direct costs, because we shall deal with the direct costs separately.)
Since the company uses a direct labour hour basis of charging overheads to jobs, we need to deduce the
indirect cost or overhead recovery rate per direct labour hour. This is simply:
The total overheads will, of course, be the same irrespective of the method of charging them to jobs.
Thus, the overhead recovery rate, on a machine hour basis, will be:
Activity 10.5
Process costing is likely to be the most appropriate for the sugar refiner, coal mining business or cement
manufacturer. Each business is normally involved in producing identical, or near-identical, items through a
series of repetitive activities.
Job costing is likely to be most appropriate for the picture framer, private hospital, architect’s office, and
antique furniture restorer. Each of these businesses is normally involved in producing a customised
product or service, with each item requiring different inputs of labour, materials and so on.
Batch costing is likely to be most appropriate for the pharmaceutical manufacturer. The production
process will normally involve making identical products in batches, where each batch is different.
Activity 10.6
Overhead rate for each activity
One order=total cost/number of orders=100,000/2,000=$50 per orderMachine hour=Total machine costs and power
Activity 10.7
The rationale for full costing is essentially to ensure that overheads are fully recovered by an addition to
the other costs charged to customers. In this case, the total overheads of $450,000 (see Note 6) are
recovered on the basis of direct labour cost. As budgeted direct labour cost is $900,000 and the
overheads to be recovered amount to $450,000, the overheads will be fully recovered if an amount
equivalent to 50% of the direct labour cost for individual jobs or contracts is added to the other costs, so
long as the actual direct labour cost is at least equal to the budgeted figure. Of course, in this case, the
contract is additional to the budget, and the justification for adding such a loading is dubious.
$ $
Revenues 250,000
Costs
Materials
Y: 100×(90+50) (opportunity cost—will cost this much elsewhere if we use it on this job) 14,000
Labour
Direct
52×800×1 41,600
52×1,000×1 54,000
Indirect
Overheads
Learning objectives
When you have completed your study of this chapter, you should be able to:
LO 1 Explain the relationship between corporate objectives, long-term plans and budgets,
and also between planning and control
LO 2 Define a budget, set out the main components of the budget-setting process, explain
how the various budgets interlink, and identify the main uses of budgeting
LO 3 Explain the importance of cash budgeting, and prepare a simple cash budget from
relevant data
LO 4 Construct a range of other budgets from relevant data
LO 5 Use a budget as a means of exercising control over the business, explain and apply
flexible budgeting, and calculate a series of variances between budget and actual to help
control activity
LO 6 Identify the limitations of the traditional approach to control through budgets and
standards.
What about that new car you’d like? You know the list price, and you
What about that new car you’d like? You know the list price, and you
also know that you can probably get it for a bit less than this price.
How much can you put in towards the cost? Can you get a loan?
How long for? Can you reasonably make the repayments, after
factoring in the running costs of the new car? Sounds like a cash
budgeting exercise.
And what about the new business you want to buy? Planning and
financing take on a new dimension. The budgeting process will
almost certainly be much more complicated, especially if you want
to fund it by debt. All of a sudden you are managing a business, and
this needs to be done in a professional manner, which will inevitably
lead you to the kind of approach set out in this chapter.
Planning and control
LO 1 Explain the relationship between corporate objectives, long-term plans and budgets, and also
between planning and control
There is a clear relationship between objectives, long-term plans and budgets. The objective, once set, is
likely to last for quite a long time, perhaps throughout the life of the business (although changes can and
do occur). A long-term plan sets out how the company will pursue its objective, while budgets identify the
detailed actions that need to occur over the short term.
An analogy can be made in terms of someone enrolling in a program of study. His or her objective might
be a working career that is rewarding in various ways. The person might have identified the program as
the most effective way to work towards this objective. In working towards achievement of this objective,
passing a particular stage of the program might be identified as the target for the forthcoming year. Here
the intention to complete the entire program can be likened to a long-term plan, and passing each stage is
analogous to achieving the budget. Having achieved the ‘budget’ for the first year, the ‘budget’ for the
second year becomes passing the second stage.
Remember that planning is the role of management rather than of accountants. The role of the
management accountant is primarily to give managers technical advice and assistance to help them plan.
However, this role is changing with the development of strategic management accounting.
Activity 11.1
List the kind of broad matters you would expect to be dealt with in a long-term plan and a budget.
Exercising control
However well planned the activities of a business might be, they will come to nothing unless steps are
taken to try to achieve them in practice. The process of making planned events actually occur is known as
‘control’.
Control, as we discussed in Chapter 1 , can be defined as compelling events to conform to plan. This
definition is valid in any context. For example, when we talk about controlling a motor car, we mean
making that car do what we plan that it should do. In a business context, management accounting is very
useful in the control process. This is because it is possible to state plans in accounting terms (as
budgets). Since it is possible to state actual outcomes in the same terms, making comparisons between
actual and planned outcomes is a relatively easy matter. Where actual outcomes are at variance with the
budget, this variance should be highlighted by accounting information. Managers can then take steps
to get the business back on track towards achieving the budget. We shall look at the control aspects of
budgets later in the chapter.
variance
The financial effect, on the budgeted profit, of the particular factor under
consideration being more or less than budgeted.
Concept check 1
Which of the following statements is true?
A. Budgets provide a means for achieving overall corporate goals.
B. Budgets do not have to be expressed in financial terms.
C. Budgets provide actionable blueprints for more general objectives.
D. The overall goal should not be sacrificed to achieve a budget objective.
E. All of the above are true.
Concept check 2
Which of the following statements is false?
A. Variances are differences between actual results and budgeted figures.
B. Variances are bad.
C. Variance analysis provides a means of control.
D. Control is all about getting things to happen as the manager desires.
E. All of the above are true.
Budgets and forecasts
LO 2 Define a budget, set out the main components of the budget-setting process, explain how the
various budgets interlink, and identify the main uses of budgeting
Before starting this next section, it is important to reinforce that budgets and plans are regarded as being
part of management accounting, not financial accounting. It is up to each organisation to develop budgets
and plans that are appropriate to their particular organisation. There are no hard and fast rules that must
be followed. There are, however, some principles which are typically followed, and the remainder of this
chapter identifies these. They will not be suitable for every business, for all circumstances. Essentially,
you will need to understand your business and incorporate as much as you think is needed from the
material included in the chapter (and possibly quite a bit that isn’t covered). Also, we have usually
assumed that we are dealing with a manufacturing business, because this is typically more complex than
a retailing or service business, and therefore the examples are fairly comprehensive. This is particularly
true when we come to variance analysis, where a manufacturing example enables us to illustrate
production variances, which clearly would have less relevance to a service or retail organisation. So, the
aim of this chapter is to provide you with a reasonably comprehensive approach to planning and
budgeting, the principles of which can then be applied to your present and future workplaces.
A budget may be defined as a financial plan for a future time; ‘financial’ because the budget is, to a great
extent, expressed in financial terms. Note, particularly, that a budget is a plan, not a forecast. To talk of a
plan suggests an intention or determination to achieve targets. Forecasts tend to be predictions of the
future state of the environment.
Clearly, forecasts are very helpful to the planner/budget-setter. If a reputable forecaster has forecast how
many new cars will be purchased in Australia next year, a manager in a car-manufacturing business will
benefit from this forecast figure when setting sales budgets. However, the forecast and the budget are
nevertheless distinctly different.
periodic budget
A budget that is prepared for a specific period, typically a year.
A rolling (or continual) budget is, as the name suggests, continually updated. An annual budget will
normally be broken down into smaller time intervals (usually a month) to help control the activities of a
business. A rolling budget will add a new month to replace the month that has just passed, thereby
ensuring that at all times there will be a budget for a full planning period. Although continual budgeting
encourages a forward-looking attitude, there is a danger that it becomes a mechanical exercise.
Managers may not have time to step back from their other tasks each month and consider the future
carefully. It may be unreasonable to expect managers to take this future-oriented approach continually.
The annual budget sets targets for the year for all levels of the business. It is usually broken down into
monthly budgets, which define monthly targets. In many cases the annual budget is built up from monthly
figures. For example, sales staff are required to achieve sales targets for each month of the budget
period. Other budgets will be set for each month of the budget period, as explained below.
Limiting factors
There is always some aspect of the business that stops it achieving its objectives to the maximum extent.
This is often its limited ability to sell its products. Sometimes the limiting factor is a production shortage
(e.g. labour, materials or plant) or, linked to these, a shortage of funds. Often, production shortages can
be overcome by an increase in funds—for example, more plant can be bought or leased. This is not
always a practical solution, however, because no amount of money will buy certain labour skills or
increase the world supply of raw materials.
Activity 11.2
Can you think of any other ways in which a manufacturer’s short-term shortage of production facilities
might be overcome?
The solution to Activity 11.2 indicates that it is sometimes possible to ease an initial limiting factor—for
example, subcontracting can ease a plant capacity problem. This means that some other problem factor,
perhaps sales, will replace the production problem, although at a higher level of output. Ultimately,
however, the business hits a ceiling and a limiting factor proves impossible to ease.
It is important to identify the limiting factor, because most, if not all, budgets become affected by it. If it
can be identified at the outset, all managers can be informed of it early in the process, so they can take
account of it when preparing their budgets.
master budget
A summary of the individual budgets, usually consisting of a budgeted income
statement, a budgeted statement of financial position, and a budgeted statement
of cash flows.
Figure 11.1 illustrates the interrelationship and interlinking of the individual budgets, using a
manufacturing business as an example. The sales budget (at the left of Figure 11.1 ) is usually the first
budget to be prepared, as this tends to determine the overall level of activity for the forthcoming period.
This is because the sales level is probably the most common limiting factor. The finished inventory
requirement is dictated partly by the level of sales, partly by the business’s policy on holding finished
inventory. The requirement for finished inventory defines the required production levels, which in turn
dictate the requirements of each production department or section. The demands of manufacturing dictate
the materials budget, and that, in conjunction with the business’s policy on raw material inventory holding,
defines the stores (raw materials) inventory budget. The purchases budget is dictated by the stores
inventory budget, which, in conjunction with the policy of the business on accounts payable, dictates the
accounts payable budget. One of the inputs into the cash budget will come from the accounts payable
budget; another will be the accounts receivable budget, which is itself derived via the accounts receivable
policy of the business from the sales budget. Cash is also affected by selling and distribution costs
(themselves indirectly related to sales), by labour and administration costs (themselves linked to
production) and by capital expenditure. The factors that affect policies on matters such as inventory
holding and accounts receivable and payable collection periods will be discussed in some detail in
Chapter 13 .
This shows the interrelationship of budgets for a manufacturing business. The starting point is usually a
sales budget. The expected level of sales normally defines the overall level of activity for the business,
and the other budgets will be drawn up in accordance with this. Thus, the sales budget will largely define
the finished inventories requirements, and from this we can define the production requirements and so on.
Figure 11.1 gives a very simplified outline of the budgetary framework of the typical manufacturing
business. A service supplier would have a similar set of budgets, but without some or all of those relating
to inventories.
Besides the horizontal relationships between budgets we have just looked at, there are usually vertical
ones as well. For example, the sales budget may be broken down into subsidiary budgets, perhaps one
for each regional sales manager. Thus, the overall sales budget will be a summary of the subsidiary ones.
The same may be true of virtually all the other budgets, most particularly the production budget.
It is usually crucial for those responsible for budget-setting to have real authority in the organisation. Quite
commonly, a budget committee is formed to supervise and take responsibility for the budget-setting
process. This committee usually comprises a senior representative of most of the functional areas of the
business: marketing, production, sales, personnel, etc. Often a budget officer is appointed to carry
out, or otherwise be directly responsible for, the committee’s tasks. Not surprisingly, given their technical
expertise in the activity, accountants are often required to take on the budget officer role.
budget committee
A group of managers formed to supervise and take responsibility for the budget-
setting process.
budget officer
An individual, often an accountant, appointed to carry out, or take immediate
responsibility for having carried out, the tasks of the budget committee.
Budgets are intended to be the short-term plans for achieving long-term plans and the overall objectives
of the business. It is, therefore, important that the managers drawing up budgets are well aware of what
the long-term plans are, and how to work towards them in the upcoming budget period. Managers must
also be well aware of the commercial and economic environments in which they will be operating. It is the
responsibility of the budget committee to see that managers have all of the necessary information.
There are two broad approaches to setting budgets: top–down or bottom–up . In the top–down
approach, the senior management of each budget area originates the budget targets, perhaps discussing
them with lower levels of management and, as a result, refining them before the final version is produced.
With the bottom–up approach, the targets are fed upwards from the lowest level. For example, junior
sales managers will be asked to set their own sales targets, which then become incorporated into the
budgets of higher levels of management until the overall sales budget emerges. This approach has
probably become most common in practice. Where the bottom–up approach is adopted, it is usually
necessary to haggle over and negotiate a consensus, because the plans of some departments may not fit
in with those of others.
top–down
An approach to budgeting where the senior management of each budget area
originates the budget targets, perhaps discussing them with lower levels of
management.
bottom–up
A term applied to decisions in which great weight is given to the views of relatively
junior staff, who often have good experience and detailed knowledge of what is
going on in the business and its markets. The term is often used in budgeting,
where budgets are driven by the views of staff such as sales representatives.
The budget committee must now review the various budgets and satisfy itself that the budgets
complement one another. Part of the process is likely to include preparation of the master budgets—the
income statement, statement of financial position and statement of cash flows.
The formally agreed budgets are then passed on to the individual managers responsible for their
implementation. This requires, in effect, the most senior level of management (the board of directors)
formally notifying all other managers of their task. Communication of the budget effectively authorises
management to deal with its part of the budget.
Finally, the budgetary system requires performance relevant to the budget to be monitored. The benefits
of the budget-setting activity will be limited unless each manager’s actual performance is compared with
planned performance, which is embodied in the budget, and remedial action taken when things are going
wrong.
Activity 11.3
a. Why do you think most businesses prepare detailed budgets for the forthcoming year?
b. Why is it crucial for those responsible for the budget-setting process to have real authority in the
organisation?
incremental budgeting
An approach to budgeting that uses what happened in the previous year as the
starting point for negotiating the budget for the next year.
budget holder
The person who is responsible for working towards and implementing a particular
section of a budget.
discretionary budget
A budget that is entirely at the discretion of management; that is, it is not linked
directly to output or sales (e.g. research and development).
Discretionary budgets are often used for activities where there is no clear relationship between inputs
(resources required) and outputs (benefits). Compare this with, say, a raw materials usage budget, where
the amount of materials used, and therefore the amount of funds involved, is clearly related to the level of
production and, ultimately, to sales volume. It is easy for discretionary budgets to eat up funds with no
clear benefit being derived. Often, only proposed increases in these budgets are closely scrutinised.
Zero-based budgeting (ZBB) rests on the philosophy that all spending needs to be justified. For
example, when establishing the training budget each year, it is not automatically accepted that training
courses should be financed in the future simply because they were undertaken this year. The training
budget will start from a zero base (i.e. no resources at all), and will be increased above zero only if a good
case can be made. Top management will need to be convinced that the proposed activities represent
value for money.
Zero-based budgeting encourages managers to adopt a more questioning approach to their areas of
responsibility. To justify the allocation of resources, they are often forced to think carefully about particular
activities and the ways in which they are undertaken. This questioning approach should result in a more
efficient use of business resources. With an increasing portion of the total costs of most businesses being
in areas where the link between outputs and inputs is not always clear, and where commitment of
resources is discretionary rather than demonstrably essential to production, zero-based budgeting is
increasingly relevant. Possible downsides are that it is time-consuming, and therefore expensive to
undertake, and managers whose sphere of responsibility is subjected to zero-based budgeting can also
feel threatened by it.
The benefits of a zero-based budgeting approach can be gained to some extent—and perhaps at not so
great a cost—by using this approach on a selective basis. For example, a particular budget area could be
subject to zero-based budgeting scrutiny only every third or fourth year. In any case, if zero-based
budgeting is used more frequently, there is a danger that managers will use the same arguments each
year to justify their activities. The process will simply become a mechanical exercise and the benefits will
be lost. For a typical business, some areas are likely to benefit more from zero-based budgeting than
others. Zero-based budgeting could, in these circumstances, be applied only to those areas that will
benefit from it, and not to others. The areas that are most likely to benefit from zero-based budgeting are
discretionary spending ones, such as training, advertising, and research and development.
If senior management is aware of the potentially threatening nature of this form of budgeting, care can be
taken to apply zero-based budgeting with sensitivity. However, in the quest for cost control and value for
money, the application of zero-based budgeting can result in some tough decisions being made.
Activity 11.4
Can you think of any problems with zero-based budgeting?
Reflection 11.1
Assume that you are the manager of a department responsible for human relations for the entire
company, with responsibilities that include training across the entire corporation. You have just
been told of a change in policy from incremental budgeting to zero-based- budgeting. How are you
likely to react? Is your reaction likely to change over time?
1. They tend to promote forward thinking and the possible identification of short-term
problems. Focusing on the future may well enable managers to spot potential problems, and to do
so at an early enough stage for steps to be taken to avoid, or otherwise deal with, each problem.
Earlier in this chapter we saw that a shortage of production capacity may be identified during the
budgeting process. This discovery, if made in plenty of time, may allow options for overcoming the
problem. The best solution may be feasible only if action can be taken well in advance.
2. They can be used to help coordinate various sections of the business. It is crucial to link the
activities of the various departments and sections so that the activities of one complement those of
another. For example, the activities of the purchasing/procurement department of a manufacturing
business should dovetail with the raw materials needs of the production department so that
production does not run out of inventory and incur expensive production stoppages. However, care
should also be taken so that excessive inventory is not bought, as this would incur large and
unnecessary inventory holding costs.
3. They can motivate managers to better performance. Having a stated task can motivate
managers and staff to improve their performance. Simply telling a manager to do his or her best is
not very motivating; defining a required level of achievement is more likely to motivate. It is felt that
managers will be better motivated by being able to relate their particular role in the business to the
overall objectives of the business. Since budgets are directly derived from corporate objectives,
budgeting makes this possible. It is obviously not sensible to let managers operate in an
unconstrained environment. Having to operate in a way that matches the goals of the business is
the price of working in a successful business. We shall consider the role of budgets as motivators
later in the chapter.
4. They can provide a basis for a system of control. Control is concerned with ensuring that
events conform to plans. If senior management wishes to control and monitor the performance of
subordinates, it needs some standard or yardstick for assessing their performance. It is tempting to
compare current performance with that of the previous month or year, or perhaps with what
happens in another business. However, the most logical yardstick is planned performance.
If there is information on the actual performance for a period (say, a month) and this can be
compared with the planned performance, a basis for control can be established. Such a basis will
allow management by exception , a technique whereby senior managers can spend most of
their time dealing with subordinates who have failed to achieve the budget, rather than with those
who are performing well. It also allows junior managers to exercise self-control—by knowing what
is expected of them and what they have actually achieved, they can assess how well they are
performing and take steps to correct matters where they are failing to achieve. We shall consider
the effect of making plans and being held accountable for their achievement later in this chapter.
management by exception
The term used to describe a system of control in which attention is given to
areas which are out of line with plans; that is, which are exceptional.
5. They can provide a system of authorisation for managers to spend up to a particular limit. A
good example of this occurs when certain activities (e.g. staff development and research
expenditure) are allocated a fixed amount of funds at the discretion of senior management.
Activity 11.5
Do you think that requiring managers to work towards predetermined targets might stifle their skill, flair or
enthusiasm? Explain.
The five identified uses of budgets can conflict with one another on occasion. Where, for example, a
budget is being used as a system of authorisation, managers may be motivated to spend to the limit of
their budget, even though this may be wasteful. This may occur where the managers are not allowed to
carry over unspent balances to the next budget period, or where they believe that the budget for the next
period will be reduced because not all of the funds for the current period were spent. The wasting of
resources in this way conflicts with the role of budgets as a means of exercising control.
A further example is use of the budget as a motivational device. Some businesses set the budget targets
at a more difficult level than the managers are expected to achieve, in an attempt to motivate managers to
strive to reach their targets. For control purposes, however, the budget becomes less meaningful as a
benchmark against which to compare actual performance. Incidentally, there is good reason to doubt the
effectiveness of setting excessive targets as a motivational device, as we shall see later in the chapter.
Conflict between the different uses will mean that managers must decide which particular uses for
budgets should be given priority; managers must be prepared, if necessary, to trade off the benefits
resulting from one particular use for the benefits of another.
There is no reason why budgeting needs to be confined to financial targets and measures. Non-financial
measures can also be used as the basis for targets. They can be incorporated into the budgeting process
and reported alongside the financial targets for the business.
SMB/SME
Abbreviation for a small or medium-sized business/enterprise.
A South Australian study on the future of management accounting found that 90% of the
respondents used an operating budget, and 86% a cash budget. The survey population consisted
of members of CPA Australia who were working in, or had a professional interest in, management
accounting.
Source: David Forsaith, Carol Tilt and Maria Xydias-Lobo, The Future of Management Accounting: A South Australian Perspective. Flinders University School of
A survey of UK businesses in the food and drink sector found that virtually all of them used
budgets. The survey also found that zero-based budgeting was most appropriate with ‘spending’
budgets, such as training, advertising and so on, which probably represented a minority for the
types of business in this survey.
Source: Magdy Abdel-Khader and Robert Luther (2006), ‘Management accounting practices in the British food and drinks industry’, British Food Journal, 108(5),
336–357.
A survey of the opinions of senior finance staff of 340 businesses of various sizes and operating in
a wide range of industries in North America revealed that 97% of those businesses had a formal
budgeting process.
A major international survey covering a range of different industries by the Chartered Institute of
Management Accountants (CIMA) found that three budgeting tools were in the top 10 most used
management accounting tools. Financial year forecasting was used by approximately 85% of
respondents, cash forecasting by between 75% and 80%, and rolling forecasts by around 65%.
Strategic planning was used by just over 70% of respondents.
This study found that zero-based budgeting was used typically by about 40% of companies. This,
of course, does not mean that it is used for all budgets, but rather for selected ones.
Source: Chartered Institute of Management Accountants (CIMA), Management Accounting Tools for Today and Tomorrow (CIMA, London, 2009).
The surveys mentioned above tended to cover larger businesses. A further CIMA-sponsored study
in 2013 by Lucas and colleagues focused on management accounting practices in UK small and
medium-sized enterprises (SMEs). Formal budgeting systems were found in all of the medium-
sized enterprises, but only in some of the small ones. Most of the benefits of budgeting
(coordination, control, motivation, communication, etc.) are not applicable to many small firms,
where decision-making is centralised—with all decisions often made by the same person.
Nevertheless, budgeting still plays a role in resource planning and forecasting, and in providing
conditions of financial constraints.
Source: Michael Lucas, Malcolm Prowle and Glynn Lowth, Management Accounting Practices of (UK) Small-Medium Sized Enterprises (SMEs) (Chartered Institute
Reflection 11.2
At a personal level, do you use any kind of regular budgeting process, or are you happy to use a
seat-of-the-pants approach with your personal finances? How effective is your current approach?
Do you feel any need to improve it?
Concept check 3
Which of the following is a NOT a component of the master budget?
A. Income statement
B. Balance sheet
C. Cash flow statement
D. Sales budget
E. All of the above are components of the master budget.
Concept check 4
Which of the following is false?
A. Zero-based budgeting rests on the philosophy that all spending needs to be justified.
B. Zero-based budgeting encourages managers to take a more questioning approach to
their areas of responsibility.
C. Zero-based budgeting must be applied on an organisation-wide basis or not at all.
D. Zero-based budgeting can be seen by some staff as threatening.
E. Zero-based budgeting must be done with sensitivity.
Concept check 5
Which of the following is NOT a usual purpose for budget preparation?
A. Budgets provide the basis for a system of control.
B. Budgets motivate employees to act in their own interest.
C. Budgets force managers to think ahead and anticipate future opportunities and
problems.
D. Budgets assist in the coordination of activities throughout the business.
E. None of the above. All are usual purposes of budgets.
Preparing the cash budget
LO 3 Explain the importance of cash budgeting, and prepare a simple cash budget from relevant data
We shall now look in some detail at how the various budgets used by the typical business are prepared,
starting with the cash budget and then looking at the others. It is helpful for us to start with the cash
budget because it is a key budget—most economic aspects of a business are reflected in cash sooner or
later, so that for the typical business the cash budget reflects the whole business more than any other
single budget. Also, as we saw in Real World 11.1 , it should be recognised that very small,
unsophisticated businesses (e.g. a corner shop) may feel that full-scale budgeting is not appropriate to
their needs, but almost certainly they should prepare a cash budget as a minimum.
Since budgets are documents to be used only internally by the business, their style and format is
determined by management choice and so vary from one business to the next. However, since
managers, irrespective of the business, are likely to be using budgets for similar purposes, most
businesses are fairly consistent in their approach, and for most the cash budget features the following:
Typically, features 3–6 are useful to management for one reason or another.
The best way to deal with this topic is through an example (see Example 11.1 ).
EXAMPLE
11.1
Suppliers Ltd is a wholesale business. The budgeted statement of financial performance (income
statement) for the next six months is:
SUPPLIERS LTD
Income statement
Jan $’000 Feb $’000 Mar $’000 Apr $’000 May $’000 June $’000
Profit 2 4 5 7 6 3
The business allows all of its customers one month’s credit (i.e. goods bought in January will be
paid for in February). Sales during December were $60,000.
The business plans to maintain inventory at its existing level of $30,000 until March, when it is to
be reduced by $5,000. Inventory will remain at this lower level indefinitely. Inventory purchases are
made on one month’s credit (the December purchases were $30,000). Salaries and wages and
other overheads are paid in the month concerned. Electricity is paid quarterly in arrears, in March
and June. The business plans to buy and pay for a new delivery van in March. This will cost a total
of $25,000, but an existing van will be traded in for $14,000 as part of the deal. The business
expects to start January with $12,000 in cash.
The cash budget for the six months ended 30 June is shown below:
Jan $’000 Feb $’000 Mar $’000 Apr $’000 May $’000 June $’000
Receipts
Payments
Opening balance 12 30 40 27 44 57
Notes
1. The cash receipts lag a month behind sales, because customers are given a month to pay
for their purchases. So December sales will be paid for in January, and so on.
2. In most months, the purchases of inventory will equal the cost of goods sold, because the
business maintains a constant level of inventory. For inventory to remain constant at the
end of each month, the business must exactly replace the amount of inventory that has
been used. During March, however, the business plans to reduce its inventory by $5,000.
This means that inventory purchases will be lower than the cost of goods sold in that month.
The payments for inventory purchases lag a month behind purchases, because the
business expects to be allowed a month to pay for what it buys.
3. Each month’s cash balance is the previous month’s figure plus the cash surplus (or minus
the cash deficit) for the current month. The balance at the start of January is $12,000,
according to the information provided earlier.
4. Depreciation does not give rise to a cash payment. In the context of profit measurement in
the income statement, depreciation is a very important aspect. Here, however, we are
interested only in cash.
Activity 11.6
a. From the cash budget of Suppliers Ltd (Example 11.1 ), what conclusions do you draw, and
what course of action do you recommend for the cash balances over the period concerned?
b. Suppliers Ltd, the wholesale business in Example 11.1 , now wishes to prepare its cash budget
for the second six months of the year. The budgeted statement of financial performance (income
statement) for the period is as follows:
SUPPLIERS LTD
Income statement
Jul $’000 Aug $’000 Sep $’000 Oct $’000 Nov $’000 Dec $’000
Sales 57 59 62 57 53 51
Profit 7 8 8 5 2 1
The business will continue to allow all of its customers one month’s credit (i.e. goods bought in July will be
paid for in August).
It plans to increase inventory from the 30 June level by $1,000 each month until, and including,
September. During the following three months inventory levels will be decreased by $1,000 each month.
Inventory purchases, which had been made on one month’s credit until the June payment, will, starting
with the purchases made in June, be made on two months’ credit.
Salaries and wages and ‘other overheads’ will continue to be paid in the month concerned. Electricity is
paid quarterly in arrears, in September and December.
At the end of December, the business intends to pay off part of a loan, and this payment will leave it with
a cash balance of $5,000 to start the next year with.
Remember that Example 11.1 gives you any information you need for the first six months of the year,
including the cash balance which is expected to be brought forward on 1 July.
Prepare the cash budget for the six months ending in December.
Concept check 6
Which of the following statements is false?
A. Cash budgeting is important for both small and large organisations.
B. Cash budgets are often prepared in a monthly columnar format.
C. Cash budgets provide details of cash inflows and cash outflows.
D. Preparation of a cash budget is undesirable as it may show the business has a cash
flow problem.
E. A cash budget is an internal document whose format is at the business’s discretion.
Concept check 7
Which of the following statements is true?
A. Cash budgets should always follow the recommended columnar format.
B. Cash budgets should be the final budget to be prepared. The income statement and
balance sheet should have priority in the budget cycle.
C. Cash budgets should separate cash flows between operating, investing and
financing.
D. All of the above are true.
E. None of the above is true.
Preparing other budgets
LO 4 Construct a range of other budgets from relevant data
Although each one will have its own idiosyncrasies, other budgets tend to follow the same sort of pattern
as the cash budget, as illustrated in Example 11.2 .
EXAMPLE
11.2
We shall use the data in Example 11.1 (Suppliers Ltd) to illustrate how to prepare the relevant
other budgets (i.e. accounts receivable, accounts payable and inventories). Add to this data the
fact that the inventories balance at 1 January was $30,000.
Take the accounts receivables (debtors) budget, for example. This normally shows the planned
amount owing from credit sales to the business at the beginning and the end of each month, the
planned total sales for each month, and the planned total cash receipts relating to accounts
receivable. The layout of the accounts receivable budget, assuming no bad debts, would be
something like this:
Accounts receivable budget
Jan $’000 Feb $’000 Mar $’000 Apr $’000 May $’000 June $’000
Opening balance 60 52 55 55 60 55
Closing balance 52 55 55 60 55 53
The opening and closing balances represent the amount planned to be owed (in total) to the
business by customers at the beginning and the end of the month, respectively.
The layout of the accounts payable (creditors) budget would be something like the following:
Accounts payable budget
Jan $’000 Feb $’000 Mar $’000 Apr $’000 May $’000 June $’000
Opening balance 30 30 31 26 35 31
Add Purchases 30 31 26 35 31 32
60 61 57 61 66 63
Closing balance 30 31 26 35 31 32
The opening and closing balances represent the amount planned to be owed (in total) by the
business to accounts payable (creditors) at the beginning and the end of the month, respectively.
An inventories budget would normally show the planned amount of inventories to be held by the
business at the beginning and the end of each month, the planned total inventories purchases for
each month, and the planned total monthly inventory usage. The layout would be something like
this:
Inventories budget
Jan $’000 Feb $’000 Mar $’000 Apr $’000 May $’000 June $’000
*
Opening balance 30 30 30 25 25 25
Add Purchases 30 31 26 35 31 32
60 61 56 60 56 57
Closing balance 30 30 25 25 25 25
*
The opening balance is $30,000, while the closing inventory is $30,000 until March, when it
becomes $25,000 and remains at this level. Cost of sales is shown and represents inventories
used. The purchases figure can be deduced as a residual figure.
A raw materials inventories budget, for a manufacturing business, would follow a similar pattern,
with the ‘inventories usage’ being the cost of the inventories put into production. A finished
inventories budget for a manufacturer would also be similar to the above, except that ‘inventories
manufactured’ would replace ‘purchases’. A manufacturing business would normally prepare both
a raw materials inventories budget and a finished inventories budget.
The inventories budget will normally be expressed in financial terms, but may also be expressed in
physical terms (for example, kilograms or metres) for individual inventories items.
Note how the accounts receivable, accounts payable and inventories budgets in Example 11.2 link to
one another, and to the cash budget for the same business in Example 11.1 .
Activity 11.7
Using the information provided in Activity 11.6 (page 487), prepare the accounts receivable budget
and the accounts payable budget for Suppliers Ltd for the six months from July to December.
(Hint: Remember that the payment period relating to accounts payable alters from the June purchases
onwards.)
Concept check 8
Which of the following statements is false?
A. The basic format of budgets is similar from organisation to organisation.
B. The monthly columnar format of the cash budget provides a pattern for other
budgets.
C. Budgets should always be expressed in financial terms.
D. The accounts receivable budget links with the sales budget.
E. The accounts payable budget links with the purchases budget.
Concept check 9
Which of the following would NOT be a component of a debtor’s budget?
A. Opening balance
B. Closing balance
C. Current period sales
D. Current period purchases
E. Cash receipts.
Concept check 10
Which of the following would NOT be a component of an inventory budget?
A. Opening balance
B. Cash receipts
C. Closing balance
D. Current period cost of sales
E. Current period purchases.
Self-assessment Question 11.1 pulls together what we have seen about preparing budgets.
SELF-ASSESSMENT QUESTION
11.1
Antonio Ltd has planned production and sales for the next nine months as follows:
Raw materials will be held in stock for one month before they are used in production. Purchases of
raw materials will be on one month’s credit (buy one month, pay the next). The cost of raw
materials is $8 per unit of production.
Other direct production expenses, including labour, are planned to be $6 per unit of production.
These will be paid in the month concerned.
Various production overheads, which during the period to 30 June had run at $1,800 per month,
are expected to rise to $2,000 each month from 1 July to 31 October. These are expected to rise
again from 1 November to $2,400 per month and to remain at that level for the foreseeable future.
These overheads include a steady $400 each month for depreciation. Overheads are planned to
be paid 80% in the month of production, and 20% in the following month.
To help meet the planned increased production, a new item of plant will be bought and delivered in
August. The cost of this item is $6,600; the contract with the supplier specifies that this will be paid
for in three equal amounts in September, October and November.
Raw materials inventory is planned to be 500 units on 1 July. The balance at the bank the same
day is planned to be $7,500.
b. The cash budget reveals a potential cash deficiency during October and November. Can
you suggest how a modification of plans could overcome this problem?
Using budgets for control
LO 4 Use a budget as a means of exercising control over the business, explain and apply flexible
budgeting, and calculate a series of variances between budget and actual to help control activity
In both Chapter 1 and earlier in this chapter, we pointed out that budgets can provide a useful basis for
exercising control over the business, because control is usually seen as making events conform to a plan.
Since the budget represents the plan, making events conform to it is the obvious way to try to control the
business. Using budgets in this way is very popular.
For most businesses the planning and control process is likely to be along the lines shown in Figure
1.6 (page 28). These steps in the control process are probably fairly easy to understand. The budget is
prepared in sufficient detail to be able to both plan and control activities. The figures for actual
performance can be compared with those budgeted, and any differences, known as ‘variances’, can then
be examined and rectified. In many businesses a simple comparison will enable issues to be identified
and examined. In other cases comparison might be difficult, especially in the situation where the actual
and budget figures are not prepared on the same basis; that is, the budgeted and actual outputs are
different. In this case the budget will need to be flexed, as discussed later. Taking steps to exercise
control means finding out where and why things did not go according to plan, and then seeking ways to
put things right for the future. One of the reasons why things may not have gone according to plan is that
the plan may, in reality, prove to be unachievable. In this case, if budgets are to be a useful basis for
exercising control in the future, it may be necessary to revise the budgets for future periods to bring
targets into the realms of achievability.
This last point should not be taken to mean that budget targets can simply be ignored if the going gets
tough. However, for a variety of reasons, including unexpected changes in the commercial environment
(e.g. unexpected collapse in demand for a business’s specific type of services), budget targets may prove
to be totally unrealistic. In this case, nothing whatsoever will be achieved by pretending they can be met.
Real World 11.2 provides examples of situations where costs have blown out significantly from the
original budget.
California’s high-speed rail was approved in 2008 at a budgeted cost of US$40 billion. By early
2018 costs had been revised upwards to between US$63.2 billion and US$98 billion, with a ‘base’
estimate of US$77.3 billion.
Source: Adam Brinklow, ‘California high-speed rail cost may approach $100 billion’, Curbed San Francisco, 12 March 2018.
Two nuclear power stations—one in Georgia and the second in South Carolina—led to
Westinghouse filing for bankruptcy in March 2017, and very nearly ruined its corporate parent
Toshiba. Overruns amounted to US$13 billion.
Source: Tom Hals and Emily Flitter Reuters, ‘How two cutting edge US nuclear projects bankrupted Westinghouse’, stltoday, 4 May 2017.
Other major projects that were horribly overspent include: the international space station
(US$68.25 billion); the Sochi Winter Olympics ($39 billion); the Channel Tunnel ($21.10 billion); the
Three Gorges Dam ($16.18 billion); and the Brazil World Cup ($2.5 billion).
Source: Niall McCarthy, ‘Major construction projects that went catastrophically over-budget’, Forbes, 28 September 2018.
In Australia, the Grattan Institute analysed all 836 transport infrastructure projects valued at $20 -
million or more since 2001. They found that ‘cost blow outs account for nearly a quarter of the total
budgets of these projects’. The Forrest Highway in Western Australia cost over five times what the
politicians had initially promised it would cost. In New South Wales the Hunter Expressway cost
four times what was originally promised.
Source: Marion Terrill, ‘How politicians’ reckless promises are distorting transport infrastructure spending’, The Grattan Institute, 23 October 2016.
More routine exercises were not immune from overruns. The Sydney Morning Herald reported that:
‘Budgeted technology projects that were supposed to slash expenses by centralising IT systems
for the state’s [NSW] transport agencies have, in fact, led to a surge in annual operating costs.’ Its
budget of $30 million blew out to $80 million.
Source: Matt O’Sullivan, ‘Bungled IT projects see costs blow out for NSW transport agencies’, The Sydney Morning Herald, 24 July 2018.
Reasons for the various overruns include: hastiness to meet deadlines; realisation of risks that
were inherent in the project but were downplayed; wages growth; taking too much price risk on
contracts; project disputes; miscalculation of time taken and potential pitfalls; a new approach that
was untested; misjudgement of regulatory hurdles; political pressure; early announcement of costs,
possibly for political purposes, without proper prior assessment; and, in the case of the Winter
Olympics and the World Cup, national pride.
The reality however, is that even complicated long-term projects should still be capable of sound
planning, assessment and costing, leading to a satisfactory outcome in terms of timing, cost and
effectiveness. A good example is the Forth Bridge, a 1.7-mile road bridge over the river Forth,
close to Edinburgh. The bridge, which was opened in August 2017, cost £1.35 billion, £245 million
less than the budgeted cost. The bridge was Scotland’s most major infrastructure project for many
years. It took six years to complete, with the 15,000 people working on it clocking up 18 million
hours of work.
Source: Based on information contained in: Aaron Morby, ‘Queensferry Crossing opens £245m below budget’, Construction Enquirer, 30 August 2017.
More generally, Real World 11.3 gives some indication as to just how accurate budgets turn out to be.
The survey of senior finance staff of North American businesses, mentioned in Real World
11.1 , asked respondents to compare the revenues that actually occurred with the revenues that
were budgeted (prior to the start of the year) for 2007. Figure 11.3 shows the results.
These figures compare with those found in a 2007 survey on forecasting carried out by KPMG. In
this survey it was found that over a three-year period only 1% of businesses hit their targets, 22%
came within 5% of their targets either way, and on average forecasts were out by 13%.
Since the principal objective of most private-sector businesses is to enhance their wealth, and
remembering that profit is the net increase in wealth gained by trading, the most important budget target
to meet is the profit target. In view of this, we shall begin with that aspect as we make the comparison
between the budget and actual results in Example 11.3 .
EXAMPLE
11.3
The following are the budgeted and actual performance figures for Baxter Ltd for the month of
May:
Budget Actual
$ $
These figures will be used to illustrate various aspects of budgetary control and variance analysis.
Clearly, the budgeted profit was not achieved. As far as May is concerned, this is a matter of history.
However, the business (at least some aspects of it) is out of control. Senior management must discover
where things went wrong during May and try to ensure that they are not repeated in later months. Thus, it
is not enough to know that overall things went wrong; we need to know where and why.
Activity 11.8
Can you see any problems in comparing the various items (sales, direct materials and so on) for the
budget and the actual performance of Baxter Ltd in order to draw conclusions as to which aspects were
out of control?
The normal starting point is to compare the budget and the actual figures for each budget line. However,
in this example the actual level of output was not as budgeted. We cannot, for example, say that there
was a labour cost saving of $2,500 (i.e. $20,000−$17,500) and conclude that all is well in that area. This
is because the level of output was 10% less than budgeted, and we would therefore expect labour costs
to be lower than budgeted.
In order to focus on the differences between budget and actual figures from a control viewpoint, we need
to compare the actual costs incurred (for the actual volume of production) with those we would have
included in a budget if we had planned to achieve the level of production that we did achieve. In other
words, in the above example we need to compare the actual costs incurred in producing 900 units (the
actual production) with a budget prepared on the assumption that 900 units would be produced.
In the context of control, the budget is usually flexed to reflect the volume which actually occurred. To flex
it we need to know which items are fixed and which are variable relative to the level of output. Once we
have this knowledge, flexing is simple. We shall assume that sales revenue, materials cost and labour
cost vary strictly with volume. Fixed overheads, by definition, will not. Whether in real life labour cost does
vary in this way is not so certain, but we will assume this for our purposes. Where labour costs are
actually fixed, we simply take this into account in the flexing process.
On the basis of the assumptions on the behaviour of costs, the flexed budget would be as follows:
flexed budget
A budget which is modified to reflect the costs that would have been expected for
the actual activity/level of output.
Flexed budget
Sales 90,000
This is simply the original budget, with the sales revenue, raw materials and labour figures scaled down to
reflect the fact that actual output is only 90% of the original budget.
Putting together the original budget, the flexed budget and the actual for May, the following is obtained:
Output (production and sales) 1,000 units 900 units 900 units
$ $ $
Flexible budgets enable us to make a more valid comparison between the budget (using the flexed
figures) and the actual results. We need to know how the $3,100 reduction in profit occurred. Key
differences, or variances, between budgeted and actual results for each aspect of the business’s activities
can then be calculated.
It may seem as if we are saying that it does not matter if there are volume shortfalls because we just
revise the budget and carry on as if all is well. However, this is not the case, because losing sales
normally means losing profit. The first point that we must pick up, therefore, is the loss of profit arising
from the loss of sales of 100 units.
Activity 11.9
What will be the loss of profit arising from the sales volume shortfall, assuming that everything except
sales volume was as planned?
The table enables us to attribute a reduction in profit of $4,000 to the reduction in volume that has
resulted—the difference between the original budget and the flexed budget. The reverse is also true:
increases in volume are usually associated with increases in profit. The resulting variance is often
referred to as the sales volume variance . Baxter Ltd’s sales volume variance for May is an adverse
variance because, taken alone, it has the effect of making the actual profit lower than the one that was
budgeted.
As we saw in Chapter 9 , when we considered the relationship between cost, volume and profit, selling
one unit less will result in a reduction of profit amounting to the lost contribution associated with one unit.
The contribution is sales revenue less variable costs. We can see from the original budget that the unit
sales revenue is $100 (i.e. $100,000/1,000), raw materials cost is $40 per unit ($40,000/1,000) and labour
cost is $20 per unit ($20,000/1,000). Thus, the contribution is $40 per unit (i.e. $100−($40+$20)).
If, therefore, 100 units of sales are lost, $4,000 (i.e. 100×$40) of contribution, and therefore profit, is
forgone. This would be an alternative means of identifying the impact on profit of a difference between
budgeted and actual sales volume, but once we have produced a flexed budget it is generally easier
simply to compare the two profit figures.
Besides this, we can see that (comparing the flexed budget with actual costs) an extra $900 was spent on
raw materials, $500 less was spent on labour and $700 more was spent on fixed overheads than we
would have expected, given the actual level of output. Also, the sales revenue was $2,000 higher than we
would have expected, which means that the selling price must have been higher than expected.
Use of the flexed budget figures facilitates a more valid comparison between budget and actual. For
example, we can now see that there was a genuine labour cost saving, even after allowing for the output
shortfall. A variance that has the effect of increasing profit above that which is budgeted is known as a
favourable variance . In this case we can see that a favourable total labour cost variance of $500 has
occurred.
favourable variance
The difference between planned and actual performance where the difference
causes the actual profit to be higher than that budgeted.
More generally, we can say that an x variance is the effect of the change in that factor (x) on the budgeted
profit. When looking at some particular aspect such as sales volume, we assume that all other factors
have gone according to plan.
Variances explain the difference between what profit was planned (budgeted profit) and what profit was
achieved (actual profit). If, therefore, we take the budgeted profit and adjust it for the totals for both
favourable and adverse variances, we should arrive at the actual profit. This is shown in Figure 11.4 .
The flexible budgeting approach follows the route from budgeted profit to the profit shown by the flexible
budget (by adjusting for the sales volume variance), and then from the profit shown by the flexible budget
to the actual profit (by adjusting for all of the remaining variances).
The variances represent the differences between the budgeted and actual profits, and so can be used to
reconcile the two profit figures.
The calculation of a variance is important, but it must be followed by a critical analysis. Who, for example,
should be held accountable for the sales volume variance? The answer is probably the sales manager,
who should know why this departure from budget has occurred. This is not the same as saying that it was
the sales manager’s fault. The problem may well be that the production department failed to produce the
budgeted production, so that there were not sufficient items to sell. What is not in doubt is that the sales
manager should know the reason for the problem.
A reconciliation between budgeted profit and actual profit is an essential part of the control process. When
the difference can be broken down by reason, control is gained. The content of Figure 11.4 might take
the form of a reconciliation, as shown in Table 11.1 .
Table 11.1 Reconciliation of differences between actual and budget for Baxter Ltd for May
$ $
Labour 500
2,500
(5,600)
Activity 11.10
If you were the chief executive of Baxter Ltd, what attitude would you take to the overall variance between
the budgeted profit and the actual one?
How would you react to the five individual variances that are the outcome of the analysis shown in Table
11.1 ?
Materials variances
In May, there was an overall or total direct materials variance of $900 (adverse). It is adverse -
because the actual material cost was higher than that allowed for in the flexed budget, and so has an
adverse effect on profit. Who should be held accountable for this variance? The answer depends on
whether the difference arose from an excess usage of raw materials, in which case it would be the
production manager, or whether a higher than budgeted price per metre was paid, in which case it would
be the buying manager.
Fortunately, we can go beyond this total variance. We can see from the figures that 37,000 metres of
materials were used when the flexed budget suggested that only 36,000 were needed. In other words,
there was a 1,000-metre excess usage of the raw materials. All other things being equal, this alone would
have led to a profit shortfall of $1,000 since the budgeted price per metre was $1. The $1,000 (adverse)
variance is known as the direct materials usage variance . Normally, this would be the responsibility
of the production manager, since it is that person’s responsibility to supervise the use of the raw material.
The other aspect of direct materials is the direct materials price variance . Here, we simply take the
actual quantity bought and compare what should have been paid for it with what was actually paid for it. In
May, for a quantity of 37,000 metres, the cost should have been $37,000; it was actually $36,900. Thus,
we have a favourable price variance of $100. Paying less than the budgeted price will tend to increase
profit, hence it is a favourable variance.
The total direct materials variance is the sum of the direct materials usage variance and the direct
materials price variance.
Labour variances
Direct labour variances are very similar in style to those for direct materials. The total direct labour
variance is the difference between the actual direct labour cost and the direct labour cost according to
the flexed budget (budgeted direct labour hours for the actual output). This variance for May was $500
(i.e. $18,000−17,500), which was a favourable variance. Again, this information is not particularly helpful
since the responsibility for the rate of pay lies primarily with the personnel manager, who should at least
be able to explain the variance. The number of hours taken to complete a particular quantity of output is,
however, the responsibility of the production manager. It is necessary to separate the total labour
variance to illustrate how efficiently labour is used and also by how much the cost of labour has affected
profits.
The direct labour usage (efficiency) variance compares the number of hours that would be expected
(also known as the ‘allowed direct labour cost’) for the level of production achieved with the actual number
of hours, and costs the difference at the allowed hourly rate. Thus, for May, it was
(900 hours–880 hours)×$20=$400 (favourable). The variance is favourable because fewer hours were
used than would have been expected (allowed) for the actual level of output.
The direct labour rate variance compares the actual cost of the hours worked with the planned cost.
For 880 hours worked in May, the allowed cost would be $17,600 (i.e. 880×$20). Since the actual cost
was $17,500, there must be a favourable labour rate variance of $100.
The fixed overhead spending (expenditure) variance is simply the difference between the flexed
budget and the actual figures. For May, this was $700 (adverse). It is adverse because more overheads
cost was incurred than was budgeted. This would tend to lead to less profit. In theory, this is the
responsibility of whoever controls overheads expenditure.
In practice, this area tends to be very slippery and notoriously difficult to control. Of course, fixed
overheads (and variable ones) are usually made up of more than one type of cost. They include such
things as rent, administrative costs, salaries of managerial staff, cleaning, electricity and so on. These can
be individually budgeted and the actuals recorded, to enable individual spending variances to be identified
for each element of overheads, in turn enabling managers to identify any problem areas.
We are now in a position to reconcile the original May budget profit with the actual one, in an expanded
way, as shown in Table 11-2 .
Table 11.2 Reconciliation of differences between actual and budget for Baxter Ltd for May—
expanded
$ $
Favourable variances
2,600
22,600
Adverse variances
(5,700)
Activity 11.11
The budget and actual figures for Baxter Ltd for June are given below.
$ $
The flexed budget is shown below, alongside the original budget and the actual figures.
$ $ $
Raw materials (44,000) (44,000 metres) (46,000) (46,000 metres) (46,300) (46,300 metres)
Labour (22,000) (1,100 hours) (23,000) (1,150 hours) (23,200) (1,170 hours)
Prepare a statement reconciling budgeted profit with actual profit, going into as much detail as possible
regarding variances.
standard costing
A more detailed system of flexible budgeting that enables more detailed variance
analysis to occur.
standards
Planned quantities and costs (or revenue) for individual units of input or output.
Standards are the building blocks used to produce the budget.
The standards, like the budgets to which they are linked, represent targets, and therefore yardsticks by
which actual performance is measured. They are derived from experience of what is a reasonable
quantity of input (for labour time and materials usage), and from assessments of the market for the
product (standard selling price) and for the inputs (labour rate and materials price). These should be
reviewed frequently and, where necessary, revised. If they are to be used as part of the control process, it
is vital that they represent realistic targets.
The calculation of most variances is, in effect, based on standards. For example, the materials usage
variance is the difference between the standard materials usage for the level of output and the actual
usage, costed at the standard materials price.
Standards can have uses beyond the context of budgetary control. The various usages and costs of
business operations give decision-makers a ready set of data for their purposes.
Reasons for adverse variances
A constant possible reason why variances occur is that the standards against which performance is being
measured are not reasonable. This is certainly not to say that the immediate reaction to an adverse
variance should be that the standard is unreasonably harsh. On the other hand, standards that are not
achievable are certainly useless.
Possible reasons for adverse variances might include the kind of things found in Table 11.3 .
Sales price
Labour efficiency
Poor supervision
Use of a low-skill grade of worker when a high-skill grade of worker was planned, resulting in a longer time taken to complete the work
Low-grade material, leading to high levels of scrap and wasted labour time
Problems with machinery, wasting labour time
Dislocation of material supply, preventing workers from proceeding with production
Labour rate
Fixed overheads
A very large number of variances can be calculated, given the range of operations in practice. We have
considered just the most basic of them. They are all, however, based on similar principles.
Although we have used the example of a manufacturing business to explain variance analysis, this does
not imply that variance analysis is not equally as applicable and useful for a service-sector business. It is
simply that in manufacturing businesses we tend to find all of the variances that occur in practice. Service
businesses, more typically, may not have materials variances.
Investigating variances
It is unreasonable to expect that budget targets will be met precisely each month. Whatever the reason
for a variance may be, it may not be very obvious, so finding it may take time, and time is costly. Since
small variances are almost inevitable and investigating them can be expensive, management needs to
establish a policy on which variances to investigate and which to ignore. The general approach to this
policy must be concerned with cost and benefit. The benefit of knowing why a variance exists needs to be
balanced against the cost of obtaining that information.
Real World 11.4 provides some indication of the importance in practice of accounting for control.
Askarany and Smith, in a South Australian survey which covered manufacturing firms in the
Australian plastics industry, found that 66% of their respondents had used standard costing.
Source: D. Askarany and M. Smith, ‘The impact of contextual factors on the diffusion of accounting innovations: Australian evidence’. In Proceedings of the Sixth
Interdisciplinary Perspectives on Accounting Conference (IPA) (12–15 November 2000, Manchester), pp. 59–64.
Source: David Dugdale, T. Colwyn Jones and Stephen Green, Contemporary Management Accounting Practices in UK Manufacturing (CIMA Publishing, Oxford,
2006).
A study of the UK food and drink industry provides some insight into the importance attached to -
flexible budgeting by management accountants. The study asked those in charge of the
management accounting function to rate the importance of flexible budgeting by selecting one of
three possible categories: ‘not important’, ‘moderately important’ or ‘important’. It was found to be
‘not important’ in 27% of cases, ‘moderately important’ in 40% of cases and ‘important’ in 33% of
cases.
Respondents were also asked to state the frequency with which flexible budgeting was used within
the business, using a five-point scale ranging from 1 (never) through to 5 (very often). Figure
11.5 sets out the results.
Source: Based on data from Magdy Abdel-Kader and Robert Luther (2006), ‘Management accounting practices in the British food and drinks industry’, British Food
We can see that, although flexible budgeting is regarded as important by a significant proportion of
management accountants and is being used in practice, not all businesses use it.
The CIMA (2009) survey mentioned in Real World 11.1 (page 483) found that variance analysis
was used by just over 60% of small businesses, ranging through to almost 85% for very large
companies. ‘Small’ in the context of this survey meant fewer than 50 employees. Standard costing
(a more refined approach to variance analysis) was found to be used in just over 35% of small
businesses, ranging through to about 55% for very large businesses.
Source: Chartered Institute of Management Accountants (CIMA), Management Accounting Tools for Today and Tomorrow (CIMA, London, 2009).
The CIMA (2013) study by Lucas and colleagues referred to in Real World 11.1 , which focused
on small and medium-sized businesses, found that variances may be of use to senior managers in
large firms for monitoring junior operational managers, but in smaller firms this need, typically, is
not perceived to arise.
Source: Michael Lucas, Malcolm Prowle and Glynn Lowth, Management Accounting Practices of (UK) Small-Medium Sized Enterprises (SMEs) (Chartered Institute
A serious attitude to the system, which is required by all levels of management, right from the very
top. For example, senior managers need to make junior managers take notice of the monthly variance
reports and base some of their actions on them.
Clear demarcation between areas of managerial responsibility so that accountability can more
easily be ascribed for any area that seems to be going out of control. It must be clear which manager
is responsible for each aspect of the business.
Reasonable budget targets; that is, rigorous yet achievable targets. This may be promoted by
involving managers in setting their own targets, which, it is argued, can increase managers’
commitment and motivation. We shall consider this in more detail shortly.
Established data collection, analysis and dissemination routines, which take the actual results
and the budget figures, and calculate and report the variances. This should be part of the business’s
regular accounting information system so that the required reports are routinely produced each month.
Reports aimed at individual managers, rather than general-purpose documents. This saves
managers from wading through reams of reports to find what is relevant to them.
Fairly short reporting periods, typically a month, so that things cannot go too far wrong before they
are picked up.
Timely variance reports, which should be made available to managers just after the end of the
relevant reporting period. If a manager is not told until the end of June that the performance for May
was below the budgeted level, the performance for June will quite likely be below target as well.
Reports on May’s performance should, ideally, emerge early in June.
Action taken to get operations back under control if they are out of control. The report will not
change things by itself. Managers must ensure that after receiving a report of significant adverse
variances, action is taken to put things right.
budgetary control
Using the budget as a yardstick against which the effectiveness of actual
performance can be assessed.
Concept check 11
Meaningful variance analysis will generally require:
A. Identification of unexpected events and an understanding of their financial
consequences
B. Realistic budgets
C. Flexing of the budget to actual volume or use of standard costs
D. None of the above
E. All of A, B and C.
Concept check 12
Which of these statements about flexible budgets is true?
A. Flexible budgets require an understanding of the organisation’s cost behaviour for
proper preparation.
B. Flexible budgets require actual output to be flexed to budgeted volume.
C. Comparison of the flexed budget with actual results provides a less valid comparison
than comparing the original budget with actual results.
D. All of the above.
E. None of the above.
Concept check 13
The sales volume variance:
A. Will generally be favourable
B. Will be favourable if actual volume is less than budgeted volume
C. Is the difference between profit as shown in the original budget and profit as shown
in the flexed budget for the period
D. None of the above
E. All of the above.
Limitations of the traditional approach to control
LO 6 Identify the limitations of the traditional approach to control through budgets and standards
Limitations can usefully be categorised into three quite distinct areas. The first of these relates to fairly
specific issues concerning budgeting systems. The second, which was the subject of huge amounts of
research over the latter half of the 20th century, relates to behavioural aspects of budgeting. The third
relates to an area which has become known as ‘Beyond Budgeting’, which sees budgeting as a
‘command and control’ system that can result in many negative outcomes. These areas of limitation are
dealt with next.
Vast areas of most business and commercial activities simply do not have the same direct relationship
between inputs and outputs as is the case with, say, the level of output and the amount of raw
materials used. Much of the expense of the modern business occurs in areas such as training and
advertising, which are discretionary and not linked to the level of output in a direct way.
Standards can quickly become out of date due to technological change or price changes. This does
not pose insuperable problems, but the potential problem must be systematically addressed.
Unrealistic standards are, at best, useless. At worst, they can adversely affect performance. A buyer
who knows that it is impossible to meet price targets, because of price rises, has less incentive to
keep costs as low as possible.
Sometimes factors beyond a manager’s control can affect the calculation of a variance for which he or
she is held accountable. This is likely to have an adverse effect on the manager’s performance, which
can often be avoided by a more considered approach to the calculation of the variance—that is, one
that separates what the manager can control from what he or she cannot control.
In practice, clearly delineating managers’ areas of responsibility may be difficult. Thus, one of the
prerequisites of good budgetary control is lost.
It has been suggested that allowing managers to set their own targets can result in slack (i.e. easily
achievable) targets. On the other hand, in an effort to impress, a manager may select a target that is not
really achievable. Therefore, care must be taken in overseeing managers who choose their own targets.
Evidence suggests that managers working in an environment where they are expected to meet the
budget targets often try to introduce slack into the budget. Where there is a more relaxed attitude, or
where other factors (e.g. good staff morale) are considered alongside the analysis of variances,
managers are generally less inclined to introduce slack.
If a manager fails to meet a budget, his or her senior must deal with the failure carefully. A harsh, critical
approach may discourage the manager. Adverse variances may imply that the manager needs help from
the senior. Budgets give senior managers a ready means to assess the performance of their
subordinates. If promotion or bonuses depend on the absence of variances, senior management must be
very cautious.
Activity 11.12
Try to identify ways in which budget game-playing might occur.
Reflection 11.3
Assume that you, as marketing manager, are responsible for your company’s marketing budget.
What kind of involvement would you like, or expect, in setting your budget? What kind of
involvement would you expect with your subordinate staff? What would be your attitude to staff
who you suspected of trying to build in slack into their section of the budget? What kind of
relationship would you try to build up with your team vis-à-vis the budget?
Real World 11.5 provides some thoughts on the behavioural and psychological aspects of budgeting
from a personal budgeting perspective, as distinct from an organisational perspective.
Real world 11.5
Why you keep busting your budget
An article in The Wall Street Journal focused on personal budgeting, and how it is possible to get
your spending under control. Several interesting comments were made:
Source: Charlie Wells, ‘Money: why you keep busting your budget’, The Wall Street Journal, 9 November 2015.
Beyond budgeting
It is interesting to note that the main period of research into behavioural aspects of budgeting occurred
last century. Over the past 20 or so years, a more general level of dissatisfaction with traditional -
budgeting has arisen. Drawbacks and limitations have been identified, and suggest that budgets:
(Source: Chartered Institute of Management Accountants (CIMA), Beyond Budgeting, Topic Gateway Series No. 35 (CIMA, London, October 2007). © 2008, Chartered Institute
Most people focus too much on income but are terrible at forecasting outflows. Do you think this is
true? If so, why? Is it true of you?
Do you reward yourself (possibly with unhealthy rewards) for displays of willpower?
When you have a bad day, do you go shopping or go out for entertainment?
Do you agree that unhappiness is associated with reduced saving and higher spending? If so, how
might you deal with this?
How might increases in home equity influence your day-to-day expenditure? Do such increases
justify substantial additional expenditure?
As a result, a movement called Beyond Budgeting has developed. The Beyond Budgeting Round Table
(BBRT) was set up in 1998 and now has membership across the world. Its website (http://bbrt.org/what-
is-beyond-budgeting/) states:
Beyond Budgeting means beyond command-and-control toward a management model that is more empowered and adaptive. Beyond
Budgeting is about rethinking how we manage organizations in a post-industrial world where innovative management models represent
the only sustainable competitive advantage. It is also about releasing people from the burdens of stifling bureaucracy and suffocating
control systems, trusting them with information and giving them time to think, reflect, share, learn and improve. Above all it is about
learning how to change from the many leaders who have built and managed ‘beyond budgeting’ organizations.
Beyond Budgeting uses a range of tools and techniques that replace the traditional budgeting process.
A number of common principles have been developed, including six that were identified by Jeremy Hope
and Robin Fraser in 2003 (Beyond Budgeting: How Managers Can Break Free from the Annual
Performance Trap (Harvard Business School, Boston, 2003)). These principles were:
Real World 11.6 summarises Hope and Fraser’s description of how companies using Beyond
Budgeting do things differently, and what the reported benefits are.
Real world 11.6
Benefits of Beyond Budgeting
Setting targets
Previously, targets were set on the basis of financial numbers and negotiated centrally. Under BB,
targets are based on high level key performance indicators (KPIs). These include return on capital,
free cash flows or cost to income ratios. Goals are set to maximise short- and medium-term profit
potential. Reported benefits: The BBRT argues that this is much faster than budgeting. The
benchmarking bar is constantly raised to encourage maximum profit potential.
Rewarding people
In traditional budgeting, rewards were linked to a fixed outcome agreed in advance. BB rewards
team success based on relative performance, not fixed annual targets. Reported benefits: The
best performers are recognised and rewarded, not just the skilled budget negotiators.
Action planning
Previously in these organisations, planning had been driven by top management. Then they
devolved responsibility for strategy review to business units or front-line teams. These are
responsible for reviewing the medium-term outlook (goals, strategies, action plans and value
drivers) annually, and the short-term outlook (actual and forecast performance indicators) every
quarter. Reported benefits: BB argues that this continuous and open process allows teams to
create value. They can respond to changing demand and anticipate business threats and
opportunities.
Managing resources
Resources were previously managed on the basis of pre-negotiated budget contracts. They now
make resources available to front-line teams as and when required. Operational resources are
managed by setting goals based on KPIs. Reported benefits: Resource decisions are devolved to
front-line teams, making them more responsive. Managers are more accountable; there is greater
ownership and less waste.
Co-ordinating action
Previously plans were linked through central co-ordination of annual departmental and business
unit budgets. Co-ordination now occurs through cross-company interaction. Reported benefits:
Operating capacity rises and falls according to demand. There is less waste as fewer items are
made for stock. The organisation acts like an integrated unit.
Measuring and controlling performance
Performance used to be controlled against predetermined budgets and corrective action was taken
where necessary. Under BB, executives and managers see the same information simultaneously.
Reported benefits: There is greater focus on trends and forecasts.
Source: Chartered Institute of Management Accountants (CIMA), Beyond Budgeting, Topic Gateway Series No. 35 (CIMA, London, October 2007). © 2008,
By 2016 BBRT had moved to 12 such principles, which are set out in Table 11.4 .
Table 11.4 Beyond Budgeting—from command and control to empower and adapt
Leadership principles
1. Purpose—Engage and inspire people around bold and noble causes; not around short-term financial targets
2. Values—Govern through shared values and sound judgement; not through detailed rules and regulations
3. Transparency—Make information open for self-regulation, innovation, learning and control
4. Organisation—Cultivate a strong sense of belonging and organise around accountable teams
5. Autonomy—Trust people with freedom to act; don’t punish everyone if someone should abuse it
6. Customers—Connect everyone’s work with customer needs; avoid conflicts of interest
Management processes
7. Rhythm—Organise management processes dynamically around business rhythms and events; not around the calendar year only
8. Targets—Set directional, ambitious and relative goals; avoid fixed and cascaded targets
9. Plans and forecasts—Make planning and forecasting lean and unbiased processes; not rigid and political exercises
10. Resource allocation—Foster a cost-conscious mind-set and make resources available as needed; not through detailed annual
budget allocations
11. Performance evaluation—Evaluate performance holistically and with peer feedback for learning and development; not based on
measurement only and not for rewards only
12. Rewards—Reward shared success against competition; not against fixed performance contracts
Source: ‘Beyond Budgeting Round Table Principles’, http://bbrt.org/the-beyond-budgeting-principles/. Beyond Budgeting Institute © BBRT 2016.
The main advantages of the Beyond Budgeting approach, as compared with the traditional budgeting
approach, can be summarised as follows:
It is more adaptive.
It is decentralised, but with an emphasis on the entire performance management process.
It is better able to deal with a rapidly changing business environment, especially for things such as:
ensuring that the business is well placed relative to its competition; dealing with intangibles (including
brands); customer loyalty; and other things that drive shareholder value.
The apparent growth in use of Beyond Budgeting over the past two decades does reinforce the fact that
traditional budgeting has some real limitations, particularly for businesses with a high degree of
unpredictability or volatility. However, the research referred to in this chapter also makes it very clear that
budgets play an important role in most organisations, particularly in giving a sense of direction and
control. Of course, one issue is that the very culture that traditional budgeting leads to may well get in the
way of implementing Beyond Budgeting principles very quickly.
Reflection 11.5
Beyond Budgeting uses team rewards based on relative performance. What kind of advantages
might result? What kind of difficulties might you envisage in implementing such an approach? How
do you feel personally about this approach? How might you deal with any perceived unfairness
that results?
Concept check 14
Control through budgets is reduced where:
A. Relationships between inputs and outputs are less defined
B. A business is impacted by rapid technological change
C. Managers are not allowed to participate in the budget-setting process
D. Budget targets are unrealistic
E. All of the above.
Concept check 15
Which of the following behavioural statements is false?
A. Demanding (but achievable) budget targets tend to motivate managers better than
less demanding targets do.
B. Unrealistically demanding targets tend to affect managers’ performance adversely.
C. Participation of managers in setting targets for themselves tends to improve
motivation and performance.
D. All of the above are true.
E. One or more statements are not true.
Overall review
Budgeting is critical to the success of most businesses, in terms of both planning and control. It has its
limitations and its critics, so any budgetary control system must be set up carefully to ensure that:
It is worth reflecting on the conclusions of the forum on Better Budgeting, run in 2004 by the Institute of
Chartered Accountants in England and Wales (ICAEW) and the Chartered Institute of Management
Accountants (CIMA). The forum discussed a range of issues relevant to the central theme, debating
possible ways of improving the budgeting process, and highlighting areas for future research. The debate
suggested that the budgetary process was very much alive, but going through a series of adaptations and
evolutions. The conclusions reached at the forum were as follows:
Budgeting is evolving.
Budgeting is not obsolete.
Change is occurring in a way that is not dramatic or radical, but steady.
Incremental improvements often involve supplementing traditional budgets with new tools and
techniques.
Forecasting is becoming more important.
There has been a shift of emphasis from top–down to bottom–up in budget preparation.
Overall, the forum participants considered that good budgeting depended on trust, integrity and
transparency, and was an essential component of good business practice.
Having said this, there is little doubt that some of the most competitive businesses are developing
systems and approaches that share much in common with the Beyond Budgeting ideas. Watch this
space!
SELF-ASSESSMENT QUESTION
11.2
Toscanini Ltd makes a standard product, which is budgeted to sell at $24.00 per unit, in a
competitive market. The product is made with a budgeted 0.4 kilograms of material, budgeted to
cost $14.40 per kilogram, and worked on by hand by an employee who is paid a budgeted $24 per
hour for a budgeted 12 minutes. Monthly fixed overheads are budgeted at $28,800. The output for
May was budgeted at 4,000 units.
a. Deduce the budgeted profit for May, and reconcile it with the actual profit in as much detail
as the information provided will allow.
b. State which manager should be held accountable, in the first instance, for each variance
calculated.
c. Assuming that the standards were all well set in terms of labour times and rates, and
materials usage and price, suggest at least one feasible reason for each of the variances
you identified in requirement (a), from what you know about the company’s performance for
May.
d. If the actual total world market demand for the company’s product turned out to be 10%
lower than estimated when the May budget was set, state how and why the variances you
identified in requirement (a) could be revised to provide information that could be more
useful.
Summary
In this chapter we have achieved the following objectives in the way shown.
Explain the relationship between corporate objectives, long- Considered the relationship between business objectives, long-term
term plans and budgets, and also between planning and control and short-term plans, and how those short-term plans or budgets are
derived
Explained the nature of control, and how a comparison between
budget and actual performance can assist
Define a budget, set out the main components of the budget- Defined a budget
setting process, explain how the various budgets interlink, and Explained the role of budgeting
identify the main uses of budgeting Illustrated how budgets can be used to pursue the business objectives
Illustrated how budgets are prepared
Worked through a typical budget-setting process
Identified and explained the role of a budget committee
Introduced the concept of key or limiting factors in relation to the
budget
Discussed top–down versus bottom–up approaches to budgeting
Explained and illustrated how budgets for different facets of the
business are coordinated
Identified the main uses of budgeting, specifically the tendency to
encourage forward thinking, help coordination, motivate better
performance and provide a basis for exercising control
Illustrated how budgets can be used to help management exercise
control over the business
Explain the importance of cash budgeting, and prepare a Explained the importance of cash budgeting
simple cash budget from relevant data Illustrated preparation of a cash budget
Construct a range of other budgets from relevant data Illustrated and prepared budgets from basic information
Use a budget as a means of exercising control over the Showed how it is possible, by making a comparison between the
business, explain and apply flexible budgeting, and calculate a actual outcomes and the original budgets, and carrying out further
series of variances between budget and actual to help control analysis, to identify areas of the business that are not performing
activity according to plan
Explained the rationale for flexible budgeting
Flexed a budget
Used flexible budgeting to provide a basis for comparing actual
performance with an appropriate standard
Calculated relevant variances
Reconciled the budgeted and actual profits
Identify the limitations of the traditional approach to control Identified the limitations of the traditional control model
through budgets and standards
Indicated that there is an important behavioural dimension to
budgeting: it has the power to motivate or discourage
Introduced the ideas of Beyond Budgeting
Applied understanding to practical problems
Reviewed the contribution and importance of budgeting in practice
Discussion questions
Easy
11.1 LO You have decided to get serious with your business career and see whether you can’t become a High Distinction (HD) student.
1 Explain the idea of budgets, long-term plans and objectives in the context of this decision.
11.2 LO In the past you have always thought that budgets and forecasts were pretty much the same thing. Describe how they are
2 different.
11.3 LO You have already prepared a budgeted income statement for your ‘ready to be launched’ business venture. You are eager to
3 get working and don’t really want to waste time preparing a cash budget. Is it important for you to do so?
11.4 LO You are about to prepare your company’s accounts payable budget, which is used solely to purchase inventories. You require
4 information from which two other budgets that link or interact with accounts payable? What information do you need, and from
which budgets?
11.5 LO Describe the basic concept of ‘flexing the budget’. Illustrate the concept with a simple example.
5
11.6 LO List and briefly discuss four general problems with, or limitations of, budgetary control through variance analysis.
6
11.7 LO How might comparison between budget and actual results help in the improvement of future budgeting?
2/5
Intermediate
11.8 LO How would you approach the planning of a world trip? What are the critical financial factors that you would take into account?
1–5 How would you approach the difficult job of choosing between what you would like to do and what you can actually afford?
11.9 LO Discuss the advantages/disadvantages of a rolling or continual budget as compared to a periodic budget.
2
11.10 LO Preparation of a master budget (e.g. forecasted financial statements) requires the preparation of a number of related,
2 interlinked individual budgets. Which of these budgets is normally the first to be prepared? Describe a situation where this is
not the case.
11.11 LO You are about to prepare your company’s accounts receivable budget. You require information from which two other budgets
4 that link or interact with accounts receivable? What information do you need, and from which budgets? A real-world
business’s accounts receivable budget would need to consider another factor in its estimation of the collectable amount of
credit sales. What is this factor, and how will it influence the accounts receivable budget?
11.13 LO Discuss controllable and uncontrollable factors that a manager should consider when using variance analysis to assist with
5 control of the business.
11.14 LO Budgetary control is about modifying employee/manager behaviour. Describe various techniques that consider such
6 behavioural implications.
11.15 LO Under what set of conditions will the budgetary system operate optimally?
2/4–
6
11.16 LO In its simplest form, variance analysis can simply require a comparison of budgeted figures for a particular area with actual
5 figures. Should this be regarded as the minimum that any business should do? Why/why not?
11.17 LO Budgeting seems to be central to most medium or large organisations’ activities. Why do you think this is so?
3
Challenging
11.18 LO One of the benefits of budgeting is that budgets provide a means for control of activities so that plans are achieved. Discuss
1 how the control objective might be thwarted with a weekly comparison of your budgeted study hours to your actual study time.
11.19 LO Discuss the meaning of an adverse sales volume variance, and provide an alternative means of calculating this variance
5 besides comparing the master and flexed budget profit figures.
11.20 LO Discuss the behavioural implications of the shift in emphasis from top–down to bottom–up budgeting.
6
11.21 LO Explain the different reasons why a manager might submit a budget estimate that is biased. How do you guard against this?
6
11.22 LO Why is it important to identify limiting factors when preparing for budgets?
2
11.23 LO Beyond Budgeting advocates a more adaptive set of management principles and a highly decentralised organisation. What are
1– the underlying advantages of the Beyond Budgeting approach compared with the traditional approach?
6
11.24 LO A Better Budgeting forum held in 2004 saw budgeting as evolving, yet still essential to most organisations. Is Beyond
7 Budgeting simply part of that necessary evolution, or is it a quite different approach to management?
Application exercises
Easy
11.1 LO The following basic information relates to a new business and its expected performance over the next six months.
2/3
1. Puts in capital of $40,000.
2. Buys, for cash, goods for resale amounting to $60,000.
3. Sells, on credit, three-quarters of these goods at a selling price of cost plus 40%.
By the end of the period, only 75% of customers had paid for the goods purchased.
4. Pays wages of $12,000 in cash.
5. Pays other expenses of $4,000 in cash.
6. Buys a new vehicle for $30,000—$15,000 paid in cash and the rest on loan carrying interest at 10% per annum.
a. Prepare a budgeted income statement for the first six months.
b. Prepare a budgeted statement of financial position at the end of the six months.
c. Prepare a budgeted summary statement of cash flows for the first six months.
d. Identify the critical decisions (possibly implicit) that have been made that have led to the resulting cash balance.
e. How might this situation have been avoided?
11.2 LO 3 Miller Manufacturing Company’s budgeted income statement includes the following data:
Prepare a cash budget for each of the months April, May and June.
11.3 LO Jose Company produced the following information for the month of April:
4/5 $
11.4 LO Bravo Ltd had the following budgeted and actual income statements for the month of October.
4/5
Produce a flexed budget to reflect the actual business output in the period.
Insert the flexed budgeted figures, based on the actual output of 550 units, in the following table.
11.5 LO 3 The budgeted income statement of Noel Ltd for the year ending 31 December 2020 is as follows:
$ $
Sales 360,000
Depreciation 25,000
Profit 50,000
The budgeted statement of financial position amounts related to trading activities are as follows:
1 January $ 31 December $
Current assets
Cash 10,000 ?
Current liabilities
Intermediate
11.6 LO The summarised statement of financial position of Belle Cross Pty Ltd as at 31 May 2020 is as follows:
2/4
BELLE CROSS PTY LTD
Statement of financial position
as at 31 May 2020
$ $
Current assets
Bank 20,000
Inventory 90,000
310,000
500,000
Current liabilities
84,500
500,000
Accounts payable represent purchases for May, and accounts receivable the sales for April and May at $100,000 per month.
The directors are seeking finance from a bank and have produced the following profit forecast, but the bank, before deciding,
has asked for a cash budget for the period showing the maximum anticipated finance needed from month to month. The profit
forecast for the next six months is:
Gross profit (20% fixed) 20,000 30,000 50,000 50,000 50,000 50,000
Stock requirement at month end 100,000 110,000 180,000 180,000 180,000 180,000
1. At each month-end, one-eighth of a month’s wages and salaries, and a quarter of other expenses, would be outstanding.
2. Rent at the rate of $20,000 per annum is payable quarterly in arrears on 31 August, 30 November, etc.
3. Assume that one month’s credit will be taken on purchases as previously, and that accounts receivable will continue to
take two months’ credit.
4. New fixed assets (additional) will be delivered in June and must be paid for on 31 August; cost $200,000.
5. If the bank grants finance, it will continue an existing $50,000 overdraft facility, and give a five-year loan of a fixed amount
as soon as necessary to maintain the overdraft within its limit for the whole period under review.
11.7 LO Avon Products Ltd is a new business and started production on 1 January. Sales are planned to start in February and to be as
3/4 follows for the rest of the year:
Sales units
February 400
March 500
April 600
May 700
June 800
July 900
August 800
September 800
October 700
November 600
December 500
For the remaining half of the units sold, customers for 95% of all units are expected to pay during the month following the sale.
The remainder is expected to be bad debts.
It is planned that sufficient finished goods inventory for each month’s sales should be available at the end of the previous month.
Raw materials purchases are planned to allow precisely enough raw materials inventory available at the end of each month to
meet the following month’s planned production. This plan will operate from the end of January. Purchases of raw materials will
be on two months’ credit. The cost of raw materials is $40 per unit of finished product.
The direct labour cost, which is variable with the level of production, is planned to be $20 per unit of finished production.
Production overheads are planned to be $20,000 each month, including $3,000 for depreciation. Non-production overheads are
planned to be $11,000 per month, of which $1,000 will be depreciation.
Various fixed assets costing $250,000 will be bought and paid for during January. Except where specified otherwise, assume
that all payments take place in the same month as the cost is incurred.
The business will raise $300,000 in cash from a share issue in January.
11.8 LO The following summary data are from a performance report for Washington Ltd for May, during which 10,700 units were
5 produced. The budget reflects the company’s normal capacity of 10,000 units.
Budget (10,000 units) Actual costs (10,700 units) Variances over (under) budget
What is the general implication of the performance report? Why might the manager question the significance of the report?
Revise the performance report using flexible budgeting, and comment on the general implication of the revised report.
11.9 LO Pilot Ltd makes a standard product, which is budgeted to sell at $15 a unit. It is made from a budgeted 0.5 kilograms of material,
5/6 budgeted to cost $9 per kilogram, and worked on by an employee paid a budgeted $15 per hour, for a budgeted 15 minutes.
Monthly fixed overheads are budgeted at $18,000. The output for March was budgeted at 5,000 units.
$
Sales revenue (5,400 units) 79,380
a. Deduce the budgeted profit for March, and reconcile it with the actual profit in as much detail as the information allows.
b. State which manager should be held accountable, in the first instance, for each variance calculated.
Challenging
11.10 LO Harris Ltd manufactures one product line—the Zenith. Sales of Zeniths over the next few months are planned as follows:
4
1 Demand Units
July 180,000
August 240,000
September 200,000
October 180,000
11.11 LO You are given the following data for a company, for a four-week period, at two forecasted levels of activity.
5
Forecast A Forecast B
Depreciation $100,000
a. Prepare comparative forecast income statements for the two output levels.
b. Prepare a statement of allowed costs (i.e. what costs you would expect to incur if you flexed the budget) for an actual
activity level of 60,000 units of production and 40,000 units of sales.
Power 124,000
Maintenance 338,000
You are also told that the prices of direct materials rose by 5% at the beginning of the period owing to an increase in tax, while
direct and indirect labour rates rose by 3% as a result of a national agreement.
c. Calculate appropriate variances between budgeted (allowed) and actual, distinguishing those that are controllable from
those that are not.
11.12 LO Melton Ltd makes and sells one standard product, the standard cost of which is as follows:
5
$
26.70
The monthly production and sales are planned to be 1,200 units. The actual results for May were as follows:
Sales 36,000
There was no inventory of any description either at the start or the end of the month.
As a result of poor sales demand during May, the company had reduced the price of all sales by 10%.
Calculate the budgeted profit for May and reconcile it to the actual profit through variances, going into as much detail as
possible from the information available.
Chapter 11 Case study
$ $ $
Less costs
Overheads
(30)
(140)
Standard profit 60
These figures are based on a budget of 1,000 parts in every four weeks (20 working days). Products are
broadly made to order so you can assume that minimal inventory is held.
$ $ $
Sales 176,000
Less costs
Labour (63,800)
Overheads
(33,500)
(145,900)
Actual profit 30,100
Questions
1. Prepare a statement reconciling budgeted and actual profits.
2. Discuss briefly:
a. how the supervisory management is likely to react to such a report, under these
circumstances
b. what steps might be taken to encourage positive attitudes to this kind of report, and the
usefulness of this kind of report.
Activity 11.1
In broad terms, a long-term plan deals with such matters as:
The budget typically will define precise targets for such things as:
Activity 11.2
We thought of the following:
Higher production in previous months and increasing inventories (‘stockpiling’) to meet periods of
higher demand.
Increasing production capacity, perhaps by working overtime and/or acquiring (buying or leasing)
additional plant.
Subcontracting some production.
Encouraging potential customers to change the timing of their purchases by offering discounts or other
special terms during the months that have been identified as quiet.
Activity 11.4
The principal problems with zero-based budgeting are:
Activity 11.5
It might seem that assigning managers predetermined targets will stifle their skill, flair and enthusiasm,
especially if targets are badly set. If, however, the budgets are set in such a way as to offer challenging,
yet achievable, targets, the manager is still required to show skill, flair and enthusiasm.
Activity 11.6
a. There appears, for the size of the business, to be a fairly large and increasing cash balance.
Management might consider putting some of the cash into an income-yielding deposit, or using it to
expand trading activities by, for example, increasing the investment in non-current assets or non-
current assets, or alternatively pay a dividend or repay some borrowing.
Receipts
Accounts receivable 53 57 59 62 57 53
Payments
Notes
1. There will be no payment of accounts payable in July, because the June purchases will be made
on two months’ credit, and therefore paid in August. The July purchases, which will equal the July
cost of sales figure plus the increase in inventories made in July, will be paid for in September, and
so on.
2. The repayment is simply the amount that will bring the balance at 31 December to $5,000.
Activity 11.7
Accounts receivable budget for the six months ended 31 December
Jul $’000 Aug $’000 Sep $’000 Oct $’000 Nov $’000 Dec $’000
*
Opening balance 53 57 59 62 57 53
Sales 57 59 62 57 53 51
Closing balance 57 59 62 57 53 51
This could, of course, be set out in any manner that gives management the sort of information it needs for
planned levels of accounts receivable and associated transactions.
Purchases 33 34 36 31 29 28
65 99 103 101 96 88
Closing balance 65 67 70 67 60 57
Notes
1. The opening balance for July will be the planned purchases figure for the previous month (June),
since the business, until the June purchases, plans to take one month’s credit from its suppliers.
The opening balances for July to December will represent the planned purchases for the previous
two months.
2. There will be no payment of accounts payable planned in July because suppliers will be paid two
months after the month of purchase, starting with the June purchases, which will be paid for in
August.
This could be set out in any manner that gives management the sort of information it needs for planned
levels of accounts payable and associated transactions.
Activity 11.8
The problem is that the actual level of output was not as budgeted.
Baxter Ltd’s actual level of output for May was 10% less than budget. This means that we cannot, for
example, say that there was a labour cost saving of $2,500 (that is, $20,000−$17,500) and conclude that
all is well in that area.
Activity 11.9
The answer is simply the difference between the original budget and the flexed budget profit figures. The
only difference between these two profit figures is the volume of sales; everything else was the same.
(That is to say that the flexing was carried out assuming that the per-unit sales revenue, material cost and
labour cost were all as originally budgeted.) This means that the figure for the loss of profit due to the
volume shortfall, taken alone, is $4,000 (that is, $20,000−$16,000).
Activity 11.10
You would probably be concerned about how large the variances are and their direction (favourable or
adverse). In particular, you may have thought of the following:
The overall adverse profit variance is $3,100 (that is, $20,000−$16,900). This represents 15.5% of the
budgeted profit (that is, $3,100/$20,000×100%) and you (as chief executive) would pretty certainly see
it as significant and worrying.
The $4,000 adverse sales volume variance represents 20% of budgeted profit, and it too would be a
major cause of concern.
The $2,000 favourable sales price variance represents 10% of budgeted profit. Since this is favourable
it might be seen as a cause for celebration rather than concern. On the other hand, it means that
Baxter’s output was, on average, sold at prices 2% above the planned price. This could have been the
cause of the worrying adverse sales volume variance. Baxter may have sold fewer units because it
charged higher prices.
The $900 adverse direct materials variance represents 4.5% of budgeted profit. It would be unrealistic
to expect the actuals to hit the precise budget figure each month. The question is whether 4.5% for
this variance represents a significant amount and a cause for concern.
The $500 favourable direct labour variance represents 2.5% of budgeted profit. Since this is
favourable and relatively small, it may be seen as not being a major cause for concern.
The $700 fixed overhead adverse variance represents 3.5% of budgeted profit. The chief executive
may be concerned about this.
Activity 11.11
Reconciliation of budgeted profit with actual profit
$ $
Favourable variances
2,900
26,900
Adverse variances
(2,200)
Activity 11.12
Examples include: trying to build in slack into a budget; using budgets as a motivator; use of inappropriate
pressure on participants; use of reward structures; ensuring no unspent allocations left at the end of the
financial year.
Chapter 12 Capital investment decisions
Learning objectives
When you have completed your study of this chapter, you should be able to:
LO 1 Identify the essential features of investment decisions, and state the four common
capital investment appraisal methods
LO 2 Demonstrate an understanding of the ‘accounting rate of return’ method with respect
to the formula, decision rule, and strengths and weaknesses
LO 3 Demonstrate an understanding of the ‘payback’ method with respect to the formula,
decision rule, and strengths and weaknesses
LO 4 Demonstrate an understanding of the ‘net present value’ method with respect to the
formula, decision rule, and strengths and weaknesses
LO 5 Demonstrate an understanding of the ‘internal rate of return’ method with respect to
the formula, decision rule, and strengths and weaknesses
LO 6 Identify and deal with a range of practical issues relating to investment appraisal
LO 7 Describe investment appraisal in practice, and explain the need to link it with strategic
planning.
This chapter is the first of three dealing with the area generally known as
finance or financial management.
Features of investment decisions and associated
appraisal methods
LO 1 Identify the essential features of investment decisions, and state the four common capital
investment appraisal methods
Investment decisions tend to be of crucial importance to the investor for the following reasons:
Large amounts of resources are often involved. Many investments made by a business involve
outlaying a significant proportion of its total resources. If mistakes are made with the decision, the
effects on the business could be significant, if not catastrophic.
Relatively long timescales are involved. There is usually more time for things to go wrong between
the decision being made and the end of the project, than with other business decisions.
It is often difficult and expensive to ‘bail out’ of an investment once it has been made.
Investments made by a business are usually specific to its needs. For example, a manufacturing
business may have a factory built to a specific design to accommodate its particular flow of production.
This may render the factory unattractive to another potential user with different needs, so its second-
hand value would be low. If the business found, after making the investment, that the product it makes
in the factory is not selling as well as planned, the only possible course of action would be to close
down production and sell the factory. This would probably mean that much less could be recouped
from the investment in the factory than it had originally cost, particularly if the costs of design were
included as part of the cost, as they logically should be.
Real World 12.1 provides some examples of recent significant investment decisions for a range of
different-sized businesses.
At a more mundane level, BHP approved a $265 million coking coal investment in Queensland’s
Bowen Basin. This project relates to a conveyor belt linking one of its mines to its processing plant.
Two key outcomes are envisaged: boosting coal production by 2 million tonnes a year, and
avoiding the current costs of trucking another 2 million tonnes between the two mines.
Sources: Paul Garvey, ‘BHP commits $3.1b to Chile mine’, The Australian, 18 August 2017.
Matt Chambers, ‘BHP spends $265m on Peak Downs coal conveyor belt’, The Weekend Australian, 22–23 April 2017.
Vodafone
In August 2017 Vodafone announced that it will spend $2 billion on beefing up its mobile network.
A ‘significant portion of it will be used to upgrade existing infrastructure rather than extending the
footprint of the network’.
Source: Supratim Adhikari, ‘Vodafone books first-half lift, joins mobile network investment race’, The Australian, 1 August 2017.
SeaLink
SeaLink Travel Group, an Adelaide-based ferry operator with existing Queensland operations,
bought Fraser Island’s Kingfisher Bay Resort and Eurong Beach Resort, and at the same time as
the Fraser Island Ferry business, which operates from Hervey Bay.
Source: Lisa Allen, ‘SeaLink in $43m swoop on Kingfisher Bay Resort’, The Australian Business Review, 22 February 2018.
Activity 12.1
When businesses are making decisions involving capital investments, what should their overall decision
aim to achieve?
Reflection 12.1
Lucas, our restaurateur, is currently running eight restaurants in various parts of the city. He is now
looking at a number of expansion projects:
1. Another traditional restaurant in a different part of the city.
2. A floating restaurant on board a modified launch that will take up to 100 customers per trip.
3. A venture to ensure that the range, quality and certainty of supply lines are improved. This
will involve setting up a completely new business about 50 miles away, and growing the
specific plants used by the restaurants.
Do you think Lucas should use the same approach to evaluating each of these decisions?
Why/why not?
Research shows that there are basically four methods used in practice by businesses to evaluate
investment opportunities:
Some businesses use variants of these four methods, such as the discounted payback, outlined later.
Other businesses, particularly smaller ones, do not use any formal appraisal methods but rely more on
managers’ instincts. Most businesses, however, seem to use one or more of the four methods.
We will now review the four methods and assess them. Note that only one of them (NPV) is not flawed to
some extent. We shall also see how popular these four methods are in practice. To help us to consider
each of the four methods, it might be useful to see how each of them would cope with a particular
investment opportunity. We shall use Example 12.1 as the basis for applying the four methods.
EXAMPLE
12.1
Billingsgate Battery Company has carried out research that shows it could manufacture and sell a
product that the business has recently developed. Production would require an investment in a
machine that would cost $100,000, payable immediately. Production and sales would take place
throughout the next five years, after which the machine could be sold for $20,000.
Production and sales of the product would be expected to occur as follows:
Number of units
It is estimated that the new product can be sold for $12 a unit, and that the relevant material and
labour costs will total $8 a unit.
To simplify matters, we shall assume that the cash from sales and for the costs of production are
received and paid, respectively, at the end of each year. This is unlikely to occur in real life; money
will have to be paid to employees weekly or monthly, and customers will pay within a month or two
of buying the product. However, this is probably not a serious distortion. It is a simplifying
assumption often made in real life, and it will make things more straightforward for us now. Note,
though, that nothing about any of the four approaches demands that this assumption be made.
Bearing in mind that each product sold will give rise to a net cash inflow of $4 (i.e.$12−$8), the
cash flows (receipts and payments) over the life of the production will be as follows:
$’000
Note that, broadly speaking, the profit before deducting depreciation (i.e. before non-cash items)
equals the net amount of cash flowing into the business. We will return to this in more detail later in
this chapter.
Concept check 1
The four methods generally used to make investment decisions are:
A. Accounting rate of return, internal rate of return, payback period and net future value
B. Accounting rate of return, external rate of return, payback period and net future value
C. Accounting rate of return, internal rate of return, payback period and net present
value
D. Accounting period of return, internal rate of return, payback period and net present
value
E. Accounting rate of return, internal rate of return, back pay period and net present
value.
Concept check 2
Investment decisions tend to be of crucial importance because:
A. Large amounts of resources are often involved
B. Many investments are highly strategic and risky
C. Once committed, it is often impossible or very costly to opt out
D. All of the above
E. A and C only.
Accounting rate of return (ARR)
LO 2 Demonstrate an understanding of the ‘accounting rate of return’ method with respect to the
formula, decision rule, and strengths and weaknesses
The accounting rate of return (ARR) method takes the average accounting profit the investment will
generate, and expresses it as a percentage of the average investment in the project as measured in
accounting terms. Thus:
In Example 12.1 (page 528), the average profit before depreciation over the five years is $40,000 (i.e.
(20+40+60+60+20)/5). Assuming straight-line depreciation (i.e. equal annual amounts), the annual
depreciation charge will be $16,000 (i.e. (100−20)/5). Thus, the average annual profit after depreciation is
$24,000 (i.e. 40−16). The machine will appear in the statement of financial position as follows:
$’000
2 68 (i.e. 84−16)
3 52
4 36
5 20
The average investment (at closing statement of financial position values) will be $60,000 (i.e.
(100+84+68+52+36+20)/6). This can also be calculated by taking the average of the initial cost and the
expected residual value ((100+20)/2). Thus, the ARR of the investment is 40% (i.e. (24/60)×100).
To decide whether the 40% return is acceptable, we need to compare this percentage with the minimum
required by the business.
Activity 12.2
Chaotic Industries is considering investing in a fleet of 10 delivery vehicles to take its products to
customers. The vehicles will cost $60,000 each to buy, payable immediately. The annual running costs
are expected to total $80,000 for each vehicle (including the driver’s wage). The vehicles are expected to
operate successfully for six years, at the end of which period they will all have to be scrapped, with
disposal proceeds expected to be about $12,000 per vehicle. At present the business uses a commercial
carrier for all of its deliveries. It expects this carrier to charge a total of $920,000 each year for the next six
years to make the deliveries.
What is the ARR of buying the vehicles? Note that cost savings are as relevant a benefit from an
investment as are actual net cash inflows.
We saw that investments are required to achieve a minimum target ARR. Given the link between ARR
and ROCE, this target could be based on a planned level of ROCE. The planned ROCE might be based
on the industry-average ROCE.
The link between ARR and ROCE strengthens the case for adopting ARR as the appropriate method of
investment appraisal. ROCE is a widely used measure of profitability, and some businesses express their
financial objective in terms of a target ROCE. It therefore seems sensible to use a method of investment
appraisal that is consistent with this overall measure of business performance. A secondary point in
favour of ARR is that it provides a result expressed in percentage terms, which many managers seem to
prefer.
Activity 12.3
The ARR suffers from a major defect as a means of assessing investment opportunities. Can you work
out what this is? Consider the three competing projects whose cash flows are set out below. All three of
these involve investment in a machine that is expected to have no residual value at the end of the five
years. Note that all of the projects have the same total operating profits over the five years.
Project
A B C
(Hint: The defect is not concerned with the decision-maker’s ability to forecast future events, although this
too can be a problem.)
12.2
George put forward an investment proposal to his boss. The business uses ARR to assess
investment proposals using a minimum ‘hurdle’ rate of 27%. Details of the proposal were:
ARR=48,000−16,000(200,000+40,000)/2×100%=26.7%
The boss rejected George’s proposal because it failed to achieve an ARR of at least 27%.
Although George was disappointed, he realised that there was still hope. In fact, all that the
business had to do was to give away the piece of equipment at the end of its useful life rather than
sell it. The residual value of the equipment then became zero and the annual depreciation charge
became ([$200,000−$0]/10)=$20,000 a year. The revised ARR calculation was then:
ARR=48,000−20,000(20,000+0)/2×100%=28%
Competing investments
The ARR method can also create problems when considering competing projects of different size, as
illustrated in Example 12.3 .
EXAMPLE
12.3
Sinclair Wholesalers Ltd is currently considering opening a new sales outlet in Bendigo. Two
possible sites have been identified for the new outlet. Site A has an area of 30,000 square metres.
It will require an average investment of $6 million, and will produce an average operating profit of
$600,000 a year. Site B has an area of 20,000 square metres. It will require an average investment
of $4 million, and will produce an average operating profit of $500,000 a year.
The ARR of site A is $600,000/$6 million=10% The ARR of site B is $500,000/$4 million=12.5%.
Site B, therefore, has the higher ARR. In terms of the absolute operating profit generated,
however, site A is the more attractive. If the ultimate objective is to increase the wealth of the
shareholders of Sinclair Wholesalers Ltd, it would be better to choose site A even though the
percentage return is lower. It is the absolute size of the return rather than the relative (percentage)
size that is more important.
Concept check 3
Accounting rate of return (ARR):
A. Expresses average accounting profit as a percentage of the average investment
B. Relates operating profit to the cost of assets used to generate that profit
C. Is used to assess expected future performance
D. Is similar to return on capital employed (ROCE)
E. All of the above.
Concept check 4
Which of the following are NOT claimed as advantages of the accounting rate of return
(ARR)?
A. It facilitates ranking of projects of different sizes.
B. It is easy to calculate.
C. It is consistent with widely used measures of profitability.
D. None of the above.
E. All of the above.
Payback period (PP)
LO 3 Demonstrate an understanding of the ‘payback’ method with respect to the formula, decision rule
and strengths and weaknesses
The payback period (PP) is the length of time it takes for an initial investment to be repaid out of the
net cash inflows from a project. Since it takes time into account, the PP method seems to go some way to
overcoming the timing problem of ARR, or at least at first glance it does.
It might be useful to consider PP in the context of Billingsgate Battery Company in Example 12.1 (page
528). Remember that essentially the project’s costs and benefits can be summarised as:
$’000
5 years’ time Operating profit before depreciation plus disposal proceeds 40 (i.e 20+20)
Note that all of these figures are amounts of cash to be paid or received. (We saw earlier that net profit
before depreciation is a rough measure of the cash flows from the project.)
As the payback period is the length of time it takes for the initial investment to be repaid out of the net
cash inflows from the project, it will be nearly three years before the $100,000 outlay is covered by the
inflows. The payback period can be derived by calculating the cumulative cash flows as follows:
Time Net cash flows $’000 Cumulative year cash flows $’000
We can see that the cumulative cash flows become positive in the third year. If we assume that the cash
flows accrue evenly over the year, the precise payback period will be:
2 years+(40/60)=223 years
where 40 represents the cash flow still required at the beginning of the third year to repay the initial
outlay, and 60 is the projected cash flow during the third year.
for a project to be acceptable, it would need to be within a maximum payback period, and
if there are two or more competing projects that both meet the maximum payback period requirement,
the decision-makers would select the project with the shorter payback period.
For example, if Billingsgate Battery Company had a required maximum payback period of three years, it
would accept the project, but it would not go ahead if its required maximum payback period was two
years.
Activity 12.4
What is the payback period of the Chaotic Industries project from Activity 12.2 (page 530)?
The PP approach has certain advantages. It is quick and easy to calculate, and can be easily understood
by managers. The logic of using PP is that projects that can recoup their costs quickly are economically
more attractive than those with longer payback periods. PP is probably an improvement on ARR in
respect of the timing of the cash flows. PP is not, however, the whole answer to the problem. It does not
focus on all of the timing issues.
Activity 12.5
For Chaotic Industries’ decision-making, in what respect, in your opinion, is PP not the complete answer
to the problem of assessing the investment opportunities? Use the cash flows from the three competing
projects given below for the purpose of illustration.
(Hint: Again the defect is not concerned with the ability of the decision-maker to forecast future events,
which is a problem whatever approach we take.)
Problems with PP
As Activity 12.5 shows, within the payback period, PP ignores the timing of the cash flows. Beyond the
payback period, the method totally ignores the size and the timing of the cash flows. While ignoring cash
flows beyond the payback period neatly avoids the practical problems of forecasting cash flows over a
long period, it does mean that relevant information may be ignored.
The PP approach may seem to deal with the problem of risk by favouring projects with a short payback
period. However, this is a fairly crude approach to the problem. It looks only at the risk that the project will
end earlier than expected—what about the risk that demand for the product may be less than expected?
More systematic approaches to dealing with risk are available.
Although the PP method takes some note of the timing of project costs and benefits, it is not concerned
specifically with enhancing the wealth of the business owners. Instead, it favours projects that pay for
themselves quickly. It seems that PP has the advantage of taking some note of the timing of the costs
and benefits from the project, but it suffers the disadvantage of ignoring relevant information. ARR ignores
timing to a great extent, but it does take account of all of the benefits and costs. What we really need to
help us to make sensible decisions is a method of appraisal that takes account of all of the costs and
benefits of each investment opportunity, but also makes a logical allowance for the timing of those costs
and benefits.
The final problem is that managers must select a maximum acceptable payback period. As this cannot be
determined objectively, it really becomes a matter of judgement. This judgement may be difficult to make,
because there are no reliable guidelines to follow. Managers may simply pick a figure out of the air.
Real World 12.2 provides examples of situations in which payback has been used.
Every year, the amount of time it takes for a company’s investment in a robot to pay off—known as
the ‘payback period’—is narrowing sharply, making it more attractive for small Chinese companies
and workshops to invest in automation. The payback period for a welding robot in the Chinese -
automotive industry, for instance, dropped from 5.3 years to 1.7 years between 2010 and 2015,
according to calculations by analysts at Citi. By 2017, the payback period was forecast to shrink to
just 1.3 years.
The mine project in Chile, which was discussed in Real World 12.1 , had an expected payback
of 4.5 years from first production. This was just one of the calculations made by the company.
Source: Paul Garvey, ‘BHP commits $3.1b to Chile mine’, The Australian, 18 August 2017.
Rolls-Royce was investing in a new HR system to manage its more than 40,000 employees, in the
expectation that the multi-million-pound system would pay for itself within two years.
Source: Bill Goodwin, ‘Rolls Royce cloud HR project will pay for itself in two years’, Computer Weekly, 16 March 2016.
Reflection 12.2
What significance is knowledge of a single figure for payback likely to have for investment
decisions?
Concept check 5
The payback period (PP):
A. Favours projects that pay for themselves quickly
B. Ignores cash flows beyond the payback period
C. Does not complicate calculations with time value of money considerations
D. Is not concerned specifically with enhancing the wealth of the business owners
E. All of the above.
Concept check 6
Which of the following is false?
A. Less is better with payback period.
B. Payback period indicates the length of time it takes for an initial investment to be
repaid out of the net cash inflows from a project.
C. Payback period provides an indicator of the riskiness of a project.
D. Payback period is sometimes criticised for its complexity.
E. None of the above is false.
Net present value (NPV)
LO 4 Demonstrate an understanding of the ‘net present value’ method with respect to the formula,
decision rule, and strengths and weaknesses
considers all of the financial costs and benefits of each investment opportunity, and
makes a logical allowance for the timing of these costs and benefits.
The net present value (NPV) method does this by comparing the sum of the present value of all -
expected cash inflows with the present value of the expected cash outflows related to a given project.
Consider the situation with Billingsgate Battery Company in Example 12.1 (page 528), which can be
summarised as follows:
$’000
Since the principal financial objective of the business is probably to increase wealth, it would be very easy
to assess this investment if all the cash flows occurred now (i.e. all at the same time). All we should need
to do is add up the benefits (total $220,000) and compare them with the cost ($100,000). This would lead
us to conclude that the project should go ahead, because the business would be better off by $120,000.
Of course, it is not as easy as this because time is involved. If the project goes ahead, the cash outflow
(payment) will occur immediately. The inflows (receipts) will arise at a range of later times.
The time factor arises because normal people will not pay out $100 now just to receive $100 in a year’s
time—these amounts are not considered equivalent in value. If you were to be offered $100 in 12 months
by a person, provided that you paid $100 to them now, you probably would not agree to this unless you
wished to do them a favour. Your $100 could be invested and could reasonably be expected to generate
income (interest or its equivalent) over the next year. The high probability of inflation provides another
reason why your $100 now is not the equivalent of $100 in one year’s time. Finally, there is the risk that is
associated with you handing out $100 now—you may not get it back.
Interest lost
If you are to be deprived of the use of your money for a year, you might as well be deprived of it by
depositing it in a bank or building society so that at the end of the year you would have your money back
and interest as well. Thus, unless the opportunity to invest offers similar returns, you will incur an
opportunity cost. This type of cost occurs when one course of action—for example, investing in, say, a
computer—deprives you of the opportunity to benefit from an alternative action—for example, putting the
money in the bank and earning interest.
From this we can see that any investment opportunity must, if it is to make you more wealthy, do better
than the returns that are available from the next best opportunity. Thus, if Billingsgate Battery Company
sees putting the money in the bank on deposit as the alternative to investing in the machine, the return
from investing in the machine must be better than the return from investing in the bank. If the bank offers
better returns, the business would become more wealthy by putting the money on deposit.
Inflation
If you are to be deprived of $100 for a year, when you come to spend that money it will not buy as much
in the way of goods and services as it would have done a year earlier. Generally, you will not be able to
buy as many tins of baked beans or loaves of bread or bus tickets for a particular journey as you could
have done a year earlier because of the loss in the purchasing power of money (inflation) that occurs over
time. Clearly, the investor needs to be compensated for this loss of purchasing power if the investment is
to be made. This compensation comes on top of a return that takes account of the returns that could have
been gained from an alternative investment of similar risk.
In practice, interest rates observable in the market tend to take inflation into account. Rates offered to
potential building society and bank depositors include an allowance for the rate of inflation that is
expected in the future.
Risk
Buying a machine to manufacture a product to be sold in the market, on the strength of various estimates
made in advance of buying the machine, is risky. For example, in the case of the Billingsgate Battery
Company in Example 12.1 (page 528), there are a number of areas in which things might not go
according to plan, including:
the machine might not work as well as expected—it might break down, causing losses in production
and sales
sales of the product may not be as buoyant as expected
labour costs may be higher than expected, or
the sales proceeds of the machine may be less than estimated.
Of course, in reality, we will usually need to decide whether or not to invest in the machine before any of
the risks identified above are clearly known. After the machine has been purchased, things can go wrong
—for example, we realise that the level of sales estimated before the event will not be achieved. It is not
possible to wait until we know for certain whether the market will behave as we expected before we buy
the machine. We can study reports and analyses of the market. We can commission sophisticated market
surveys, and these may give us more confidence in the likely outcome. We can advertise strongly and try
to expand sales. Ultimately, however, we have to jump into the dark and accept the risk if we want the
opportunity to make profitable investments.
Normally, people expect to receive greater returns when risk is involved. Examples of this abound in real
life, such as the fact that banks tend to charge a higher rate of interest to an apparently ‘risky’ borrower
than to one who offers good security for the loan and has a regular income to cover repayments.
Going back to Billingsgate Battery Company’s investment opportunity in Example 12.1 , it is not enough
to say that we would advise against the investment unless the returns it offers exceed those from a bank
deposit. We would want returns higher than the bank deposit interest rates because the logical
investment opportunity equivalent to investing in the machine is not putting the money on deposit but
making an alternative investment that carries a risk similar to that of the machine investment.
In practice, we tend to expect a higher rate of return from investment projects when the risk seems higher.
How risky a particular project is, and therefore how large this risk premium should be, are matters that are
difficult to gauge. In practice, we have to make some judgements on these questions.
There is little doubt that the HECS and HECS-HELP schemes have assisted many people to
access higher education (HE). The HECS scheme operated using a system of discounts for many
years. These ranged from 25% down to 10% in 2013, before being phased out in 2014.
In his article, Gittins asked whether or not students should take the opportunity to pay their HECS
fees in advance, and thus get a discount (25% at the time the article was written). He pointed out
that many people would consider this a no-brainer: if you had the money, you’d be a fool not to pay
and take the discount. However, he then pointed out that this may not be so straightforward, that in
fact it might be better to let the HECS debt grow. This is all because of the time value of money.
Gittins did not attempt to provide any particular answers, but he pointed out the need to make
some reasonable estimates of the future. The kind of things that needed thinking about included
making some reasonable estimates of your future income, determining the current and likely future
repayment thresholds, and deciding whether you were likely to engage in any long-term overseas
travel. The end result might surprise you. While this particular issue is now no longer current, it
nevertheless provides an extremely effective illustration of the impact of the time value of money
on decisions.
You may remember that, in the Accounting and You box in Chapter 9 (page 414), we dealt with
a range of marginal and incremental examples that were spread over several years. At that stage
we made nothing more than a casual reference to discounting. You might like to revisit some of the
issues in that box and consider how the use of discounting might affect the decisions.
Source: Adapted from Ross Gittins, ‘Time takes its toll on HECS discounts’, The Sydney Morning Herald, 13 March 2004.
Reflection 12.3
Assume that you are 28 years old and have a young family. What factors might you consider when
looking at the possibility of taking out:
$’000
Let us assume that instead of making this investment, the business could make an alternative investment,
with similar risk, and obtain a return of 20% a year. Remember, we have concluded that it is not possible
just to compare the basic figures listed above. It would therefore be useful if we could express each of
these cash flows in similar terms to let us make a direct comparison between the sum of the inflows and
the $100,000 investment. In fact, we can do this.
By way of illustration, consider the first-year receipt of $20,000. We should obviously be happier to accept
a lower amount if we could get it immediately than if we had to wait a year, because we could invest it at
20% (in the alternative project). Logically, we should be prepared to accept the amount that with a year’s
income will grow to $20,000. If we call this amount PV (for present value) we can say:
PV+(PV×20%)=$20,000
That is, the amount plus income from investing the amount for the year equals the $20,000.
PV×(1+0.2)=$20,000
PV=$20,000/(1+0.2)PV=$16,667
Thus, rational investors who have the opportunity to invest at 20% a year would not mind whether they
have $16,667 now or $20,000 in a year’s time. In this sense we can say that, given a 20% investment
opportunity, the present value of $20,000 to be received in one year’s time is $16,667.
If we could derive the PV of each of the cash flows associated with the machine investment, we could
easily make the direct comparison between the cost of making the investment ($100,000) and the various
benefits that would derive from it in years 1 to 5. Fortunately, we can do precisely this. We can make a
more general statement about the PV of a particular cash flow. It is:
where
n is the year of the cash flow (i.e. how many years into the future), and
We have already seen how this works for the $20,000 inflow for year 1. For year 2 the calculation would
be:
Thus, the PV of the $40,000 to be received in two years’ time is $27,778. This can be shown as follows:
33,334
40,001
Thus, because the investor can turn $27,778 into $40,000 in two years, these amounts are equivalent,
and we can say that $27,778 is the present value of $40,000 receivable after two years, assuming a 20%
investment opportunity.
Now let us calculate the PVs of all of the cash flows associated with the machine project, and hence the
NPV of the project as a whole. The relevant cash flows and calculations are as follows:
24.19
Once again, we must ask how we can decide whether the machine project is acceptable to the business.
In fact, the decision rule is simple: if the NPV is positive, we accept the project; if it is negative, we reject
the project. If there are two or more competing projects that have positive NPVs, the project with the
higher (or highest) NPV should be selected.
In this case the NPV of $24,190 is positive, so the project should be accepted. The reasoning is quite
straightforward. We can now say that, given the investment opportunities available to the business
elsewhere, investing in the machine will make the business $124,190 better off. In other words, the
benefits from investing in this machine are worth a total of $124,190 today (total PVs of five years’
cashflow). Since the business can ‘buy’ these benefits for just $100,000, the investment should be made.
Clearly, at any price up to $124,190 the investment would be worth making, as its return would exceed
the 20% opportunity rate.
discount factor
The rate applied to future cash flows to derive the present value of those cash
flows.
Using financial calculators or spreadsheets to deal with the calculations represents a more practical
approach to solving such problems. Familiarity with present value tables is, nevertheless, encouraged, at
least in the early stages while you develop your understanding of the process.
Activity 12.6
What is the NPV of the Chaotic Industries project in Activity 12.2 (page 530), assuming a 15%
opportunity cost of finance (discount rate)? Use the present value table in Appendix 12.1 (page 574).
Figure 12.1 shows how the present value of $1 diminishes as its receipt goes further into the future,
assuming an opportunity cost of finance of 20% per annum. The $1 to be received immediately,
obviously, has a PV of $1. As the time before it is to be received grows larger, the present value
diminishes significantly.
Figure 12.1 Present value of $1 receivable at various times in the future, assuming an annual
financing cost of 20%
The present value of a future receipt (or payment) of $1 depends on how far in the future it will occur.
Those that will occur in the near future will have a larger present value than those whose occurrence is
more distant in time.
cost of capital
The cost to a business of long-term finance needed to fund its investments.
Another way of calculating the appropriate discount rate is the capital asset pricing model (CAPM) .
Essentially, CAPM is about calculating an appropriate rate using the risk-free rate plus a risk
premium ; the latter is derived from the returns of an average portfolio of shares and the variability of
returns of the particular business. It is beyond the scope of this book.
risk premium
A rate of return in excess of what would be expected from a risk-free investment,
to compensate the investor for bearing that particular risk.
The timing of the cash flows. Discounting the various cash flows associated with each project
according to when they are expected to arise takes into account the fact that cash flows do not all
occur simultaneously. Furthermore, by discounting—using the opportunity cost of finance (i.e. the
return which the next best alternative opportunity would generate)—the net benefit after financing
costs have been met is identified (as the NPV).
The whole of the relevant cash flows. NPV includes all of the relevant cash flows irrespective of
when they are expected to occur. It treats them differently according to their date of occurrence, but
NPV takes them all into account and they can all influence the decision.
The objectives of the business. NPV is the only method of appraisal in which the output of the
analysis bears directly on the wealth of the business. (Positive NPVs enhance wealth, negative ones
reduce it.) Since most private-sector businesses seek to increase their value and wealth, NPV clearly
is the best approach to use, at least of all the methods we have considered so far.
The actual return percentage is unknown. Where the NPV is positive (+) you simply know that the
projected return is higher than the discount rate, or where it is negative (−) that it is lower than the
discount rate. However, you do not know how much higher or lower. For example, project X has an
NPV of +$1,900after discounting at 12%. We do not know whether the return is 13% or 17%.
Ranking of alternative projects. If funds were unlimited, then all projects with positive (+) NPVs
would be selected. However, funds are normally restricted, and ranking alternative projects on the
basis of NPV may not achieve the best investment strategy. Relating the NPV to the amount of capital
invested provides one possible solution.
In general, and subject to qualifications dealt with later, NPV users should adopt the following decision
rules:
Take on all projects with positive NPVs, when they are discounted at the opportunity cost of finance.
When a choice has to be made between two or more projects, select the one with the larger or largest
NPV.
NPV is the most logical approach to making business decisions about investments in productive assets. It
also provides the basis for valuing any economic asset; that is, any asset capable of yielding financial
benefits. This definition will include such things as equity shares and loans. In fact, when we talk of
economic value, we mean the value derived by adding together the discounted (present) values of all
future cash flows from the asset concerned.
Discounted payback
We noted earlier that the payback method does not take into account the concept of the time value of
money. One way of changing this is to compare the initial cost with the cash inflows, after discounting
(see Example 12.4 ).
EXAMPLE
12.4
Suppose a project has an initial cash outflow of $60,000 and cash inflows of $20,000 for each of
the next five years. Clearly, the payback period is three years. If the cash inflows are discounted at
10%, the relevant figures will be:
In its 2016 annual report and accounts, Rolls-Royce plc stated that: ‘The Group subjects all major
investments and capital expenditure to a rigorous examination of risks and future cash flows to
ensure that they create shareholder value.’ All major investments, including the launch of major
programmes, require board approval.
The group has a portfolio of projects at different stages of their life cycles. Discounted cash flow
analysis of the remaining life of projects is performed on a regular basis.
Rolls-Royce indicates that it uses NPV (the report refers to creating shareholder value and to
discounted cash flow, which strongly imply NPV). It is interesting to note that Rolls-Royce not only
assesses new projects but also reassesses existing ones. This is a sensible commercial approach.
Businesses should not continue with existing projects unless those projects have a positive NPV
based on future cash flows. Just because a project seemed to have a positive NPV before it
started, and at early stages in its life, does not mean that this will persist, in the light of changing
circumstances.
Vodafone
In an article for the Financial Times, Jonathan Guthrie looks at the NZ$3.4 billion merger of New
Zealand’s Sky Network Television into ‘deal-hungry telecoms group Vodafone’. The commercial
reasons underpinning the merger are the increased commodification of telephone air time, and the
fierce competition in pay TV. Combining Vodafone and SKY’s New Zealand operations ‘is
expected to yield cost and capital expenditure synergies (benefits) with a net present value of
NZ$295 million’.
Concept check 8
Which of the following statements is false?
A. When a choice has to be made between two or more projects, select the one with the
larger or largest NPV.
B. The NPV decision rule is to take on all projects with positive NPVs.
C. NPV provides a better approach for evaluating investments than payback period.
D. If funds available for investment are limited, NPV will achieve the best investment
strategy.
E. NPV provides a better approach for evaluating investments than ARR.
Internal rate of return (IRR)
LO 5 Demonstrate an understanding of the ‘internal rate of return’ method with respect to the formula,
decision rule, and strengths and weaknesses
This is the last of the four main methods of investment appraisal applied in practice. It is quite closely
related to the NPV method in that, like NPV, the internal rate of return involves discounting future cash
flows. The internal rate of return (IRR) of a particular investment is the discount rate that, when
applied to its future cash flows, will produce an NPV of precisely zero. In essence, it represents the yield
from an investment opportunity.
Remember that, when we discounted the cash flows of the Billingsgate Battery Company machine
investment opportunity at 20%, we found that the NPV was a positive figure of $24,190. The fact that the
NPV is positive when discounting at 20% implies that the project generates a rate of return that is more
than 20%. The fact that the NPV is a pretty large figure implies that the actual rate of return is quite a lot
above 20%. We should expect that an increase in the size of the discount rate would reduce the NPV
because a higher discount rate gives a lower discount factor. Thus, future inflows are more heavily
discounted, which will reduce their impact on the NPV. In fact, the IRR is the discount rate that will have
the effect of producing an NPV of zero.
It is somewhat laborious to deduce the IRR by hand, since it cannot usually be calculated directly. Thus,
without access to a financial calculator or computerised spreadsheet, iteration (trial and error) is the only
approach. Let us try a higher rate—say, 30%—and see what happens.
(1.88)
By increasing the discount rate from 20% to 30%, we have reduced the NPV from $24,190 (positive) to
$1,880 (negative). Since the IRR is the discount rate that will give us an NPV of exactly zero, we can
conclude that the IRR of Billingsgate’s machine project is slightly under 30%. Further trials could lead us
to the exact rate, but there is probably not much point given the likely inaccuracy of the cash flow
estimates. Of course, a spreadsheet or financial calculator will give a precise figure. Remember that since
some of the cash flows are tentative, such precision could mislead.
Figure 12.2 shows the relationship between the NPV method discussed earlier and the IRR, using the
Billingsgate data. Where the discount rate is zero, the NPV will be the sum of the net cash flows. In other
words, no account is taken of the time value of money. However, as the discount rate increases, there is
a corresponding decrease in the NPV of the project. When the NPV line touches the horizontal axis, there
will be a zero NPV and that point will also represent the IRR.
If the discount rate were zero, the NPV would be the sum of the net cash flows. In other words, no
account would be taken of the time value of money. However, if we assume increasing discount rates,
there is a corresponding decrease in the NPV of the project. When the NPV line crosses the horizontal
axis there will be a zero NPV, and the point where it crosses is the IRR.
Activity 12.7
What is the IRR of the Chaotic Industries project in Activity 12.2 (page 530)? Use the present value
table in Appendix 12.1 (page 574).
(Hint: Remember that you already know the NPV of this project at 15%.)
In answering Activity 12.7 , we were fortunate in using a discount rate of 10% for our second iteration,
as this happened to be very close to the IRR figure. However, what if we had used 6%? This discount
factor would give us a large positive NPV, as we can see below:
Time Cash flows $’000 Discount factor (from the table) Present value $’000
We can see that the IRR will fall somewhere between 15%, which gives a negative NPV, and 6%, which
gives a positive NPV. We could make further iterations to derive the IRR. More realistically, we could use
either a financial calculator or a spreadsheet to do this very quickly. However, if you have to calculate the
IRR manually, further iterations can be time-consuming. Nevertheless, by linear interpolation we can get
close to the answer fairly quickly. Linear interpolation assumes a straight-line relationship between the
discount rate and the NPV, which may be a reasonable approximation over a relatively short range. To
understand the principles behind this method, study the diagram in Figure 12.3 .
Figure 12.3 Finding the IRR of an investment by plotting the NPV against the discount rate
The IRR is calculated as the point at which the line between the two NPVs cross zero on the NPV axis.
The graph plots the NPV of the investment against the discount rates. Thus, point D represents the NPV
at a discount rate of 6% and point F represents the NPV at a discount rate of 15%. The point at which the
sloping line DF intersects the discount rate line (point E) is the IRR. This figure can be derived by
calculation. Set out two discount rates and their associated NPVs and find the differences between the
two as shown below.
15 (93,960)
6 74,640
Difference 9 168,600
The IRR occurs where the NPV is zero. We need to find just how far above 6% (or below 15%) the
discount rate needs to go in order to get an NPV of zero. At 6% the NPV is $74,640. Every increase of
1% will reduce the NPV by $18,732. Dividing 74,640 by 18,732 is just under 4%. This implies that the IRR
is just under 10%.
15−9×(93,960/168,600)
or:
6+9×(74,640/168,600)
We can see that the figure derived through this process is slightly different from the figure for the IRR
calculated earlier where one of the discount rates used was very close to the actual IRR. It is less
accurate because of the linearity assumption employed (which is strictly incorrect), but it is likely to be a
reasonable approximation for most purposes. If you refer back to Figure 12.3 , you can see that the line
curves. Superimposing a curve on Figure 12.3 implies that the linear interpolation will be slightly on the
high side of the correct figure, but, as pointed out above, this is unlikely to be a problem unless you try to
interpolate between substantially different figures. In fact, the correct IRR figure is 9%.
In practice, most businesses would use a computer spreadsheet, which would derive a project’s IRR very
quickly. It is not usually necessary, therefore, to use a series of trial discount rates manually or to make
the approximation just described.
Users of the IRR approach normally apply the following decision rules:
For any project to be acceptable, it must meet a minimum IRR requirement. This is known as the
‘hurdle rate’ and, logically, this minimum should be the opportunity cost of finance.
Where there are competing projects (e.g. the business can choose one of the projects, but not all), the
one with the higher or highest IRR would be selected.
The IRR has certain attributes in common with NPV. All cash flows are taken into account, and the timing
of them is logically handled.
Real World 12.4 illustrates how the French energy business EDF used IRR in assessing a deal to build
a nuclear power station in the United Kingdom. It also gives the IRR that went with BHP’s mining
investment in Chile.
The deal for EDF to build the Hinkley Point nuclear plant in the UK could either be the salvation, or
the ruin, of the French state-owned group.
Jean-Bernard Lévy, the chief executive of EDF, told journalists the decision was ‘a big moment’ for
securing the future of EDF and also signified the ‘relaunch of nuclear in Europe’, which should also
benefit the group.
The British government confirmed on Thursday that EDF will be paid £92.50 per megawatt hour for
the electricity generated by Hinkley Point C for 35 years, more than double the current rate for
wholesale electricity prices.
According to the company this will deliver a 9% internal rate of return over the 60 years lifespan on
the £18 billion project.
The fixed price offered by the UK compares to the French market, which is being deregulated,
leaving the company to sell an ever-increasing share of its electricity at market prices.
Source: Extract from: Michael Stothard, ‘Hinkley Point is risk for overstretched EDF, warn critics’, ft.com, 15 September 2016.
Chilean mine
The IRR for the Chilean mining project by BHP in Real World 12.1 was 16%.
Some examples of the required (and achieved) internal rates of return can be seen in Real World 12.5 ,
although the publication of these figures is not common.
IRRs for investment projects can vary considerably. Some are still high, but with low interest costs
the IRRs are tending to move downwards.
Leveraged buy-outs
On the website quora.com, a question-and-answer website started in 2009, one question asked
was: ‘What’s the typical IRR (internal rate of return) hurdle for a LBO deal?’ Leveraged buy-outs
are discussed in Chapter 14 , but essentially they occur when management buys out the
company in which they are working, using debt. They are inherently riskier than more typical
projects. The answers given, which covered the period from late 2014 and obviously reflected the
personal experiences of the respondents, were that in the past a figure of around 40%+ was often
modelled, but that this was now down to much closer to 20%+. The reason given was that the
market has become much more efficient, sellers have become more sophisticated, and capital
structure so standardised that it has become very difficult to get much more than that. Other
respondents suggested that 12–20% is a likely figure over the next few years. In an article written
in 2018 it was suggested that the target had been close to 20% since 2009, although this rate was
falling, albeit very slowly.
Source: Antonella Puca, ‘Private equity funds: leverage and performance evaluation’, blogs.cfainstitute.org, 17 July 2018.
Source: Investment Property Forum (IPF), An Investigation of Hurdle Rates in the Real Estate Investment Process. IPF Research Programme 2015–2018. (IPF,
In Australia the Mandurah Forum Regional Centre undertook a $350m redevelopment with a target
IRR of >10%.
Source: Penny Berger, Perth Investor Day and Asset Tours (Vicinity Centres, Perth, 2017).
Kerching Capital acquired Ferny Grove Shopping Village in Queensland with a target IRR of 12%.
Source: Lloyd Edmunds, Ferny Grove Shopping Village, QLD (Kerching Capital, Brisbane, 2017).
Others
NBN Co had an IRR of 7.1% (based on a 30-year unlevered business) included in its Corporate
Plan for 2012–15. In its 2019–2022 Corporate Plan its base case IRR was 3.2%.
Source: NBN Co., Corporate Plan 2012–2015 (NBN Co., Sydney, August 2012). NBN Co., Corporate Plan 2019–2022 (NBN Co., Sydney, August 2018).
A paper entitled ‘Australian dairy offers best risk- adjusted returns in global agriculture’ cites Aquila
Capital, a leading independent European alternative asset manager, identifying IRRs of 11–16%
being offered in the Australian dairy sector.
In the oil industry, where prices can be quite volatile, it would not be uncommon to calculate a
range of IRRs (providing an IRR profile) for a range of differing assumptions about price.
In a more general article on capital expenditure by Victoria Thieberger, the Commonwealth Bank’s
senior economist Gareth Aird highlighted that high hurdle rates had not been lowered to adjust for
‘the low inflation, low interest environment of the last eight years’, with ‘the majority of hurdle rates
... around 10–16%’. About 90% were over 10%, with approximately 40% falling in the 10–13%
band. These rates were significantly higher than the cost of capital for businesses.
Sources: Ciaran Morgan, ‘Australian dairy offers best risk-adjusted returns in global agriculture’, AgriLand, 15 April 2014. Mark Venables, ‘Has oil and gas finally got
it right with ontime and on budget projects’, The Forbes, 31 August 2018. Victoria Thieberger, ‘Capital expenditure survey looking dim’, The Australian, 23 February
2016.
Reflection 12.4
What hurdle rate would you suggest that Lucas (our restaurateur), or Tim (our agricultural
engineer), or our young high-tech entrepreneurs, use in their project appraisal? Explain your logic.
EXAMPLE
12.5
In practice, many businesses have more than one way of dealing with a problem. For example,
suppose that one solution is to buy a special-purpose machine costing $100,000, which is
expected to return $130,000 in one year’s time. Another solution is to buy a machine that is more
general-purpose and offers a range of uses. Its cost would be $200,000, and it would be expected
to yield returns of $250,000 in one year’s time. The NPV and the IRR are as shown below.
Special-purpose General-purpose
The problem in this case is that the NPV and IRR methods give different results. The special-
purpose machine has an NPV of $18,170 and an IRR of 30%, while the general-purpose machine
has an NPV of $27,250 and an IRR of 25%. The results differ because the two investments are of
different sizes. It should be clear that the absolute size of the NPV for the larger project should be
larger than that of the smaller project, even though the rate of return is smaller. If there are no
limits on the amount to be spent, the project giving the largest NPV should be selected.
It may be worthwhile reviewing this from a different perspective, the incremental perspective. The
incremental difference between the two projects is as follows:
The internal rate of return on the incremental cost is 20%. The net present value (at 10%) on the
incremental cost can be obtained by ((120,000×0.909)−$100,000); i.e.
$109,080−$100,000=$9,080.
Clearly, it is worth taking on the larger project since the incremental returns are favourable, with a
positive NPV of $9,080 and an incremental yield of 20%.
A further problem with the IRR method is that it has difficulty handling projects with unconventional cash
flows. In the examples studied so far, each project has a negative cash flow arising at the start of its life
and then positive cash flows thereafter. However, in some cases a project may have both positive and
negative cash flows at future points in its life. With such a pattern of cash flows, the IRR method may
provide more than one solution.
Concept check 9
Internal rate of return (IRR) is most similar to:
A. Payback period
B. Accounting rate of return
C. Net present value
D. Discounted payback period
E. None of the above.
Concept check 10
Which of the following statements is false?
A. The use of the IRR ensures that decisions always maximise wealth generation.
B. The IRR method has difficulty handling projects with unconventional cash flows.
C. The IRR of a project provides the discount rate where NPV will be zero.
D. IRR considers the timing of the investment cash flows.
E. A project with an IRR greater than the firm’s hurdle rate or cost of capital should be
accepted.
Concept check 11
The IRR will be decreased by which of the following?
A. An increase in the initial investment purchase cost of $1,000
B. A decrease in the initial investment purchase cost of $1,000
C. An increased cash inflow in year 10 of $1,000
D. A decreased cash outflow in year 10 of $1,000
E. None of the above.
Some practical points
LO 6 Identify and deal with a range of practical issues relating to investment appraisal
EXAMPLE
12.6
Suppose that a business is considering investing in a project costing $120,000. It has prepared the
following forecasts:
The question inevitably arises: how to convert profit flows into cash flows?
All of the figures for revenues and expenses are associated with cash flows, other than
depreciation. The cash flows for each of the years 1–3 can be calculated as:
100,000
This pattern gives an NPV at 12% of $24,120 (using the present value tables) and an IRR at 23%.
In practice, the situation is rarely this simple. It is almost certain that inventory will need to be
purchased upfront, and this means that cash payments must be earlier than was assumed above.
If sales are made on credit, the associated cash receipts will be delayed. If credit periods are
obtained from suppliers, then cash payments can be delayed.
Suppose that this project involved holding an average inventory figure of $25,000, that customers
took 112 months to pay, and suppliers were paid after one month. In effect, this means that the
project has additional working capital tied up, amounting to:
Inventory $25,000
Accounts payable ($11,667) (112 of variable expenses 112 of other expenses; i.e. 140,000/12)
The revised cash flows for the project would now be:
Year 0
(158,333)
Year 1 60,000
Year 2 60,000
Year 3 60,000
When an adjustment of this type is made, the adjusted operating profit (pre-depreciation) will
provide a reasonable approximation to cash flows.
Assuming a 12% discount rate, this will give an NPV of $13,080 (using the present value tables).
The IRR will be 16.3%. There is quite a difference between the figures for the project with and
without the working capital adjustments.
This situation is fairly typical. While it is strictly true that the working capital adjustment can go in either
direction, the working capital needs are usually positive, and in this case if no adjustment is made the
appraisal gives a more favourable result than is justified.
Remember that the above procedure is still only an approximation of the likely cash flows. One striking
anomaly is that cash flows are frequently assumed to occur at the end of each year. Such an assumption
is probably quite realistic for securities and associated returns, where interest and dividends are typically
received at the end of the year. It is unlikely to be true of sales of a commodity, though, where sales and
expenses are usually spread over each year, sometimes fairly evenly, sometimes with a substantial
seasonal bias. If more accurate calculations are desired, the cash flows can be done on a range of
alternative bases, such as half-yearly, quarterly, or even monthly. The discount rates used will need to be
modified to reflect this; that is, instead of using, say, 12% per annum, we use 6% for a half-year, and 1%
for cash flows done on a monthly basis.
Relevant costs
As with all decisions, we should take account only of relevant costs in our analysis. In other words, only
costs that vary with the decision should be considered, as we discussed in Chapter 9 . Thus, all past
and common future costs should be ignored as they cannot vary with the decision. Also, opportunity costs
arising from benefits forgone must be taken into account. For example, when considering whether to keep
using a machine to produce a new product, the realisable value of the machine may be an important
opportunity cost.
Taxation
Tax will usually be affected by an investment decision: the profits will be taxed, the capital investment
may attract tax relief, etc. Tax is levied on these profits at significant rates, so in real life, unless tax is
formally taken account of, the wrong decision could easily be made. In practice, some, if not all, of the
taxation relating to the current year’s profits will be paid in a later period (usually the following year). The
timing of the tax outflow must be taken into account when preparing the cash flows for the project.
Interest payments
When using discounted cash flow techniques, interest payments that have been charged to the income
statement should not be taken into account when deriving the cash flows for the period (i.e. the relevant
figure is the operating profit—profit before interest and depreciation). The discount factor already takes
account of the costs of financing, so to take account of interest charges when deriving cash flows for the
period would be double-counting.
Other factors
Investment decision-making must not be viewed as simply a mechanical exercise. The results derived
from a particular investment appraisal method will be only one input into the decision-making process.
There may be broader issues that are relevant but difficult, or impossible, to quantify. For example, a
regional bus company might consider investing in a new bus to serve a busy local route. Although the
NPV calculations may reveal that the investment will incur a loss, it is also possible that by not investing in
the new bus for the local route, the renewal of the company’s licence to operate will be put at risk. In such
a situation, before a final decision is made the calculated investment loss must be weighed against the
risk of losing the right to operate. The reliability of the forecasts and the validity of the assumptions used
in the evaluation will also influence the final decision.
Activity 12.8
The directors of Manuff (Steel) Ltd have decided to close one of its factories. There has been a reduction
in the demand for the products made at the factory in recent years, and the directors are not optimistic
about the products’ long-term prospects. The factory is situated in an area north of Sydney where
unemployment is high.
The factory is leased, with four years’ worth of the lease remaining. The directors are uncertain whether to
close the factory immediately or at the end of the lease period. Another company has offered to sublease
the premises from Manuff at a rental of $40,000 per annum for the rest of the lease period.
The machinery and equipment at the factory cost $1.5 million and have a written-down value of $400,000.
In the event of immediate closure, the machinery and equipment could be sold for $220,000. The working
capital at the factory is $420,000 and could be liquidated for that amount immediately if required, or the
working capital could be liquidated in full at the end of the lease period. Immediate closure would incur
employee redundancy payments of $180,000.
If the factory keeps operating until the end of the lease period, the following operating profits (losses) are
expected:
The above figures include a charge of $90,000 per year for depreciation of machinery and equipment.
The residual value of the machinery and equipment at the end of the lease period is estimated at
$40,000.
Redundancy payments are expected to be $150,000 at the end of the lease period if the factory continues
operating. The company has a required rate of return of 12%. Ignore taxation.
a. Calculate the incremental cash flows arising from a decision to continue operations until the end of
the lease period rather than to close immediately.
b. Calculate the net present value of continuing operations until the end of the lease period rather
than closing immediately.
c. What other factors might the directors of the company take into account before deciding when to
close the factory?
d. State, with reasons, whether or not the company should continue to operate the factory until the
end of the lease period.
Concept check 12
Which of the following should NOT be taken into account with an investment decision?
A. Working capital requirements
B. That cash flows do not occur at the end of each year
C. Historical cost of the asset being replaced
D. Opportunity costs
E. Taxes.
Concept check 13
Which of the following statements is false?
A. Past costs should be ignored as they do not vary with the decision.
B. Depreciation should be included in the cash flows.
C. Common future costs should be ignored as they do not vary with the decision.
D. Interest costs should not be included with NPV and IRR calculations.
E. Reliability of the cash flow forecasts and the validity of the assumptions used in the
evaluation are critical for the analysis to be meaningful.
SELF-ASSESSMENT QUESTION
12.1
Beacon Chemicals Ltd is considering the erection of a new plant to produce a chemical named
X14. The new plant’s capital cost is estimated at $100,000, and if its construction is approved now
the plant can be erected and commence production by the end of 2020; $50,000 has already been
spent on research and development work. Estimates of revenues and costs arising from the
operation of the new plant are provided below:
2021 2022 2023 2024 2025
If the new plant is erected, sales of some current products will be lost, and this will result in a loss
of contribution of $15,000 per year over the new plant’s life.
The accountant has informed you that the fixed costs include depreciation of $20,000 per annum
on new plant, and an allocation of $10,000 for fixed overheads. A separate study shows that, if the
new plant was built, its construction would incur additional overheads, excluding depreciation, of
$8,000 per year, and it would require additional working capital of $30,000. For the purposes of
your initial calculations, ignore taxation.
a. Deduce the relevant annual cash flows associated with building and operating the plant.
b. Deduce the payback period.
c. Calculate the net present value using a discount rate of 8%.
(Hint: Treat the investment in working capital as a cash outflow at the start of the project and an
inflow at the end.)
Investment appraisal in practice
LO 7 Describe investment appraisal in practice, and explain the need to link it with strategic planning
Methods used
Surveys of the methods of business investment appraisal tend to show the following:
Increasingly over time businesses have used more than one method to assess each investment
decision.
There has been greater use of the discounting methods (NPV and IRR) over time, with these two
becoming the most popular appraisal methods in recent years.
ARR and PP continue to be popular, despite their theoretical shortcomings and the rise in popularity of
the discounting methods.
There is a tendency for larger businesses to use the discounting methods, and to use more than one
method for each decision.
The 2009 CIMA worldwide survey Management Accounting Tools for Today and Tomorrow
(referred to in Real World 11.1 ) found that overall NPV was the most popular investment
decision-making tool, being used by almost 65% of respondents, while PP was next at 55%. IRR
was used by about 42% of respondents, discounted payback by about 35%, and ARR by about
18%. Other important elements in the decision-making included post-completion audits (35%),
sensitivity analysis (50%) and non-financial issues (49%).
For very large organisations, NPV was used by about 75% of respondents, sensitivity analysis by
about 65%, PP by 60%, IRR by about 50%, discounted payback by around 45%, post-completion
audits by just under 50%, and non-financial issues by around 50%.
The survey found that, on average, respondents used between three and four investment decision-
making tools. The extent of use of PP might be seen as a surprise.
The 2013 survey by Lucas and colleagues (also referred to in Real World 11.1 ), which was
based on small and medium-sized enterprises, found little evidence of use of capital expenditure
appraisal techniques; rather, decisions were based on ‘“strategic” reasons or “operational”
imperatives—i.e. “we have to do this or we’re in trouble”, as one respondent put it’.
When we turn to an Australian survey carried out by Truong and colleagues (2005), the results -
indicated that NPV, PP and IRR were the methods most frequently used by the Australian
companies participating in the survey. The first five methods by ranked use and importance were:
Of the respondents, 88% used at least three techniques and 72% used at least four techniques.
These figures are similar to those found in surveys of investment appraisal in both the United
Kingdom and the United States. It is also reassuring to see that practice fits the theory fairly well.
Sources: Chartered Institute of Management Accountants (CIMA), Management Accounting Tools for Today and Tomorrow (CIMA, London, 2009).
Michael Lucas, Malcolm Prowle and Glynn Lowth, Management Accounting Practices of (UK) Small-Medium Sized Enterprises (SMEs) (Chartered Institute of
Management Accountants, London, 2013), http://www.cimaglobal.com. Giang Truong, Graham Partington and Maurice Peat (2005), ‘Cost-of-capital estimation
and capital-budgeting practice in Australia’, AFAANZ Conference Proceedings (AFAANZ, Melbourne, 2005).
Activity 12.9
Earlier in the chapter we discussed the theoretical limitations of the PP method. How do you explain the
fact that it still seems to be a popular method of investment appraisal among businesses?
PP can make a convenient, though rough-and-ready, assessment of a project’s profitability. Its popularity
may suggest a lack of sophistication in managers dealing with investment appraisal.
IRR may be as popular as NPV, in spite of its shortcomings, because it is expressed in percentage terms
rather than in absolute terms. This seems to be more acceptable to (and probably better understood by)
managers, perhaps because managers are used to using percentages as targets (e.g. return on assets).
Investment appraisal and planning systems
So far, we have been concerned with the process of carrying out the necessary calculations that enable
managers to select among already identified, often unconnected, investment opportunities. Although the
assessment of projects is undoubtedly important, we must bear in mind that it is only part of the process
of investment decision-making. There are other important aspects that managers must also consider.
It is possible to see the investment process as a sequence of five stages, each of which managers must
pay attention to. The five stages are set out below.
The ability and commitment of those responsible for proposing and managing the project will be vital to its
success. This means that when evaluating a new project one consideration will be the quality of those
proposing it. Senior managers may decide not to support a project that appears profitable on paper if they
lack confidence in the ability of key managers to see the project through to completion.
Much of the control of a project is through the routine budgetary control procedures that we met in
Chapter 11 . Management should also receive progress reports on the project at regular intervals.
These reports should provide information relating to the actual cash flows for each stage of the project,
which can then be compared against the forecast figures provided when the proposal was submitted for
approval. The reasons for significant variations should be ascertained and corrective action taken where
possible. Any changes in the expected completion date of the project or any expected variations in future
cash flows from budget should be reported immediately; in extreme cases, managers may even abandon
the project if circumstances appear to have changed dramatically for the worse.
Project management techniques (e.g. critical path analysis) should be employed wherever possible, and
their effectiveness reported to senior management.
An important part of the control process is a post-completion audit of the project. This is, in essence, a
review of the project performance to see whether it has lived up to expectations, and whether any lessons
can be learned from the way the investment process was carried out. In addition to an evaluation of
financial costs and benefits, non-financial measures of performance, such as the ability to meet deadlines
and levels of quality achieved, should also be reported.
The fact that a post-completion audit is an integral part of the management of a project should encourage
those who submit projects to use realistic estimates. Studies have found evidence that estimates of
revenues or cash inflows tend to be optimistic. It seems that sometimes this is done deliberately in an
attempt to secure project approval. Where over-optimistic estimates are used, the managers responsible
may well find themselves accountable at the post-completion audit stage. Post-completion audits also
suggest that there is always a proportion of projects that do not deliver what was expected, and other
projects that were rejected which, with hindsight, should have been accepted. Such audits, however, can
be difficult and time-consuming to carry out. The likely benefits must therefore be weighed against the
costs involved. Senior management may feel that only projects above a certain size should be subject to
a post-completion audit.
Clearly, investment appraisal methods are an important part of planning and decision-making. It is
important to estimate the relevant cash flows in as professional a way as possible, and to make the
calculations in such a way that the implications of following through on the estimates are clear. Plans can
then be modified as appropriate. Capital investment appraisal needs to be fully integrated with more
comprehensive planning systems and decision-making.
The techniques discussed in this chapter can be applied very easily to most, if not all, routine investment
decisions. In most such decisions, the strategic directions have already been set by the overall strategic
plan, so the particular investment decision can be made fairly easily by using the approaches discussed.
However, many (probably most) major decisions are made along strategic lines, for strategic reasons.
Many strategic decisions relate to positioning the overall business, or positioning within a particular
market. The techniques in this chapter still form part of the decision, but they are often relegated to
running through the numbers to confirm whether a decision made along strategic lines will produce the
desired results. This is not to underplay the importance of the appraisal methods, but rather to emphasise
that they must be part of the formal planning system to be effective.
sensitivity analysis—where variations are run through one at a time, with the aim being to identify how
sensitive the end results are to each variable used
scenario analysis—where alternative sets of variables (scenarios) are examined
the use of probabilities and expected values (averages)
the use of risk-adjusted discount rates (or the requirement for a risk-adjusted return incorporating an
allowance for a risk premium).
An important aim of the first two methods is to try to identify aspects of the decision which are particularly
risky. At some stage, a decision will be required as to just how much risk is to be borne.
Besides project risk, overall risk needs to be addressed as part of the strategic plan. Typically, some
types of activity are likely to be closely correlated, with returns going up (and down) together. Taking on
more of this type does not reduce risk. In some strategic plans, taking on a portfolio of differing projects is
seen as reducing overall risk. While risk can never be completely eliminated, diversification can reduce it.
As we saw in Chapter 5 , in the section on corporate governance, risk management is seen as a core
board function. The additional risks identified with capital investment appraisal reinforce the importance of
identifying risk and then coming to terms with just how much risk you wish to bear.
Reflection 12.5
We have talked about a number of young entrepreneurs in our Reflections. Choose one of them.
Identify the kind of planning and investment decisions that you think they are most likely to
encounter. Then outline how you might deal with these, and how you might use and integrate what
you have learned so far. Assess the relative importance of the various components.
One final point relates to planning and strategy for a large public company. The reality is that this area is
complex and beyond the scope of this book. In order to begin to understand the nature of a sophisticated
process of strategy development it is suggested that you have a look at what seems to be a regular
strategy briefing by BHP. Two recent briefings are:
Concept check 14
Which of the following statements is false?
A. Firms should stick with one investment appraisal method.
B. NPV is the most commonly used method.
C. Payback period is quite widely used, especially by smaller companies.
D. Capital investment appraisal needs to be fully integrated with more comprehensive
planning systems and decision-making.
E. None of the above. All are true.
Concept check 15
Which of the following are issues that must be taken into account when using the various
investment appraisal techniques?
A. The need for integration with overall corporate planning and decision-making
B. That managers can easily manipulate the analysis
C. That major decisions are made largely for strategic reasons
D. None of the above
E. All of the above.
Summary
In this chapter we have achieved the following objectives in the way shown.
Identify the essential features of investment decisions, and state the four common Examined and identified the following features:
capital investment appraisal methods
significant capital outlays
returns over an extended period
difficulties or expenses of ‘bailing out’ of the
investment
Examples included:
Demonstrate an understanding of the ‘accounting rate of return’ method with Explained ARR:
respect to the formula, decision rule, and strengths and weaknesses
method: ARR=Average return/Average investment
decision rules:
—above a minimum return
strengths:
—easily calculated
—readily understood
weaknesses:
—problems with using the average
Demonstrate an understanding of the ‘payback’ method with respect to the formula, Explained payback:
decision rule, and strengths and weaknesses
method:
PP=Time taken to recover amount of investment
decision rules:
—below a maximum payback period
strengths:
—simple to implement
—readily understood
weaknesses:
—disregards the timing of cash flows
Demonstrate an understanding of the ‘net present value’ method with respect to Explained NPV:
the formula, decision rule, and strengths and weaknesses
method: NPV=PVinflows– PVoutflows
decision rules:
—accept the highest positive NPV
strengths:
—based on all cash flows
weaknesses:
—more difficult to calculate
Demonstrate an understanding of the ‘internal rate of return’ method with respect to Explained IRR:
the formula, decision rule, and strengths and weaknesses
method:
IRR=The rate at which PVinflows=PVoutflows
decision rules:
—accept the highest IRR
strengths:
—based on all cash flows
weaknesses:
—more difficult to calculate
—there may be multiple returns
Identify and deal with a range of practical issues relating to investment appraisal Illustrated how to convert profit flows into cash flows,
including:
Describe investment appraisal in practice, and explain the need to link it with Provided research evidence of what methods are
strategic planning used in practice
Identified the importance of setting capital
investment decisions in a strategic context
Discussion questions
Easy
12.1 LO 1 What are the key features of capital investment decisions that distinguish them from other types of business decisions?
12.2 LO 1 List the four methods commonly used to evaluate investment opportunities. Indicate a variant for one or more of these basic
methods, and which methods are considered to have at least one serious failing.
12.3 LO 2 List and briefly describe two strengths and two weaknesses of the accounting rate of return evaluation method.
12.4 LO 3 List and briefly describe two strengths and two weaknesses of the payback evaluation method.
12.5 LO 4 List and briefly describe two strengths and two weaknesses of the net present value evaluation method.
12.6 LO 5 List and briefly describe two strengths and two weaknesses of the internal rate of return evaluation method.
12.7 LO 6 The discounted cash flow capital investment evaluation methods require the use of cash flows for their determination. How
might such cash flow amounts be derived from an accrual accounting statement of performance?
12.9 LO 4 What arguments are advanced to justify the use of discounted cash flow criteria?
12.10 LO Consider an investment in something new for your home (e.g. a new solar heating system). Try to estimate the relevant cash
4/6/7 flows and calculate the NPV of the investment.
Intermediate
12.11 LO The payback method has been criticised for not taking into account the time value of money. Could this limitation be
3/4 overcome? If so, would this method then be preferable to the NPV method?
12.12 LO An NPV analysis of an investment project yields a +$3,600 magnitude based on a discount rate of 14%.
4
a. What does this mean?
b. What does it not tell us about the financial viability of the project?
12.13 LO Why is the NPV method of investment appraisal considered to be theoretically superior to other methods found in accounting
2–5 texts?
12.14 LO Describe the cause and effect of two errors that will occur with the assumption that cash flow will be equal to the accounting
6 profit plus depreciation.
12.15 LO Discuss how the use of multiple evaluation methods by most companies might link with the significant practical issues
7 encountered with investment evaluations.
12.17 LO What implications does working capital have for the four investment appraisal approaches?
6
Challenging
12.18 LO When might it be appropriate not to use one of the four basic investment evaluation methods? List three other evaluation
1 techniques that could be used.
12.19 LO Discounted cash flow techniques ignore interest payments in their determination of cash flows. Why?
6
12.20 LO It can be argued that the major investment decisions made by a business are made at a strategic level, and the use of
7 discounted cash flow techniques only acts as a check on that decision. Discuss this view.
12.21 LO CEOs of large companies are often offered a contract for only 3–5 years. Do you think this might impact the way investment
5/7 evaluation methods are chosen and the long-term strategic planning of a business?
Application exercises
Easy
12.1 LO Using the information given below, calculate the accounting rate of return for each investment project, assuming depreciation at
2 20% straight line.
Investment A B C
1 8,000 20,000 –
How useful are the ARR figures in reaching a decision relative to the other methods?
12.3 LO The directors of Mylo Ltd are considering two mutually exclusive investment projects, both concerned with the purchase of new
3– plant.
5
The following data are available for each project.
Project 1 Project 2
$ $
b. State which, if any, of the two investment projects the directors of Mylo Ltd should accept, and why.
c. State, in general terms, which method of investment appraisal you consider to be most appropriate for evaluating
investment projects, and why.
12.4 LO A special-purpose machine costing $30,000 will save Toora Ltd $9,500 per year in cash operating expenses for the next six
2– years. Straight-line depreciation with a zero salvage value will be used (for accounting and tax purposes), and the minimum
4 desired rate of return is 12%.
Assuming a 30% income tax rate and rounding amounts to the nearest dollar, calculate the following:
12.5 LO North Coast Rail is considering electrification of a number of its locomotives. It has prepared the following estimates of changes
4– in costs per locomotive that would occur. No changes in revenue are expected since demand is already being met.
6
Cost of new electric motors, including associated installation costs $250,000
Increase in costs elsewhere in the system due to rescheduling caused by the project (in practice, costs like this can $50,000
be very significant)
It is estimated that locomotives will be in use for 300 days each year.
12.6 LO Arkwright Mills Ltd is considering expanding its production of a new yarn code named X15. The plant is expected to cost $1
3– million and have a life of five years and a nil residual value. It will be ready for operation before 31 December 2020, and the
7 initial period will be used to build up inventory; $500,000 has already been spent on product development costs, and this has
been charged to revenue in the year it was incurred. The following income statements for the new yarn are forecast:
$m $m $m $m $m
Tax is charged at 50% on profits and paid one year in arrears. Depreciation has been calculated on a straight-line basis.
Additional working capital of $0.6 million will be required at the beginning of the project. Assume that all cash flows occur at the
end of the year in which they arise.
a. Prepare a statement showing the incremental cash flows of the project relevant to a decision on whether or not to
proceed with building the new plant.
b. Calculate the net present value of the project, using a 10% discount rate.
c. Calculate the payback period to the nearest year. Explain the meaning of this term.
Intermediate
12.7 LO Dolly Ltd is contemplating renting a factory on a four-year lease from 1 January 2021, investing in some new plant, and using it
4– to produce a new product code-named GS7. Since it seems impossible for the plant to stay economically viable beyond a four-
6 year life, it has been decided to assess the new product over a four-year manufacturing and sales life.
Under the lease the business will pay $100,000 annually in advance on 1 January. The plant is expected to cost $600,000. This
will be bought and paid for on 1 January 2021, and is expected to be scrapped with zero proceeds on 31 December 2024. The
business will depreciate this asset, in its accounts, on a straight-line basis at 25% per year.
Each unit of GS7 is estimated to give rise to a variable labour cost of $200 and a variable material cost of $100. GS7
manufacture will be charged with an annual share of the business’s administrative costs, totalling $150,000 a year. Manufacture
and sales of GS7s is expected to increase total administrative costs by $90,000 each year.
2021 400
2022 600
2023 500
2024 200
The business will need to support the manufacture and sales of the product with working capital. This has been estimated at an
amount equivalent to $100 per unit of the product sold each year. The working capital would need to be in place by the
beginning of the relevant year of production and sales, and reduced to zero at the end of 2024.
The business’s accounting year-end is 31 December. It has been decided, given the level of risk involved with the project, to
use a discount rate of 15%.
a. Identify the annual net relevant cash flows, and use this information to assess the project on a net present value basis at
1 January 2021.
b. Estimate the IRR of the project.
12.8 LO Henry Ltd manufactures a thermostat for a range of kitchen appliances. The manufacturing process is, at present, semi-
4/6 automated. The equipment used costs $540,000 and has a written-down value of $300,000. Demand for the product has been
fairly stable, and output has been maintained at 50,000 units per annum in recent years. The following data, based on the
current level of output, have been prepared in respect of the product:
Per unit
$ $
Less
Labour 3.30
Materials 3.65
Overheads—variable 1.58
—fixed 1.60
10.13
Profit 2.27
Although the existing equipment is expected to last for a further four years before it is sold for an estimated $40,000, the
company is now considering purchasing new equipment which would completely automate much of the production process. The
new equipment would cost $670,000 and would have an expected life of four years, at the end of which it would be sold for an
estimated $70,000. If the new equipment was purchased, the old equipment could be sold for $150,000 immediately.
The assistant to the company accountant has prepared a report to help assess the viability of the proposed change. This
includes the following data:
Per unit
$ $
Less
Labour 1.20
Materials 3.20
Overheads—variable 1.40
—fixed 3.30
9.10
Profit 3.30
Depreciation charges will increase by $85,000 per annum as a result of purchasing the new machinery, but other fixed costs are
not expected to change.
In the report the assistant wrote: ‘The figures shown above which relate to the proposed change are based on the current level
of output and take account of a depreciation charge of $150,000 per annum in respect of the new equipment. The effect of
purchasing the new equipment will be to increase the net profit to sales ratio from 18.3% to 26.6%. The new equipment will also
enable us to reduce our inventory level immediately by $130,000. In view of these facts I recommend purchase of the new
equipment.’
a. Prepare a statement of the incremental cash flows arising from the purchase of the new equipment.
b. Calculate the net present value of the proposed purchase of new equipment.
c. State, with reasons, whether the company should purchase the new equipment.
d. Explain why cash flow forecasts are used rather than profit forecasts to assess the viability of the proposed capital
expenditure projects.
Challenging
12.9 LO Harvey Hearing Ltd has spent $5 million over the past three years on researching and developing a miniature hearing aid.
4–6 The hearing aid is now fully developed and the directors of the company are considering which of three mutually exclusive
options should be taken to exploit the potential of the new product. The options are as follows:
Option 1. The company could manufacture the hearing aid itself. This would be a new departure for the company, which has
so far concentrated on research and development projects. However, the company has manufacturing space available which
it currently rents to another business for $100,000 per annum. The company would have to purchase plant and equipment
costing $9 million and invest $3 million in working capital immediately for production to begin.
A market research report, for which the company paid $50,000, indicates that the new product has an expected life of five
years. Sales of the product during this period are predicted as follows:
The selling price per unit will be $30 in the first year, but will fall to $22 in the following three years. In the final year of the
product’s life, the selling price will fall to $20. Variable production costs are predicted to be $14 per unit, and fixed production
costs (including depreciation) will be $2.4 million per annum. Marketing costs will be $2 million per annum.
The company intends to depreciate the plant and equipment by using the straight-line method and basing the depreciation
on an estimated residual value at the end of the five years of $1 million. The company has a cost of capital of 10%.
Option 2. Harvey Hearing Ltd could agree to another company manufacturing and marketing the product under licence. A
multinational company, Faraday Electricals Ltd, has offered to carry out the product’s manufacture and marketing, and in
return will make Harvey Hearing a royalty payment of $5 per unit. It has been estimated that the annual number of sales of
the hearing aid will be 10% higher if the multinational company rather than Harvey Hearing manufactures and markets the
product.
Option 3. Harvey Hearing Ltd could sell the patent rights to Faraday Electricals Ltd for $24 million, payable in two equal
instalments. The first instalment would be payable immediately, and the second instalment would be payable at the end of
two years. This option would give Faraday the exclusive right to manufacture and market the new product. Ignore taxation.
a. Calculate the net present value of each of the options available to Harvey Hearing Ltd.
b. Identify and discuss any other factors which Harvey Hearing Ltd should consider before arriving at a decision.
c. State what you consider to be the most suitable option, and why.
12.10 LO You are employed as the accountant of Newstart Ltd, whose directors are considering two mutually exclusive investment
3/4 projects. Both projects concern the purchase of new plant. The following data are available for each project.
Re-tread Re-line
$ $
*
Before depreciation
Newstart Ltd has a required rate of return of 10%, and employs the straight-line method of depreciation for all non-current
assets when calculating profit. Neither project would increase the working capital of the company, which has insufficient
funds to meet all capital expenditure requirements. The company tax rate is 30%.
b. State which, if either, of the two investment projects the directors of Newstart Ltd should select. Justify your answer.
12.11 LO Creative Products Ltd is running a cost-reduction program. As part of this program it is considering modernising some of the
4–7 machine processes. Details of one such proposal, intended to replace three machines with one multi-purpose machine, are
as follows:
Operating costs
*
*
A major overhaul of these machines is due, estimated to cost an additional $250,000.
The old machines have about another 10 years of life, after which each one is likely to have a residual value of $10,000.
However, their present second-hand value is $20,000 each. The new machine would also have a 10-year life and an
estimated residual value of $100,000.
Introducing the new machine would not gain any revenue, since the old machines can provide adequate capacity during the
period under consideration. Production (and sales) is estimated to be:
However, using the new machine will reduce material scrap so that a saving of 20¢ may be expected from each product.
Management expects each capital investment proposal to earn at least 12% and that it should pay for itself within a period of
five years.
12.12 LO Melbourne United is a professional soccer club, and has been so successful in recent years that it has accumulated $10
4/6/7 million to spend on further development. Its board is now considering two mutually exclusive options for spending these
funds.
The first option is to acquire another player. The team manager is keen to acquire Frankie O’Farrell, a central defender who
plays for a rival club. The rival club has agreed to release Frankie immediately for $10 million. Acquiring Frankie would mean
that the club’s current central defender, Luke Hammer, could be sold to another club, and Melbourne United has recently
been offered $2.2 million for Luke. This offer is still open, but will be accepted only if Frankie joins United. Otherwise, Luke is
expected to stay on with the club until the end of his playing career in five years’ time. During this period Luke will receive an
annual salary of $400,000, and a loyalty bonus of $200,000 at the end of his five-year period with the club.
Assuming Frankie O’Farrell is acquired, the team manager estimates that gate receipts will increase by $2.5 million in the
first year and $1.3 million in each of the four following years. Sponsorship and advertising revenue will also increase by $1.2
million for each of the next five years if the player is acquired. At the end of five years, Frankie can be sold for about $1
million. During his time with the club, he will be paid $800,000 a year and a loyalty bonus of $400,000 after five years.
The second option is for the club to improve its ground facilities. The west stand could be extended and executive boxes
could be built for businesses wishing to offer hospitality to clients. These improvements would also cost $10 million, and
would take one year to complete. During this period the west stand would be closed, reducing gate receipts by $1.8 million.
However, gate receipts for each of the next four years would be $4.4 million higher than current receipts. In five years’ time,
the club plans to sell its present grounds and move to a new stadium nearby. Improving the ground facilities is not expected
to affect their sale value. Payment for the improvements will be made when they are completed at the end of the first year.
Whichever option is chosen, the board of directors has decided to take on additional ground staff. The additional wages bill is
expected to be $350,000 a year over the next five years.
The club has a capital cost of 10%. Ignore taxation.
a. Calculate the incremental cash flows arising from each of the options available.
b. Calculate the net present value of each of the options.
c. On the basis of the calculations made in (b) above, which of the two options would you choose, and why?
d. Discuss the validity of using the NPV method in making investment decisions for a professional soccer club.
e. Which strategic factors must be considered before reaching a decision?
Chapter 12 Case study
We saw in Reflection 12.5 that even for a relatively small business the investment process can be
quite complicated, and that the techniques introduced in this chapter represent a relatively small, but
necessary, part of this process. Consider the following questions.
1. In screening investment proposals, what kind of things might prevent an investment being seriously
considered?
2. Do you consider that strategic decisions can be made by using discounted cash flow (DCF)? What
role do you think DCF plays in strategic decision-making?
3. What kind of risks might lead to an investment being rejected even though it showed a positive
present value?
4. How might bias or manipulation by sponsoring managers be prevented?
5. Is there a link between a decision to ration capital and a chosen hurdle rate?
6. It can be argued that decisions are made on strategic lines, with a present value calculation being
used only to confirm the decision. Do you agree? Why/why not?
7. Do you think that the generation of good ideas, rather than the generation of figures, is the most
important part of investment decision-making?
8. Does the use of discounting techniques lead to a false sense of security regarding investments, in
that the technical rigour is improved?
9. How easy is it for managers to manipulate or circumvent discounted cash flow analysis?
10. The concept of strategic positioning is very important to the development of strategy. Can this be
linked with investment appraisal methods?
Activity 12.1
The answer is that any decision must be made in the context of the objectives of the business concerned.
For a private-sector business, this is likely to include increasing the wealth of the owners/shareholders of
the business through long-term profitability.
Activity 12.2
The vehicles will save the business $120,000 a year (i.e. 920−(80×10) before depreciation, in total. Thus,
the inflows and outflows will be:
$’000
The total annual depreciation expense (assuming a straight-line approach) will be $80,000 (i.e.
(600−120)/6) Thus, the average annual saving, after depreciation, is $40,000 (i.e. 120−80).
$’000
2 440(i.e.520−80)
3 360
4 280
5 200
6 120
The average investment (at reporting date values) will be $360,000 (i.e.
(600+520−440+360+280+200+120)/7) or (600+120)/2. Thus, the ARR of the investment is 11.1% (i.e.
(40/360)×100).
Activity 12.3
ARR suffers from a major defect: it almost completely ignores the time factor. In this case, exactly the
same ARR would have been calculated under any of the three scenarios.
Since the same total profit ($200,000) over the five years arises in all three of these cases, the average
profit after depreciation must be the same in each case. The average profit is, therefore, $40,000. The
average investment is $160,000/2=$80,000. In turn, this means that each case will give rise to the same
ARR of 50%.
Given a financial objective of increasing the wealth of the business, any rational decision-maker faced
with these three scenarios as a choice between three separate investments would strongly favour project
C. This is because most of the benefits from the investment accrue within 12 months of spending the
$160,000 to establish the project. Project A would rank second, and project B would come a poor third.
Any appraisal technique that cannot distinguish between these three situations is seriously flawed.
Activity 12.4
The inflows and outflows are expected to be:
$’000 $’000
6 years’ time Operating saving before depreciation plus disposal proceeds 240(i.e.120+120) 240
The payback period here is five years—that is, only at the end of the fifth year will the vans pay for
themselves out of the savings they are expected to generate.
Activity 12.5
Any rational decision-maker would prefer project 3, yet PP sees them as being all the same; that is, there
is a three-year payback period. The method cannot distinguish between projects that pay back a
significant amount before the three-year payback period and those that do not. Project 3 is by far the best
bet, because the cash flows come in earlier and they are greater in total, yet PP would not identify it as
the best. The cumulative cash flows of each project are set out in Figure 12.4 .
Activity 12.6
The calculation of the NPV of the project is as follows:
Time Cash flows $’000 Discount factor (from the table) Present value $’000
The fact that the project has a negative NPV means that the benefits from the investment are worth less
than the cost of making it. Any cost up to $506,400 (the present value of the benefits) would be worth
paying, but not $600,000.
Activity 12.7
Since we know (from Activity 12.6 ) that at a 15% discount rate the NPV is a relatively large negative
figure ($93,960), our next trial is using a lower discount rate, say 10%.
Cash flows $’000 Discount factor (from the table) Present value $’000
Time
We can see that NPV rose about $84,000 (from negative $93,960 to negative $9,840) for a 5% drop in
the discount rate—that is, about $16,800 per 1%. We need to know the discount rate for a zero NPV—
that is, a fall of a further $9,840. This logically would be roughly 0.6%. Thus, the IRR is close to 9.4%.
However, to say that the IRR is about 9% is near enough for most purposes.
Activity 12.8
Your answer to this activity should be as follows.
0 1 2 3 4
b. The sale value of the machinery represents an opportunity cost of keeping the factory operational,
as does the sublease rentals lost if the factory keeps going.
Discount rate 12% 1.00 0.893 0.797 0.712 0.636
d. The NPV of the decision to continue factory operations rather than close immediately is positive, so
in this case shareholders would be better off and this decision is likely to be welcomed by
employees as unemployment is high in the area.
Activity 12.9
Several factors may explain this finding:
PP is easy to understand and use.
It can avoid the problem of forecasting far into the future.
It gives emphasis to the early cash flows when there is greater certainty over the accuracy of their
predicted value.
It emphasises the importance of liquidity. A business with liquidity problems tends to prefer a short
payback period for a project.
Appendix 12.1
where
(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 1
2 0.980 0.961 0.943 0.925 0.907 0.890 0.873 0.857 0.842 0.826 2
3 0.971 0.942 0.915 0.889 0.864 0.840 0.816 0.794 0.772 0.751 3
4 0.961 0.924 0.888 0.855 0.823 0.792 0.763 0.735 0.708 0.683 4
5 0.951 0.906 0.863 0.822 0.784 0.747 0.713 0.681 0.650 0.621 5
6 0.942 0.888 0.837 0.790 0.746 0.705 0.666 0.630 0.596 0.564 6
7 0.933 0.871 0.813 0.760 0.711 0.665 0.623 0.583 0.547 0.513 7
8 0.923 0.853 0.789 0.731 0.677 0.627 0.582 0.540 0.502 0.467 8
9 0.914 0.837 0.766 0.703 0.645 0.592 0.544 0.500 0.460 0.424 9
10 0.905 0.820 0.744 0.676 0.614 0.558 0.508 0.463 0.422 0.386 10
11 0.896 0.804 0.722 0.650 0.585 0.527 0.475 0.429 0.388 0.350 11
12 0.887 0.788 0.701 0.625 0.557 0.497 0.444 0.397 0.356 0.319 12
13 0.879 0.773 0.681 0.601 0.530 0.469 0.415 0.368 0.326 0.290 13
14 0.870 0.758 0.661 0.577 0.505 0.442 0.388 0.340 0.299 0.263 14
15 0.861 0.743 0.642 0.555 0.481 0.417 0.362 0.315 0.275 0.239 15
(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833 1
2 0.812 0.797 0.783 0.769 0.756 0.743 0.731 0.718 0.706 0.694 2
3 0.731 0.712 0.693 0.675 0.658 0.641 0.624 0.609 0.593 0.579 3
4 0.659 0.636 0.613 0.592 0.572 0.552 0.534 0.516 0.499 0.482 4
5 0.593 0.567 0.543 0.519 0.497 0.476 0.456 0.437 0.419 0.402 5
6 0.535 0.507 0.480 0.456 0.432 0.410 0.390 0.370 0.352 0.335 6
7 0.482 0.452 0.425 0.400 0.376 0.354 0.333 0.314 0.296 0.279 7
8 0.434 0.404 0.376 0.351 0.327 0.305 0.285 0.266 0.249 0.233 8
9 0.391 0.361 0.333 0.308 0.284 0.263 0.243 0.225 0.209 0.194 9
10 0.352 0.322 0.295 0.270 0.247 0.227 0.208 0.191 0.176 0.162 10
11 0.317 0.287 0.261 0.237 0.215 0.195 0.178 0.162 0.148 0.135 11
12 0.286 0.257 0.231 0.208 0.187 0.168 0.152 0.137 0.124 0.112 12
13 0.258 0.229 0.204 0.182 0.163 0.145 0.130 0.116 0.104 0.093 13
14 0.232 0.205 0.181 0.160 0.141 0.125 0.111 0.099 0.088 0.078 14
15 0.209 0.183 0.160 0.140 0.123 0.108 0.095 0.084 0.074 0.065 15
Chapter 13 The management of working capital
Learning objectives
When you have completed your study of this chapter, you should be able to:
LO 1 List the items that make up working capital, discuss the nature and importance of
working capital, and illustrate the working capital cycle
LO 2 Demonstrate the importance of inventory, and the techniques available to manage this
asset efficiently
LO 3 Discuss the provision of credit to customers, and use various management tools to
monitor and control the resulting asset
LO 4 Explain the reasons for holding cash, and the basis of its management and control
LO 5 Summarise the key aspects of management of accounts payable.
In this chapter we consider the factors that must be taken into account
when managing the working capital of a business. We identify each
element of working capital and discuss the major issues relevant to them.
The nature and purpose of working capital
LO 1 List the items that make up working capital, discuss the nature and importance of working
capital, and illustrate the working capital cycle
Working capital is usually defined as current assets less current liabilities. The main elements of current
assets are:
inventory
accounts receivable (trade debtors), and
cash (in hand and at the bank).
The size and composition of working capital can vary considerably between industries. For some types of
business, the investment in working capital can be substantial. For example, a manufacturing company
invests heavily in raw materials, work-in-progress and finished goods, and often sells its goods on credit,
thereby incurring accounts receivable. A retailer, on the other hand, holds only one form of inventory
(finished goods) and usually sells goods for cash. Many service businesses hold no inventories. Most
businesses buy goods and/or services on credit, giving rise to accounts payable. Few, if any, businesses
operate without a cash balance, although in some cases it is a negative balance in the form of an
overdraft.
The amount and composition of working capital can also vary between businesses of similar size within
the same industry. This may reflect different approaches towards the management of working capital and
its individual elements, which, in turn, is often linked to different attitudes towards risk.
Working capital represents a net investment in short-term assets which continually flow in and out of the
business and are essential for day-to-day operations. The various elements of working capital are
interrelated and can be seen as part of a short-term cycle. For a manufacturing business, the working
capital cycle is shown in Figure 13.1 .
For a retailer the situation would be as in Figure 13.1 except that there would be only inventories of
finished goods. There would be no work-in-progress or raw materials. For a purely service business, the
working capital cycle would also be similar to that depicted in Figure 13.1 except that there would be
no inventories of finished goods or raw materials. There may well be work-in-progress, however, since
many forms of service take time to complete. A case handled by a firm of solicitors, for example, could
take several months. During this period, costs would build up before the client could be billed for them.
The management of working capital is an essential part of the short-term planning process. Management
has to decide how much of each element to hold. As we shall see later, costs are incurred by holding both
too much and too little of each element. Management must be aware of these costs and risks, and must
also be aware that there may be other, more profitable, uses for the funds of the business. Hence, the
potential benefits must be weighed against the likely costs to achieve the optimum investment.
Working capital needs are likely to change due to changes in the business environment, including
changes in interest rates, market demand, the state of the economy, and the season of the year, so
working capital decisions are rarely one-off decisions. Managers must try to identify such changes to
ensure that the level of investment in working capital is appropriate.
In addition to changes in the external environment, many changes arise in the business itself, such as
changes in production methods (requiring, perhaps, less inventory) and changes in the level of risk
managers are prepared to take, and these could alter the required level of investment in working capital.
Working capital usually represents a substantial investment for a business, so its management is very
important. Real World 13.1 gives some indication of the scale of the working capital needs of various
types of business.
Boral
Boral indicated in its 2019 annual report that its current assets were $1,811 million, while current
liabilities were 1,392 million. Non-current assets were $7,732 million. This gives a proportion of
total assets attributable to current assets as 19%, and a current ratio of around 1.30.
Harvey norman
The amount held in current assets by Harvey Norman at the end of its 2019 financial year was
$1,456 million, and its current liabilities were $899 million. This gives a working capital of $557
million, and a current ratio of 1.62. The total shown under non-current assets was $3,342 million.
The percentage share of total assets accounted for by current assets was 30%.
Myer
The current assets of Myer at the end of its 2019 financial year amounted to $431 million, with
current liabilities amounting to $451 million, giving a current ratio of .96. Not surprisingly, being a
retailer dealing with mainly cash sales, receivables amounted to only $31 million. Non-current
assets amounted to $855 million. The percentage share of total assets accounted for by current
assets was 34%.
BHP billiton
The BHP Billiton 2019 annual report showed current assets of US$23,373 million, current liabilities
of US$12,339 million, and total assets of US$100,861 million. The percentage share of total assets
accounted for by current assets was 19%. The current ratio was about 1.9, a figure which is quite a
bit higher than it has been in the past.
In the sections that follow, we consider each element of working capital separately, and examine the
factors necessary to ensure their proper management. Before doing so, however, it is worth looking at
Real World 13.2 , which suggests that there is considerable scope for improving working capital
management among businesses globally.
According to a global survey by PwC, working capital is not as well managed as it could be. The
survey suggests that improvements ‘have been marginal, with no clear leap forward’. The report
found that an improvement of working capital efficiency to the level of performance of the next
quartile would release extra cash of the equivalent of €1.3 trillion, enough to boost capital
expenditure by 55%.
The study showed some slight improvement in net working capital in 2017, the first since 2014,
driven by reductions in days held for inventory and receivables, of 0.7 and 0.1 of a day,
respectively. There was also a reduction in the time taken to pay creditors, down by 0.3 of a day in
2017 from the ‘high-water mark in terms of squeezing suppliers’. In absolute terms net working
capital increased by 10.3% from the previous year, representing the equivalent of €300 billion of
additional cash used by working capital.
The average investment (in days) for each of the last five years to 2017, for each of the main
elements of working capital, is set out in Figure 13.2. As the figure shows, the working capital
performance of businesses has not altered very much over the period. Within each average,
however, some businesses have improved and some have deteriorated.
Average investment (in days) for the main working capital elements
The study results also showed that there are slightly lower levels of working capital held by large
US businesses than their European counterparts. Australasia had ‘the best net working capital
performance globally’, although its performance was not as good as in the past.
Source: PwC, Navigating uncertainty: PwC’s annual global Working Capital Study, 2018/19 (PwC, London, 2018).
There are wide variations in payment terms, customer types, discount practices and so on, across
different geographical areas, sectors and within each sector. By way of example, a 2017 New
Zealand working capital report provided figures for a range of sectors, but also provided figures for
the best and worst performer in each sector. They found the following:
Sector Best Worst
This implies that there is tremendous scope for all but the very best businesses to make
considerable efficiencies in working capital management.
Source: McGrathNicol, New Zealand Working Capital Report 2017 (McGrathNicol, Auckland, 2017).
Real World 13.2 focuses on the working capital problems of large businesses. For smaller businesses,
however, these problems may be even more acute.
Activity 13.1
Why might smaller businesses carry more excess working capital than larger businesses? Try to think of
at least one reason.
Reflection 13.1
What are the likely working needs of our restaurateur Lucas, and our agricultural engineer Tim?
Concept check 1
Which of the following lists contains an item that is NOT working capital?
A. Accounts payable, debtors, cash, accounts receivable
B. Bank overdraft, inventory, work-in-progress, accounts receivable
C. Creditors, inventory, cash, accounts receivable, raw materials
D. Accounts payable, bank overdraft, cash, accounts receivable, finished goods
E. None of the above. No non-working capital items are listed.
Concept check 2
Which list properly depicts the working capital cycle for a retailer?
A. Raw materials purchase, labour payments, work-in-progress production, raw
materials payments, finished goods production, finished goods sales, accounts
receivable collection
B. Inventory purchases, labour payments, work-in-progress production, raw materials
payments, finished goods production, finished goods sales, accounts receivable
collection
C. Inventory purchases, labour payments, inventory payments, sales of goods,
accounts receivable collection
D. Raw materials purchase, labour payments, work-in-progress production, raw
materials payments, sales of goods, accounts receivable collection
E. Inventory purchases, labour payments, inventory payments, finished goods
production, sales of goods, accounts receivable collection.
Concept check 3
Which of the following statements is false?
A. Working capital management is an essential part of a firm’s long-term planning.
B. Cost–benefit analysis should be used to determine working capital levels.
C. The components of working capital will vary depending on the type of business.
D. Working capital represents a net investment in short-term assets, which continually
flow in and out of the business and are essential for day-to-day operations.
E. None of the above is false. All are true statements.
The management of inventories
LO 2 Demonstrate the importance of inventory, and the techniques available to manage this asset
efficiently
A business may hold inventories for various reasons, and the most common of these is to meet the
immediate day-to-day requirements of customers and production. However, a business may hold more
than is necessary for this purpose if it believes that future supplies may be interrupted or scarce. Similarly,
if it believes that the cost of inventory will rise in the future, it may decide to stockpile.
For some types of business the inventory held may represent a substantial proportion of the total assets
held. For example, a car dealership that rents its premises may have nearly all of its total assets in the
form of inventory. In the case of manufacturing businesses, inventory levels tend to be higher than in
many other forms of business, as it is necessary to hold three kinds of inventory—raw materials, work-in-
progress and finished goods. Each form of inventory represents a particular stage in the production cycle.
For some types of business the level of inventory held may vary substantially over the year due to the
seasonal nature of the industry—for example, hard-copy greeting-card manufacturers—whereas for other
businesses inventory levels may remain fairly stable throughout the year.
A business that holds inventory simply to meet the day-to-day requirements of its customers and
production normally tries to minimise the inventory because it incurs significant costs. These include
storage and handling costs, financing costs, the risks of pilferage and obsolescence, and the
opportunities forgone by tying up funds in this form of asset. However, a business must also recognise
that if the inventory level is too low there will also be associated costs. Examples include:
loss of sales, from being unable to provide the goods required immediately
loss of customers’ goodwill, by being unable to satisfy their demand
high transport costs incurred to replenish inventories quickly
lost production due to the shortage of raw materials
inefficient production scheduling due to shortages, and
purchasing inventories at a higher price than what might have been normal in an effort to replenish
inventories quickly.
Inventories can be properly managed by using a range of procedures and techniques, as reviewed below.
Financial ratios
One ratio that can be used to help monitor inventory levels is the inventories turnover period, which we
examined in Chapter 8 . You may recall that this ratio is calculated as follows:
This will provide a picture of the average period in days for which inventory is held, and can be useful as a
basis for comparison. This ratio gives a figure often referred to as ‘days inventory on-hand (DIO)’ in the
working capital literature. It is possible to calculate the turnover period for individual product lines as well
as for inventory as a whole.
lead time
The time lag between placing an order for goods or services and their delivery to
the required location.
EXAMPLE
13.1
An electrical retailer holds a particular type of light switch in its inventory. The annual demand for
the light switch is 10,400 units, the lead time for orders is four weeks, and demand for the switch is
steady throughout the year.
The average weekly demand for the inventory item is 10,400/52=200 units. During the time
between ordering the inventory and receiving the goods, the inventory sold will be
4x200 units=800 units. So the company should reorder no later than when the inventory level goes
down to 800 units, to avoid a stockout (i.e. running out of stock/inventory).
Most businesses have to deal with some uncertainty about inventory levels, and they sometimes maintain
a buffer or safety inventory level in case problems occur. The amount of safety inventory to be held is
really a matter of judgement, depending on:
The effect of holding a buffer inventory will be to raise the inventory level and cost; however, the holding
cost must be weighed against the cost of running out of inventories, in terms of lost sales, production
problems and so on.
Activity 13.2
Assume the same facts as in Example 13.1 , except that the business wishes to maintain buffer
inventories of 300 units. At what level should the business reorder?
Activity 13.3
Hora Ltd holds inventories of a particular type of motor car tyre, which is ordered in batches of 1,200
units. The supply lead times and usage rates for the tyres are:
1. At what minimum level of inventories should Hora Ltd place a new order to guarantee it will not to
run out?
2. What is the size of the buffer inventories based on the most likely lead times and usages?
3. If Hora Ltd were to place an order based on the maximum lead time and usage, but only the
minimum lead time and usage were actually to occur, what would be the level of inventories
immediately following the delivery of the new inventories? What does this inventories figure
represent?
Real World 13.3 illustrates the difficulty businesses have in deciding on what levels of stock to order,
and the ways in which retailers are thinking about inventory management.
Walmart, which was in a protracted and intense battle with Amazon, miscalculated its online
inventory for the Christmas holiday season, which saw its share price fall by more than 10% as a
result.
‘[A]s holiday goods like TVs and toys flooded Walmart’s e-commerce warehouses, they squeezed
the room for everyday items such as toilet paper. That meant the retailer ran out of some items,
hurting online sales.’ While at the time e-commerce accounted for only about 4% of Walmart’s
sales, it had been expecting growth in its online sales of 40% and had invested substantially in its
web-based activities.
Source: Sarah Nassauer, ‘Walmart shares dive after inventory blunder’, The Wall Street Journal, 21 February 2018.
Home Depot, a major US home-improvement business, which sells both through stores and
online, ‘wants fewer items on its shelves and it wants them to be within customers’ reach’. The
company is still aiming for 15% growth by 2018 and ‘wants to keep inventory levels flat or
slightly down’.
Various ways were identified to deal with this issue, including: reducing the number of items,
notably bulky items, which take up a lot of space; widening the aisles to ‘reduce the amount of
goods on its shelves’; and moving ‘bulky items such as patio furniture’ out of the individual
stores and ‘into centralised distribution centres’.
The creation of large online sales has also prompted a rethink of strategy regarding inventory in
the retail sector. The question as to how to service both online and traditional customers
effectively requires considerable thought.
While inventory is trending downwards, care is still being taken to balance this against any
potential customer dissatisfaction with de-stocking leading to a lack of immediate availability.
The trend seems to be to ‘put less inventory in the stores, but replenish more frequently’. More
emphasis needs to be on management of the supply chain.
Source: Paul Ziobro, ‘Home Depot leads retailers’ inventory rethink’, The Wall Street Journal, 29 June 2016.
Class discussion point
1. What do you see as the main problems and opportunities for a business developing its
online business alongside a normal retailing operation?
Reflection 13.2
Assume that you work in the marketing department of a company. How might you contribute to the
decision about the level of inventory to be held? What differences might it make to your answer if
you are working for a company like Walmart which is expanding its online activity? If you were
working for Home Depot (see Real World 13.3 ), what input would you like into the decisions
being made?
Levels of control
Management must make a commitment to the management of inventory, but the cost of controlling
inventory must be weighed against the potential benefits. It may be possible to have different levels of
control according to the nature of the inventory held: the ABC system of inventories control is based
on this idea of selective levels. A business may be able to divide its inventory into three broad categories
—A, B and C—each one based on the value of inventory held. Category A will represent the high-value
items. However, although these items may represent a high proportion of the total value of inventory held,
they may represent only a relatively small proportion of its total volume. For example, 10% of the physical
inventory held may account for 65% of the total value. For these items, management may decide to use
sophisticated recording procedures, exert tight control over inventory movements, and keep a high level
of security at the inventory location.
Category B will represent less valuable inventory items. Perhaps 30% of the total volume of inventory
may account for 25% of the total value held. For this category a lower level of recording and management
control would be appropriate.
Category C will represent the least valuable items. Say 60% of the volume of inventory may account for
10% of the total value held. For these items the level of recording and management control would be
lower still. Categorising inventory in this way (see Figure 13.3 ) can help to ensure that management
effort is directed towards the most important areas and that the costs of controlling inventories are
commensurate with their value.
Category A contains inventories that, although relatively low in quantity, account for a large proportion of
the total value. Category B inventories consist of those items that are less valuable but more numerous.
Category C comprises those inventory items that are numerous but relatively low in value. Different
inventory control rules would be applied to each category. For example, only category A inventories would
attract the more expensive and sophisticated controls.
Here we assume that there is a constant rate of usage of the inventory item, and that inventories are
reduced to zero just as new inventories arrive. At time ‘0’ there is a full level of inventories. This is steadily
used as time passes; just as it falls to zero, it is replaced. This pattern is then repeated.
The EOQ model recognises that the total cost of inventory is made up of the costs of holding inventory
and the costs of ordering inventory. It calculates the optimum size of a purchase order by taking account
of both of these cost elements. The cost of holding inventory can be substantial, so management may try
to reduce the average amount that is held to as low a level as possible. However, by reducing its level,
and therefore its holding costs, the business will need to increase the number of orders during the period
and so ordering costs will rise.
Figure 13.5 shows that, as the level of inventory and the size of orders increase, the annual costs of
placing orders will probably decrease because fewer orders will be placed. However, the cost of holding
inventory will increase as there will be higher inventory levels. The total costs curve, which is a function of
the holding costs and ordering costs, will fall to a minimum level. Thereafter, total costs begin to rise. The
point of minimum costs corresponds with an inventory level E, as shown in the figure.
The EOQ model aims to identify the size of the order that minimises the total costs. If it can do this, the
EOQ will represent the optimum amount that should be ordered on each occasion. The EOQ can be
calculated by using the following equation:
EOQ=2DCH
where
D = the annual demand for the item of inventory C = the cost of placing an order H =
the cost of holding one unit of inventory for one year .
Activity 13.4
HLA Ltd sells 2,000 units of product X each year. It has been estimated that the cost of holding one unit of
the product for a year is $4. The cost of placing an order for inventory is estimated at $25. Calculate the
EOQ for the product.
Note that the cost of the inventories concerned, which is the price paid to the supplier, does not directly
affect the EOQ model. The EOQ model is only concerned with the administrative costs of placing each
order and the costs of looking after the inventories. Where the business operates an ABC system of
inventory control, however, more expensive inventory items will have greater holding costs. So the cost of
the inventories may have an indirect effect on the economic order size that the model recommends.
However, these limiting assumptions do not mean we should underrate the model. It can be developed to
accommodate the problems of uncertainty and uneven demand. Many businesses use this model (or a
development of it) to help with the management of inventory.
Activity 13.5
Petrov Ltd sells 10,000 tonnes of sand each year, and demand is constant over time. The purchase cost
of each tonne is $15, and the cost of placing and handling an order is estimated to be $32. The cost of
holding one tonne of sand for one year is estimated to be $4. The business uses the EOQ model to
determine the appropriate order quantity and holds no buffer inventories. Calculate the total annual cost
of trading in this product.
just-in-time (JIT)
A system of inventories management that aims to have supplies delivered just in
time for their required use in production or sales.
For JIT to be successful, it is important that the business informs suppliers of its production plans and
inventory requirements in advance, and that suppliers deliver materials of the right quality at the agreed
times. Failure to do either could lead to a dislocation of production or supply to customers and could be
very costly. Thus, a close relationship is required between the JIT business and its suppliers. This close
relationship also enables suppliers to schedule their own production to suit their customers. Ideally, JIT
suppliers and customers should gain a net saving between them from the reduced amount of inventories
held. Adopting JIT may well require re-engineering a business’s production process. To ensure that
orders are quickly fulfilled, factory production must be flexible and responsive. This may require changes
to both production layout and working practices. Production flows may have to be redesigned, and
employees may have to be given greater responsibility, allowing them to deal with unanticipated problems
and encouraging greater commitment. Information systems must also be installed that facilitate an
uninterrupted production flow.
Although a business using JIT does not have to hold inventory, JIT involves certain costs. As the
suppliers probably have to hold inventory for the business, they may try to recoup this additional cost by
raising their prices. Also, the close relationship necessary between the business and its suppliers may
prevent the business from taking advantage of cheaper sources of supply when they become available.
The close relationship between business and supplier, however, should enable the supplier to predict the
business’s inventories needs.
Many people view JIT as more than simply an inventory control system. The philosophy behind this
method is concerned with eliminating waste and striving for excellence. It expects that suppliers will
always deliver materials on time and that there will be no defects in them. JIT also expects that the
production process will operate at maximum efficiency. This means there will be no production
breakdowns, and the queuing and storage times of manufactured products will be eliminated, as only the
time that is spent directly on processing the products is considered to add value. While these
expectations may be impossible to fulfil, they do help to create a culture that is dedicated to the pursuit of
excellence.
A final point worth making is that successful implementation of a JIT system rests with the workforce. A
more streamlined and efficient production flow will be achieved only if workers are well trained and fully
committed to the pursuit of quality. They must be prepared to operate as part of a team, and to adapt to
changes in both the nature and the pace of working practices. They must also be prepared to show
initiative in dealing with problems arising in the production process.
Real World 13.4 shows how Nissan is using JIT in the United Kingdom, and also how Walmart is
changing its approach to delivery times for inventory.
More recently, however, Nissan has drawn back from its total adherence to JIT. By using only local
suppliers, it had cut itself off from the opportunity to exploit low-cost suppliers, particularly those
located in China. A change in policy has led the business to hold buffer inventories for certain
items to guard against disruption of supply arising from sourcing parts from the Far East.
Most automobile companies use JIT in some areas. Other companies that have used JIT
successfully include Dell and Harley Davidson.
Source: Christopher Ludwig, ‘Local logistics and engineering partnership at Nissan Europe’, Automotive Logistics, 6 February 2014.
Source: Sarah Nassauer and Jennifer Smith, ‘Wal-Mart tightens delivery times for suppliers’, The Wall Street Journal, 21 February 2018.
There are currently a range of trends that are likely to impact on inventory management in the future.
Real World 13.5 provides an indication of these.
A search of the Internet fairly quickly finds a number of blogs dealing with this topic. They generally
include the following or variations along a similar theme.
Customer orientation
Omni-channel shopping experience—where people get better at multi-tasking, and customers
should be able to interact with the product in a shop, on a mobile, or on a desktop-friendly
website and have the same experience.
Variable logistics—customers needs require variable delivery options.
Sources: Megan Nichols, ‘Watch out for these 6 Inventory Management trends in 2018’, Fishbowl, 21 January 2018, https://www.fishbowlinventory.com/blog/
2018/02/21/watch-out-for-these-6-inventory-management-trends-in-2018. Magentone Developers, ‘Big trends for inventory management in 2018’, Magentone
Developers Website, 5 March 2017, http://magentone.over-blog.com/2017/03/big-trends-for-inventory-management-in-2018. Kevin Hill, ‘5 trends impacting modern
ottomotors, ‘5 supply chain logistics trends for 2018’, ottomotors, 25 May 2018, https://ottomotors.com/blog/5-supply-chain-logistics-trends-2018
Concept check 4
Which of the following statements is false?
A. Inventory is commonly held to meet the immediate day-to-day requirements of
customers and production.
B. For some types of business the level of inventory held may vary substantially over
the year due to the seasonal nature of the industry.
C. A business that holds inventory simply to meet the day-to-day requirements of its
customers and production normally tries to minimise its inventory level.
D. Lower inventory levels will result in lower overall costs.
E. None of the above are false. All are true statements.
Concept check 5
Inventory management techniques include which of the following?
A. Statistical analysis for sales demand forecasting and monitoring of inventory turnover
ratio
B. Periodic checking of inventory levels for reordering point determination and use of
EOQ models
C. ABC method of analysing and controlling inventories
D. JIT inventory management
E. All of the above.
Concept check 6
Which of the following is NOT a limitation of the EOQ method of inventory management?
A. Discounts for bulk purchases are not taken into account.
B. The EOQ method assumes stable demand.
C. Calculation of a precise order quantity is time-consuming.
D. The EOQ method assumes that product demand can be accurately predicted.
E. None of the above. All are limitations of EOQ.
The management of accounts receivable (debtors)
LO 3 Discuss the provision of credit to customers, and use various management tools to monitor and
control the resulting asset
Selling goods or services on credit incurs costs. These include credit administration costs, bad debts and
opportunities forgone in using the funds for more profitable purposes. However, these costs must be
weighed against the benefits of increased sales gained by allowing customers to delay payment.
Selling on credit is widespread and appears to be the norm outside the retail trade. When a business
offers to sell its goods or services on credit, it must make the following policies clear:
1. Capital. The customer must appear to be financially sound before any credit is extended. If the
customer is a business, its accounts should be examined. Particular regard should be given to the
customer’s profitability and liquidity, and any onerous financial commitments must be taken into
account.
2. Capacity. The customer must seem able to pay amounts owing. Where possible, the customer’s
payment record should be examined. If the customer is a business, the type of business and its
physical resources are relevant. The value of goods that the customer wishes to buy on credit must
be in keeping with its financial resources.
3. Collateral. On occasions, it may be necessary to ask for some kind of security for goods supplied
on credit. When this occurs, the business must be convinced that the customer is able to offer a
satisfactory form of security.
4. Conditions. The state of the industry in which the customer operates and the general economic
conditions of its particular region or country may have an important influence on its ability to pay
the amounts outstanding on the due date.
5. Character. It is important for a business to make some assessment of the customer’s character,
as willingness to pay will depend on the customer’s honesty and integrity. If the customer is a
limited company, this will mean assessing the characters of its directors. The business must feel
satisfied that the customer will make every effort to pay any amounts owing.
five Cs of credit
It should now be clear that a business needs to gather information on the customer’s ability and
willingness to pay the amounts at the due date. Sources of information you might choose to help you
assess the company’s financial health include the following:
Trade references. Some businesses ask a potential customer to give them references from other
suppliers the customer has dealt with. This may be extremely useful, so long as such references are
genuine. There is a danger that a potential customer will be highly selective with references from other
suppliers, to make a good impression.
Bank references. It is possible to ask the potential customer for a bank reference. Although banks are
usually prepared to oblige, the content of a reference is not always very informative. If customers are
in financial difficulties, their banks are usually unwilling to add to their problems by supplying poor
references.
Annual accounts. All public limited companies and all large proprietary companies are required to
prepare an annual report. These are available for public inspection and can provide a useful insight
into performance and financial position. Many companies also publish their annual financial
statements on their websites or on computer-based information systems. A problem with the publicly-
available financial statements is that they are often quite out of date by the time they can first be
examined by the potential supplier of credit. Under the circumstances, the company that is being
asked to grant credit could reasonably expect to receive a copy of the financial report, whether it is
legally required to or not. A company that is not prepared to provide a copy of its report is potentially a
greater risk to the business considering credit.
The customer. You may wish to interview the directors of the company and visit its premises to gain
some impression of how it conducts its business. Where a significant amount of credit is required, the
business may ask the company for internal budgets and other unpublished financial information to
help assess the level of risk.
Credit agencies. Specialist agencies provide information that can be used to assess the
creditworthiness of a potential customer. Such information may be gleaned from various sources,
including the accounts of the customer, court judgments, and news items about the customer from
published and unpublished sources.
Other suppliers. Similar businesses will often be prepared to exchange information concerning slow
payers or defaulting customers through an industry credit circle. This can be a reliable and relatively
cheap way of obtaining information.
Once a customer is considered creditworthy, credit limits for the customer should be established. When
doing so, the business must take account of its own financial resources and risk appetite. Unfortunately,
there are no theories or models to guide a business when deciding on the appropriate credit limit to adopt;
it is really a matter of judgement. Some businesses adopt simple ‘rule of thumb’ methods based on the
amount of sales made to the customer (say, twice the monthly sales figure for the customer) or the
maximum the business is prepared to be owed (say, a maximum of 20% of its working capital) by all of its
customers.
The last factor may require some explanation. The marketing strategy of a business may have an
important influence on the length of credit allowed. For example, if it wishes to increase its market share,
it may decide to liberalise its credit policy to stimulate sales. Potential customers may be attracted by the
offer of a longer period in which to pay. However, any such change in policy must take account of the
likely costs and benefits, as the following example shows.
Example 13.2 demonstrates how a business should assess changes in credit terms. However, if
extending the length of credit runs the risk of an increase in bad debts, this should also be taken into
account in the calculations, as should any additional collection costs incurred.
EXAMPLE
13.2
Senior Ltd was formed in 2020 to produce a new type of golf putter. The company sells the putter
to wholesalers and retailers and has an annual sales turnover of $1.2 million. The following data
relates to each putter produced.
$ $
Selling price 72
Profit 24
Senior Ltd wishes to expand the sales of this new putter, and believes this can be done by offering
customers a longer period in which to pay. Its current average collection period is 30 days.
Senior’s three options for increasing sales are as follows:
Option
1 2 3
Prepare calculations to show which credit policy the company should offer its customers.
To decide on the best option to adopt, the company must weigh the benefits of each option against
its cost. The benefits will entail the increase in profit from the sale of additional putters. From the
cost data supplied we can see that the contribution (i.e. sales less variable costs) is $36 per putter.
This represents 50% of the selling price. The fixed costs can be ignored in our calculations, as they
will remain the same whichever option is chosen.
Option
1 2 3
Option
1 2 3
Planned level of accounts receivable
The increase in accounts receivable which results from each option will mean an additional cost to
the company, since it has an estimated cost of capital of 15%. Thus, the cost of the increase in the
additional investment in accounts receivable will be:
Option
1 2 3
Option
1 2 3
The calculations show that option 2 will be the most profitable, but there is little to choose between
options 2 and 3.
Example 13.2 illustrates the broad approach that a business should take when assessing changes in
credit terms. However, by extending the length of credit, other costs may be incurred. These may include
bad debts and additional collections costs, and should also be taken into account in the calculations.
Approaching the problem as an NPV assessment is not different in principle from the way that we dealt
with the decision in Example 13.2 . In both approaches the time value of money is considered, but in
Example 13.2 we did it by charging interest on the outstanding accounts receivable.
cash discount
A reduction in the amount due for goods or services sold on credit in return for
prompt payment.
In practice, there is always the danger that a customer may be slow to pay and yet may still take the
discount offered. If the customer is important to the business, it may be difficult for the business to insist
on full payment. Some businesses may charge interest on overdue accounts to encourage prompt
payment. However, this is only possible if the business is in a strong bargaining position with its
customers. For example, it may be the only supplier of a particular product in the area.
Reflection 13.4
Tim, our agricultural engineer, finds himself in a position where he regularly gets paid late (usually
by many weeks), net of the discount. How might he deal with this?
Activity 13.6
Williams Wholesalers Ltd at present requires payment from its customers by the end of the month after
the month of delivery. On average, it takes customers 70 days to pay. Sales amount to $4 million per
year, and bad debts to $20,000 per year.
It is planned to offer customers a cash discount of 2% for payment within 30 days. Williams estimates that
50% of customers will accept this facility, but that the rest, who tend to be slow payers, will not pay until
80 days after the sale. At present the company has a partly used loan facility costing 13% per annum. If
the plan goes ahead, bad debts will be reduced to $10,000 per annum and there will be savings in credit
administration expenses of $6,000 per annum.
Should Williams Wholesalers Ltd offer the new credit terms to customers? Support your answer with any
calculations and explanations you consider necessary.
Collection policies
A business offering credit must ensure that amounts owing are collected as quickly as possible. Various
steps can be taken to achieve this, including the following.
Develop customer relationships. For major companies it is often useful to cultivate a relationship
with the key staff responsible for paying sales invoices. This increases the chances of prompt
payment. For less important customers, the business should at least identify which key staff
responsible for paying invoices can be contacted over a payment problem.
Publicise credit terms. The credit terms of the business should be made clear in all relevant
correspondence, such as order acknowledgements, invoices and statements. In early negotiations
with the prospective customer, credit terms should be openly discussed and an agreement reached.
Issue invoices promptly. An efficient collection policy requires an efficient accounting system.
Invoices must be sent out promptly, along with regular monthly statements. Reminders must also be
dispatched promptly where necessary. If a customer fails to respond to a reminder, the accounting
system should alert managers so that a stop can be placed on further deliveries.
Monitor outstanding debts. Management can monitor the efficiency of collection policies in several
ways. One method (dealt with in Chapter 8) is to calculate the ratio for the average settlement
period for accounts receivable. This ratio, you may recall, is calculated as follows:
Average settlement period for accounts receivable = Average accounts receivable Credit sales × 365
Although this ratio can be useful, remember that it produces an average figure for the number of days that
debts are outstanding. This average may be badly distorted by a few large customers who are also very
slow payers. This ratio is usually called ‘days sales outstanding (DSO)’ in the working capital literature.
Produce an ageing schedule of accounts receivable. A more detailed and informative approach to
monitoring accounts receivable is to produce an ageing schedule of accounts receivable .
Accounts receivable are divided into categories according to the length of time the debt has been
outstanding. An ageing schedule can be produced regularly to help managers see the pattern of
outstanding debts. Example 13.3 illustrates this.
EXAMPLE
13.3
Ageing schedule of accounts receivable at 31 December
Days outstanding
Customer $ $ $ $
B Ltd – 24,000 – –
This shows a business’s accounts receivable figure at 31 December, which totals $111,000. Each
customer’s balance is analysed according to how long the debt has been outstanding. Thus, we
can see from the schedule that A Ltd has $20,000 outstanding for 30 days or less, and $10,000
outstanding for between 31 and 60 days. This information can be very useful for credit control
purposes.
Computers can make the task of producing such a schedule simple and straightforward. Many accounting
software packages now include this ageing schedule as one of the routine reports available to managers.
Many such packages can put customers on hold when they reach their credit limits. Putting a customer
‘on hold’ means that no further credit sales will be made to them until their accounts receivable balance
has been settled.
Answer queries quickly. It is important for relevant staff to deal quickly and efficiently with customer
queries on goods and services supplied. Customers are unlikely to pay until their queries have been
dealt with.
Deal with slow payers. Almost inevitably a business making significant sales on credit will have
customers who do not pay. When this occurs, there should be set procedures for dealing with the
problem. There should be a timetable for sending out reminders and for adding customers to a ‘stop
list’ for future supplies. The timetable may also specify the point at which the unpaid amount is passed
to a collection agency for recovery. These agencies often work on a ‘no collection, no fee’ basis.
Charges for their services vary, but can be up to 15% of the amounts collected. However, the cost of
taking action against delinquent customers must be weighed against the likely returns. For example,
there is little point in pursuing a customer through the courts and incurring large legal expenses if
there is evidence that they cannot pay. Where possible, the cost of bad debts should be taken into
account when pricing products or services.
A slightly different approach to exercising control over accounts receivable is to identify the monthly
pattern of receipts from credit sales. This involves monitoring the percentage of accounts receivable paid
(and the percentage of debts that remain unpaid) in the month of sale, and the percentage paid in
subsequent months. To do this, credit sales for each month must be examined separately. To illustrate
how a pattern of credit sales receipts is produced, consider a business that achieved credit sales of
$250,000 in June and received 30% of the amount owing in the same month, 40% in July, 20% in August
and 10% in September. The pattern of credit sales receipts and amounts owing would be as shown in
Table 13.1 .
Receipts from June credit sales Received Amount outstanding from June sales at month-end Outstanding
Month $ % $ %
September 25,000 10 – –
Table 13.1 shows how cash from sales for June were received over time. This information can be used
as a basis for control. The actual pattern of receipts can be compared to the expected (budgeted) pattern
of receipts to see whether there is any significant deviation. If this comparison shows that customers are
paying more slowly than expected, management may decide to take corrective action. This might include:
In 2015 Dun and Bradstreet prepared a summary of average payment times over the period from
2006 to 2015. This showed that average invoice payment times for Australia were in a range
between 51 and 57 days for the period from 2006 to mid-2014. By the third quarter of 2015
payment periods fell to 45 days. However, the proportion of businesses that paid promptly (i.e.
within 30 days) actually fell from 68% in the second quarter to 66% in the third; 26% of businesses
paid their invoices in 31–60 days; 5% paid in 61–90 days; 22% in 91–120 days; and 1% in 121
days plus. Businesses in the utilities sector continued to be the slowest to pay their invoices, with
an average of 53.7 days.
For the September quarter of 2018 ‘Australian businesses continue to set records for paying
overdue bills faster’, with the new 10.4-day low, the lowest on record. Agriculture was the lowest
sector with 7.1 days, down from 21.2 in March 2014. Retailing had the highest figure of 13.5 days,
down from 21.5 in March 2014. Mining had a figure of 11.7 days, down from 21.4 in March 2014. A
new high was achieved for payments on time, at 71.7%. Note that these figures relate to the length
of time bills are overdue. In order to arrive at the average payment times, we need to add the
normal period of credit, usually 30 days. Small businesses received payment 6.7 days later than
large businesses, on average. ‘The largest businesses remain well behind Australia’s smaller
entities’.
It is interesting to note that Business Council Australia launched the Supplier Payment Code,
which was endorsed by the Council of Small Business Australia in 2017. This is a voluntary code in
which signatory organisations commit to pay eligible small business suppliers within 30 days, pay
all suppliers on time, provide clear guidance about payment procedures to suppliers, work with
suppliers to improve invoicing and payments practices, follow a process for resolving disputes and
complaints, and have basic reporting on company policies and practices in place to comply with
the code. A similar code was developed in the United Kingdom in 2015.
Sources: Dun and Bradstreet, ‘Payment times plummet’, Scoop, 23 June 2015, https://www.scoop.co.nz/stories/BU1506/S00798/payment-times-plummet.htm.
Illion (formerly Dun & Bradstreet), Australian Late Payments Analysis, September Quarter 2018, 11 December 2018.
Australian_supplier_payment_code_2019_MARCH.pdf?1552016780
Concept check 8
A business needs to gather information on customer likelihood of payment. Sources of
information you might choose to help you assess a company’s financial health include the
following:
A. Trade and bank references
B. Financial statements
C. Credit agencies
D. Industry credit circle
E. All of the above.
Concept check 9
Which of the following policies might be unlikely to ensure that credit sales amounts are
collected as quickly as possible?
A. Issue invoices promptly.
B. Make credit terms clear.
C. Deal with slow payers.
D. Respond to customer queries and complaints on a limited scope.
E. Monitor outstanding debts with an ageing schedule.
The management of cash
LO 4 Explain the reasons for holding cash, and the basis of its management and control
Transactionary motive. To meet its day-to-day commitments a business requires a certain amount of
cash. Payments in respect of wages, overhead expenses, goods purchased, etc., must be made at
the due dates. Cash has been described as the ‘life blood’ of a business. Unless it ‘circulates’ through
the business and is available for the payment of maturing obligations, the survival of the business will
be put at risk. We saw in an earlier chapter that profitability alone is not enough—a business must
have sufficient cash to pay its debts when they fall due.
Precautionary motive. If future cash flows are uncertain for any reason, it would be prudent to hold a
balance of cash. For example, if a major customer owing a large sum to the business is in financial
difficulties, the business can retain its capacity to meet its obligations by holding a cash balance.
Similarly, any uncertainty over future outlays requires a cash balance.
Speculative motive. A business may decide to hold cash so that it can exploit profitable opportunities
as and when they arise. For example, by holding cash a business may be able to acquire a competitor
business that suddenly becomes available at an attractive price. Holding cash has an opportunity cost
for the business that must be taken into account. Thus, when evaluating the potential returns from
holding cash for speculative purposes, the cost of forgone investment opportunities must also be
considered.
Most businesses hold a certain amount of cash as part of the total assets held, although the amount may
vary considerably.
The nature of the business. Some businesses, such as utilities (e.g. water, electricity and gas
suppliers), have cash flows that are both predictable and reasonably certain. This enables them to
hold lower cash balances. For some businesses, cash balances may vary greatly according to the
time of year. For example, a seasonal business may accumulate cash during the high season to
enable it to meet commitments during the low season.
The opportunity cost of holding cash. Where there are profitable opportunities in which to invest,
either within or outside the business, it may not be economically prudent to hold a large cash balance.
The level of inflation. Holding cash during a period of rising prices will lead to a loss of purchasing
power. The higher the level of inflation, the greater will be the loss.
The availability of near-liquid assets. If a business has marketable securities or inventories that
may easily be liquidated, a high cash balance may not be necessary.
The availability of borrowing. If a business can borrow easily (and quickly)—for example, through a
bank overdraft—there may be less need to hold cash.
The cost of borrowing. When interest rates are high, the option of borrowing becomes less
attractive.
Economic conditions. When the economy is in recession, businesses may prefer to hold cash so
that they can be well placed to invest when the economy improves. In addition, during a recession
businesses may experience difficulties in collecting trade receivables. They may, therefore, prefer to
hold higher cash balances than usual in order to meet commitments.
Relationships with suppliers. Too little cash may hinder the ability of the business to pay suppliers
promptly. This can lead to a loss of goodwill; it may also lead to discounts being forgone.
When a cash surplus is expected to arise, managers must decide on the best use of the surplus funds.
When a cash deficit is expected, managers must make adequate provision by borrowing, liquidating
assets, or rescheduling cash payments and receipts to deal with this. Cash budgets are also useful in
helping to control the cash held. The actual cash flows can be compared to the budgeted cash flows for
the period. For any significant divergence between the budgeted cash flows and the actual cash flows,
explanations must be sought and corrective action taken where necessary. To refresh your memory on
cash budgets, review the section on preparing the cash budget in Chapter 11 .
The OCC is the time lapse between paying for goods and receiving the cash from the sale of those
goods. The length of the OCC has a significant impact on the amount of funds the business needs to
apply to working capital.
The operating cash cycle is the time period between the payment made relating to accounts payable for
goods supplied and the cash received from customers through accounts receivable. Although Figure
13.6 depicts the position for a retailing or wholesaling business, the precise definition of the OCC can
easily be adapted for both service and manufacturing businesses.
The operating cash cycle is important because it has a significant influence on the financing requirements
of the business. The longer the cash cycle, the greater the financing requirements and the greater the
financial risks. For this reason, a business is likely to want to reduce the operating cash cycle to a
minimum if possible.
For the type of business mentioned above, the operating cash cycle can be calculated from the financial
statements by the use of certain ratios. The cash cycle is calculated as shown in Figure 13.7 .
For businesses that buy and sell on credit, three ratios are required to calculate the OCC.
(We have already noted that there are alternative names given to the components of the operating cycle.
The average inventory holding period is often referred to as ‘days inventory outstanding (DIO)’. The
average settlement period is often referred to as ‘days sales outstanding (DSO)’. The average payment
period for accounts payable is often called ‘days payable outstanding (DPO)’.)
Activity 13.7
The following figures are taken from the financial statements of Freezeqwik Ltd, a distributor of frozen
foods, for the year ended 31 December last year:
$’000
Purchases 568
All purchases and sales are on credit. There has been no change in the level of trade receivables or
payables over the period.
Calculate the length of the OCC for the business, and go on to suggest how the business may seek to
reduce this period.
Activity 13.8
Assume that Freezeqwik Ltd (Activity 13.7 ) wishes to reduce its OCC by 30 days. Evaluate each of
the options available to this business.
An objective of working capital management may be to maintain the OCC at a particular budget target or
within certain limits each side of the target. A problem with this objective is that not all days in the OCC
are equally valuable. Take, for example, the information in Activity 13.7 , where the operating cycle is
119 days. If both accounts receivable and accounts payable were increased by seven days (by allowing
customers longer to pay, and by Freezeqwik taking longer to pay suppliers), the OCC would be
unchanged at 119 days. This would not, however, leave the amount tied up in working capital unchanged.
Accounts receivable would increase by $15,726 (i.e. 7 × $ 820,000 / 365 ), whereas accounts payable
would increase by only $10,893 (i.e. 7 × $ 568,000 / 365 ). This would mean a net increase of $4,833 in
working capital.
Real World 13.7 provides information about the average OCC in various parts of the world.
The PwC’s annual global Working Capital Study provides extensive information across the world
on what it calls net working capital. Table 13.2 provides some examples of this ratio for 2017,
for selected countries or regions. The figures are rounded.
DSO 45 39 48 40 63 47
DIO 60 37 60 48 64 51
DPO 68 43 72 57 73 64
C2C 39 32 41 34 56 35
A b b r e v i a t i o n s : C2C = cash-to-cash ratio; DIO = days inventory outstanding; DPO = days payable outstanding; DSO =
days sales outstanding .
Source: Based on information from PwC, Navigating Uncertainty: PwC’s Annual Global Working Capital Study, 2018/19 (PwC, London, 2018).
Over the preceding year 11 out of 17 sectors had improved their working capital performance,
with the largest reduction being in energy and utilities.
Between sectors and within sectors there were wide variations in performance.
Improvements often came at the expense of suppliers, as 11 sectors ‘have further stretched
their payable days’, this being the easiest approach.
Changing the supply chain is perceived as hard and slow.
Size still matters.
It is recommended that you print out the entire report from the website and examine it more fully. It
forms the basis of the Case Study for this chapter.
Source: Based on information from PwC, Navigating Uncertainty: PwC’s Annual Global Working Capital Study, 2018/19 (PwC, London, 2018).
Cash transmission
A business will normally wish to benefit from receipts from customers at the earliest opportunity. Where
cash is received, the benefit is immediate. Where payment is made by cheque, however, there may be a
delay before it is cleared through the banking system. The business must therefore wait before it can
benefit from the amount paid in. In recent years, improvements have helped to reduce the time that
cheques spend in the banking system. It is now possible for cheques to be fast-tracked so that they reach
the recipient’s bank account on the same day. Payment by cheque, however, is in decline. Increasingly,
customers prefer to instruct their bank (usually through internet banking) to make a direct transfer of the
amount owed to the business’s bank account. The transfer may be completed within hours, and provides
a more efficient form of cash transmission for both parties.
Setting up a standing order or a direct debit is another way of carrying out transfers between a customer’s
bank account and the business’s bank account. In both cases, the transfer will take place on an agreed
date. Businesses providing services over time, such as insurance, satellite television and mobile phone
services, often rely on this method of payment.
A final way in which a business may be paid promptly is through the use of a debit or credit card. This
allows the customer’s bank account or credit card account to be charged, and the seller’s bank account to
be simultaneously increased with the sale price of the item, less any commission in the case of a credit
card. Many types of business, including retailers and restaurants, use this method. It is operated through
computerised cash tills and is referred to as electronic funds transfer at point of sale (EFTPOS).
These days, the use of direct-credit transfer or credit or debit cards is extensive. With credit transfer, the
cash is transferred instantly (or at least over a very short timeframe). When a customer uses a debit card
it effectively leads to an instant draw-down of funds from the cardholder’s bank account. With credit cards,
purchasers are charged with the amount of the purchases, and the business (merchant) is paid directly by
the financial institution associated with the card. With credit cards, the purchaser does not have to pay for
the goods immediately, but can pay them off in line with the agreed terms and conditions associated with
the particular card. Interest associated with unpaid credit-card balances tends to be high. The advantages
for businesses of entering into credit-card facilities include the following:
The financial institution undertakes its own credit assessment of each potential cardholder, so the
business can be sure that cash is received.
It reduces losses from errors (e.g. no change is given, no losses associated with refund payments).
There is less risk of theft of cash, since the balances of cash held will be much lower.
It reduces the amount of time managing and handling cash.
Cash is received in the business bank account more quickly than by use of most other methods.
It has been suggested that the average value of transactions made with a debit/credit card is higher
than for purchases made with cash.
Use of cards is convenient for purchasers and has been associated with enhanced sales.
The downside is that credit cards usually involve higher costs as a percentage of average transaction
value.
Bank overdrafts
Bank overdrafts are simply bank current accounts that contain a negative amount of cash. They are a
type of bank loan, and we look at them in Chapter 14 . They can be useful for managing the business’s
cash flow requirements.
Concept check 10
According to economic theory, the three motives for holding cash are:
A. Transactionary, precautionary and exploratory
B. Transactionary, precautionary and speculative
C. Transactionary, protective and speculative
D. Transactionary, preventive and speculative
E. Transactionary, precautionary and provisional.
Concept check 11
Which of the following should influence the amount of cash that a firm holds?
A. Opportunity cost of holding cash
B. Availability and cost of borrowing
C. Economic conditions
D. Relations with suppliers
E. All of the above.
Concept check 12
Which of the following statements is false?
A. The operating cash cycle is the time period between the payment made relating to
accounts payable for goods supplied and the cash received from customers through
accounts receivable.
B. The operating cash cycle is important because it has a significant influence on the
financing requirements of the business.
C. The shorter the cash cycle, the greater the financing requirements and the greater
the financial risks.
D. A business is likely to want to reduce the operating cash cycle to a minimum.
E. None of the above are false. All are true.
The management of accounts payable (creditors)
LO 5 Summarise the key aspects of management of accounts payable
Trade credit arises from the fact that most businesses buy their goods and service requirements on credit.
In effect, suppliers are lending the business money, interest-free, on a short-term basis. Accounts payable
(creditors) are the other side of the coin from accounts receivable (debtors). One business’s accounts
payable are another’s accounts receivable in a transaction. Trade credit is regarded as an important
source of finance by many businesses. It has been described as a ‘spontaneous’ source of finance, as it
tends to increase in line with the increase in sales. Trade credit is widely regarded as a ‘free’ source of
finance, and therefore a good thing to have. However, there may be real costs associated with taking
trade credit.
Customers who pay on credit may not be as well favoured as those who pay immediately. For example,
when goods are in short supply, credit customers may receive lower priority when it comes to allocating
inventory, setting delivery dates, or providing technical support. Sometimes, goods or services may be
more costly if credit is required, but in most industries trade credit is the norm and extra costs will not
apply unless, perhaps, the credit facilities are abused by the customer. A business purchasing supplies
on credit will also have to incur additional administration and accounting costs to deal with the scrutiny
and payment of invoices, the maintaining and updating of creditors’ accounts, and so on. In some cases,
delaying payment to suppliers beyond the due date can be taken as a sign of financial distress.
These points are not meant to imply that taking credit is a burden to a business. There are, of course, real
benefits that can accrue. Provided that trade credit is not abused, it can represent a form of interest-free
loan. It can be a much more convenient method of paying for goods and services than paying by cash,
and during a period of inflation there will be economic gain from paying later rather than sooner for goods
and services purchased. For most businesses, these benefits will exceed the costs involved.
Activity 13.9
Why might a supplier prefer a customer to take a period of credit rather than pay for the goods or services
on delivery? (There are probably two reasons.)
EXAMPLE
13.4
Simat Ltd takes 70 days to pay its supplier for goods. To encourage prompt payment, the supplier
has offered the company a 2% discount if it pays for goods within 30 days.
Simat Ltd is not sure whether the discount is worth taking. What is the annual percentage cost to
Simat Ltd of forgoing the discount?
If the discount is taken, payment could be made on the last day of the discount period (i.e. the 30th
day). However, if the discount is not taken, payment will be made after 70 days. This means that
by not taking the discount, Simat Ltd will receive an extra 40 days’ credit (i.e. 70 – 30), and the
cost of this extra credit will be the 2% discount forgone. If we annualise the cost of this discount
forgone we have:
2 % × 365 / 40 = 18.3 %
Note that this is an approximate annual rate. For the more mathematically minded, the precise rate
is:
( 1 + 2 / 98 ) 365 / 40 − 1 = 20.24 %
We can see that the annual cost of forgoing the discount is quite high, and so it may be profitable
for the company to pay the supplier within the discount period, even if it means that it will have to
borrow to do so.
Activity 13.10
During the last year Aussie Homeware purchased $180,000 inventory on credit from House of Fashion. At
the beginning of the year Aussie Homeware owed House of Fashion $40,000, and at the end of the year
$36,000. In an effort to improve Aussie Homeware’s payment rate, House of Fashion is offering them a
2% discount for payments made within 30 days.
1. Calculate Aussie Homeware’s average settlement period for its accounts payable.
2. What is the annual percentage cost to Aussie Homeware if it does not take advantage of the
discount offered?
This is frequently referred to as ‘days payable outstanding (DPO)’. Once again this provides an average
figure, which can be distorted. A more informative approach would be to produce an ageing schedule for
accounts payable. This would look much the same as the ageing schedule for accounts receivable
described earlier. Alternatively, you could prepare a pattern of credit payments similar to the pattern of
credit receipts discussed earlier.
Concept check 13
Which of the following should be considered when making credit purchases?
A. Trade credit is a free source of finance.
B. Cash customers may receive higher priority with delivery dates, support, etc.
C. The availability of cash discounts for prompt payment.
D. All of the above.
E. None of the above.
Concept check 14
Which of the following statements is false?
A. Delaying payments to suppliers provides an effective interest-free loan which will
never be seen as a sign of financial distress.
B. Accounts payable (creditors) are the other side of the coin from accounts receivable
(debtors).
C. Purchasing on credit will result in administration and accounting costs.
D. Accounts payable can be controlled with an ageing schedule.
E. None of the above are false. All statements are true.
Do you pay your bills on time? Do you know the consequences of not paying on time?
A 2010 study by Dun & Bradstreet found that one in three Australians indicated that in the year
ahead they would pay bills late. The pay TV account (33%), mortgages (25%), mobile phone
(19%) and electricity bill (17%) were the least likely to get paid if the household ran short of cash.
The study further revealed that many Australians were unaware of the consequences of paying
their bills late, with 57% indicating they would have been more likely to have paid the bill had they
known that late payments worsened their credit rating.
Not surprisingly, younger Australians and those on lower incomes were more likely to pay their bills
late.
At the time of this study, the late payment of bills could have a negative impact on an individual’s
ability to access credit for up to five years, and could result in the possible addition of an interest
component. A possible incidental cost is that it could lead to increased pressure on suppliers in
terms of cash flows, with the possible result being closure of the business and the loss of jobs.
In the study, the main reasons for non-payment were lack of money (47%) or forgetfulness (28%).
In 2014, new privacy and credit reporting laws were introduced. The new system has the potential
to further affect your ability to obtain credit, as the information available on your credit file—perusal
of which is the way lenders decide whether you can afford to pay back any debt you incur—will be
much more detailed. Basically, what this means is that it is now even more important that you
manage your credit positively and well. It may well be worth your while obtaining a copy of your
current credit file.
Times have moved on, but paying bills on time just became even more important, as from July
2018 comprehensive credit reporting started. Financial planner Paul Clitheroe explains the
implications: ‘The proposed legislation calls for our big financial institutions to provide details of
positive as well as negative events, and up to 24 months of debt repayment history can be
recorded on your personal credit file.’ Prompt payment will reflect favourably on your credit report.
The opposite is also true. This offers even more incentive to pay bills on time.
In an article published in July 2018, Dominic Powell revealed that one in six Australians struggle
with credit card debt, including small business owners. There were ‘14 million open credit card
accounts in Australia in June 2017, with outstanding balances totalling nearly $45 billion, of which
$31.7 billion was incurring interest. Between 2016–17, Australian consumers were charged $1.5
billion in credit card fees’.
The important message for consumers is: put yourselves in a position to understand what
information is listed on your credit records and act appropriately to manage your credit
commitments. Failure to do so could result in an inability to access credit in the future or to incur
high interest costs due to a poor credit history.
Sources: Dun & Bradstreet, ‘One in three Aussies to pay their bills late in the year ahead’, 25 May 2010. Paul Clitheroe, ‘Paying bills on time just became more
important’, MBA Financial Strategies, 19 April 2018. Dominic Powell, ‘ASIC reveals one in six Australians struggle with credit card debt, and that includes small
Reflection 13.5
Following from Accounting and You:
1. Where do you sit with regard to late payment of your credit-card bills?
2. Do you know your credit score?
3. Are you in survival mode, or do you consciously aim to pay bills on time?
4. Credit cards make spending easy. It has been argued that social media s driving us to
engage in conspicuous consumption.
SELF-ASSESSMENT QUESTION
13.1
Town Mills Ltd is a wholesale business. Extracts from the business’s most recent financial
statements are as follows:
$’000
Sales 903
Interest (11)
Taxation (38)
$’000
Assets
Current assets
Inventories 192
394
419
Equity
446
Current liabilities
367
The levels of trade receivables and trade payables increased by 10%, by value, during the year
ended 31 May. Inventories levels remained the same. The finance director believes that
inventories levels are too high and that they should be reduced.
a. Calculate the average cash operating cash cycle (in days) during the year ended 31
May, and explain to what use this value can be put and what limitations it has.
b. Discuss whether there is evidence that the company has a liquidity problem.
c. Explain the types of risk and cost that might be reduced by following the finance
director’s proposal to reduce inventories levels.
Summary
In this chapter we have achieved the following objectives in the way shown.
List the items that make up working capital, discuss the Identified working capital as current assets (cash + accounts receivable
nature and importance of working capital, and illustrate the + inventories) less current liabilities (accounts payable + bank overdrafts)
working capital cycle Identified working capital as the pool of short-term assets necessary for
the day-to-day operations of the entity
Showed the net period that requires funding for trading activities
(inventory turnover period + accounts receivable turnover period –
accounts payable turnover period)
Demonstrate the importance of inventory, and the techniques Discussed inventory issues and techniques as follows:
available to manage this asset efficiently
the costs/benefits of too little and too much inventory
forecasting inventory needs
calculating the inventory turnover period
calculating the economic order quantity (EOQ)
applying the ABC system of inventory control
implementing materials requirements planning (MRP)
assessing just-in-time (JIT) inventory management
Discuss the provision of credit to customers, and use various Discussed credit and the following related issues:
management tools to monitor and control the resulting asset
the costs/benefits of selling on credit
evaluating credit applications
determining the credit period
understanding early settlement discounts
tools for assessing collection policies:
—average collection period
Explain the reasons for holding cash, and the basis of its Explained the costs/benefits of holding cash
management and control
Discussed the following aspects of cash management and control:
Summarise the key aspects of management of accounts Explained the costs/benefits of using suppliers’ finance:
payable
average payment period
ageing schedule of accounts payable
pattern of credit purchase payments
Discussion questions
Easy
13.1 LO 1 Describe the components of working capital, and indicate the importance of this calculation.
13.2 LO 2 List four factors that support holding lower inventory levels, and four factors supporting higher inventory levels.
13.3 LO 3 What considerations should a company make in deciding whether to sell on credit as opposed to requiring cash payment
when a sale is made?
13.4 LO 4 List and briefly discuss the three motives for a business holding cash, according to economic theory.
13.6 LO 5 From the perspective of an individual, what are the main reasons for paying bills on time?
13.7 LO What impact does shortage of credit availability have on working capital management of small businesses?
1/3
Intermediate
13.8 LO Describe two components of the working capital for a manufacturing company that will not be relevant for a retail company.
1 Discuss how the working capital formula has changed, or not, in this situation.
13.9 LO The EOQ curve is relatively flat at the optimum order quantity. What is the implication of this for practical purposes?
2
13.10 LO List and briefly discuss six policies that a business should establish when they sell on credit.
3
13.11 LO What is the operating cash cycle (OCC) for a retailer, and why is it important for the management and control of cash?
4
13.12 LO The ‘free finance’ from trade credit seems like a great deal for both businesses and individuals. Are there any risks or
5 downsides?
13.13 LO How might each of the following affect a business’s level of inventory?
2
an increase in the number of production bottlenecks
a rise in the level of interest rates
a decision to offer customers a narrower range of products in the future
a switch from an overseas supplier to a local one
a deterioration in the quality and reliability of bought-in components.
13.14 LO How would you establish reorder points for inventory items?
2
13.15 LO What is the rationale behind the ABC system of inventory control?
2
13.16 LO JIT inventory management has many advantages, but what are some of its drawbacks?
2
b Is there any benefit in calculating all three, or does each one largely duplicate information derived from the others?
Challenging
13.18 LO Discuss the various methods that can be used to monitor and control accounts receivable.
3
13.19 LO Tariq, the credit manager of Heltex Ltd, is concerned that the pattern of monthly sales receipts shows that credit collection is
3 poor compared to budget. The sales director believes that Tariq is to blame for this, but Tariq insists he is not. Why might Tariq
not be to blame for the deterioration in the credit collection period?
13.20 LO Comment on the direction and size of the current ratio for each of the companies in Real World 13.1 .
1
13.21 LO Consider the implications for strategy regarding inventory of a substantial growth in online sales in a retailing business.
2
13.23 LO What differences might you expect to find between the payment of bills by large and small businesses?
3
Application exercises
Easy
13.1 LO Albinoni Ltd sells a single product and has annual sales of $200,000 per year. Inventories are held at a constant level and each
1 product is sold at a mark-up of 25%. The average settlement period for trade receivables is two months, and for trade payables
it is one month. However, the business is considering changing these periods to 1.5 months and three months, respectively.
These changes are not expected to have any effect on the level of sales or inventories.
What will be the decrease in working capital if the proposed changes are implemented?
13.2 LO Aristotle Ltd holds a particular type of tyre for which annual sales are $468,000. Each tyre is sold for cost plus 50%. The tyre
2 supplier takes six weeks to supply the tyre from the date that an order is raised by Aristotle Ltd. Each tyre costs $80. The
business holds 600 units of the tyre as a safety buffer, and wishes to retain this buffer at all times.
13.4 LO A business has the following details concerning its sales for the period:
4
Opening trade receivables $84,000
13.5 LO Stone Ltd produces a mobile phone that is designed for the elderly.
3
Selling price (per unit) $80
Profit $18
Annual sales revenue is $2.4 million and the average settlement period for trade receivables is 40 days. The company has a
cost of capital of 12%. The marketing department believes that a 5% increase in sales could be achieved if the average
settlement period for trade receivables was extended to 60 days.
What would be the increase or decrease in annual profit if the business adopted the suggestion of the marketing department?
13.6 LO Wong Ltd recently opened a new supermarket in a Sydney suburb. It uses data analytics to assist with inventory management.
2– The data showed that Monday is the quietest day for the supermarket, with an average of 500 customers visiting the store;
4 Saturday is the busiest, with 2,000 customers visiting the store. While Wednesday is busier than Monday, it is the day with the
highest online orders. How should the business manage the inventory in this supermarket based on the data collected,
particularly for products with short expiry dates like milk?
Intermediate
13.7 LO Servers Ltd produces a graphite tennis racquet that has been reasonably successful, but sales have remained stable in recent
2/3 years. Financial data on the racquet are as follows:
$ $
Selling price 40
Variable cost 30
Profit 5
Servers Ltd has recently been approached by a large supermarket that wishes to buy 30,000 racquets each year but has
demanded four months’ credit. Servers is concerned that if the demand is accepted, its other customers, who are allowed only
one month’s credit, will make similar demands. The current level of sales is 120,000 racquets each year. If Servers accepts the
supermarket order, it will have to hold 10,000 extra racquets in inventory (where inventory is valued at total cost) and accounts
payable will increase by $350,000. The business expects a return of 25% on its net capital invested.
13.8 LO Your superior, the general manager of Plastics Manufacturers Ltd, has recently been talking to the chief buyer of Plastic Toys
3 Ltd, which makes a wide range of toys for young children. Plastic Toys is considering changing its supplier of plastic granules
and has offered to buy its entire requirement of 2,000 kilograms per month from you at the going market rate, providing you will
grant it three months’ credit on its purchases. The following information is available:
1. Plastic granules sell for $10 per kilogram, variable costs are $7 per kilogram and fixed costs are $2 per kilogram.
2. Your own company is financially strong and has sales of $15 million per year. For the foreseeable future it will have
surplus capacity, and so it is actively looking for new outlets.
3. Extracts from Plastic Toys’ accounts:
Current assets
Current liabilities
a. Write some short notes suggesting sources of information you would use to assess the creditworthiness of potential
customers who are unknown to you. Critically evaluate each source of information.
b. Describe the accounting controls you would use to monitor the level of your company’s accounts receivable.
c. Advise your general manager on the acceptability of the proposal, giving your reasons and making any calculations you
consider necessary.
Challenging
13.9 LO Hercules Wholesalers Ltd has been particularly concerned with its liquidity position in recent months. The most recent income
2-5 statement and statement of financial position of the company are as follows:
$ $
Sales 452,000
466,000
Expenses 132,000
$ $
Current assets
Inventory 143,000
306,000
Non-current assets
357,000
Current liabilities
285,000
Non-current liabilities
Loans 120,000
Shareholders’ equity
258,000
The level of accounts receivable and accounts payable were maintained at a constant level throughout the year.
a. Explain why Hercules Wholesalers Ltd is concerned about its liquidity position.
b. Explain the term ‘operating cash cycle’, and state why this concept is important to the financial management of a
business.
c. Calculate the operating cash cycle for Hercules Wholesalers Ltd from the information above.
d. State what action might improve the company’s operating cash cycle.
13.10 LO Each of the five firms below currently takes the indicated number of days to pay their main supplier. To encourage prompt
5 payment, the supplier has offered the company a discount if payment is received within the discount period.
If the discount is taken, payment could be made on the last day of the discount period (i.e. the 30th day for firm 1). However, if
the discount is not taken, payment will be made in the current number of days (i.e. 70 days for firm 1).
Calculate the annual percentage cost of forgoing the discount, and compare this amount to the firm’s cost of borrowing to
determine whether payment should be made in the discount period.
Discount if paid in discount period (below) 2.0% 1.0% 2.0% 1.0% 2.0%
13.11 LO Domestic Energy Ltd at present offers its customers 30 days’ credit. Half of the customers, by value, pay on time. The other
3 half take an average of 70 days to pay.
The company is considering offering a cash discount of 2% to its customers for payment within 30 days. It anticipates that half
of the customers who now take an average of 70 days to pay will pay in 30 days. The other half will still take an average of 70
days to pay. The scheme will also reduce bad debts by $300,000 per year.
Annual sales of $365 million are made evenly throughout the year. At present the company has a large overdraft ($60 million)
with its bank at 12% per annum.
a. Calculate the approximate equivalent annual percentage cost of a discount of 2% that reduces the time taken by
accounts receivable to pay from 70 days to 30 days. (This part can be answered without reference to the narrative
above.)
b. Calculate accounts receivable outstanding under both the old and the new schemes.
c. How much will the scheme cost the company in discounts?
d. Should the company go ahead with the scheme? State what other factors, if any, should be taken into account.
e. Outline the controls and procedures a company should adopt to manage the level of its accounts receivable.
13.12 LO Flodden Enterprises Ltd is reviewing its trade credit policy. The business, which sells all its goods on credit, has estimated that
3 sales revenue for the forthcoming year will be $3 million under the existing policy. Credit customers representing 30% of
accounts receivable are expected to pay one month after being invoiced, and 70% are expected to pay two months after being
invoiced. These estimates are in line with previous years’ figures.
At present, no cash discounts are offered to customers. However, to encourage prompt payment, the business is considering
giving a 2.5% cash discount to credit customers who pay in one month or less. Given this incentive, Flodden expects that
credit customers accounting for 60% of accounts receivable will pay one month after being invoiced, and those accounting for
40% of accounts receivable will pay two months after being invoiced. The business believes that this cash discount policy will
prove attractive to some customers and will lead to a 5% increase in total sales revenue.
Irrespective of the trade credit policy adopted, the gross profit margin of the business will be 20% for the forthcoming year, and
three months’ inventories will be held. Fixed monthly expenses of $15,000 and variable expenses (excluding discounts),
equivalent to 10% of sales revenue, will be incurred and will be paid one month in arrears. Accounts payable will be paid in
arrears, and will be equal to two months’ cost of sales. The business will hold a fixed cash balance of $140,000 throughout the
year, whichever trade credit policy is adopted. No dividends will be proposed or paid during the year. Ignore taxation.
a. Calculate the investment in working capital at the end of the forthcoming year under:
i. the existing policy
ii. the proposed policy.
(Hint: The investment in working capital will be made up of inventories, accounts receivable and cash, less accounts payable
and any unpaid expenses at the year-end.)
Chapter 13 Case study
Obtain a copy of the PwC report Navigating Uncertainty: PwC’s global Working Capital Study, 2018/19
(https://www.pwc.com/gx/en/working-capital-management-services/assets/pwc-working-capital-
survey-2018-2019.pdf), read it and answer the following questions:
Activity 13.1
Two possible reasons are:
1. Smaller businesses tend to be less well managed. They often lack the specialist skills and
expertise that can be found in larger businesses.
2. Economies of scale may be a factor. For example, a business with twice the sales revenue of a
competitor business would not normally need twice the level of inventories.
Activity 13.2
Reorder point = expected level of demand during the lead time plus the level of buffer inventories = 800
+ 300 = 1 , 100 units
Activity 13.3
To be certain of avoiding running out of inventories, the business must assume a reorder point based on
the maximum usage and lead time. This is 750 units (i.e. 30×25).
The most likely usage during the lead time will be only 300 units (i.e. 20×15). Thus, the buffer inventories
based on most likely usage and lead time is 450 units (i.e. 750−300).
The level of inventories when a new order of 1,200 units is received, immediately following the minimum
supply lead time and minimum daily usage during the lead time, is 1,854 units (i.e. 1,200+750−(8×12)).
This will represent the maximum inventories holding for the business.
Activity 13.4
Your answer to this activity should be as follows:
EOQ = 2 × 2 , 000 × 25 4 = 158 unit ( to the nearest whole unit )
This will mean that the business will have to order product X about 13 times each year to meet sales
demand.
Activity 13.5
The total annual cost will be made up of three elements:
This will mean that 10,000/400 = 25 orders will be placed each year. The annual cost of ordering is
therefore:
25 × $ 32 = $ 800
The average quantity of inventories held will be half the optimum order size, as mentioned earlier. That is:
200 × $ 4 = $ 800
*
*
Note that the annual ordering cost and annual holding cost are the same. This is no coincidence. If we
look back at Figure 13.5 on page 584 we can see that the economic order quantity represents the
point at which total costs are minimised. At this point, annual order costs and annual holding costs are
equal.
Activity 13.6
$ $
Less savings
The above calculations reveal that the company will be worse off by offering the discounts.
Activity 13.7
The operating cash cycle may be calculated as follows:
Number of days
( Opening inventory + closing inventory ) / 2 Cost of sales × 365 = ( 142 + 166 / 2 ) 544 × 365 = 103
Add the average settlement period for accounts receivable (based on the closing balance, as the average
figure is not available):
Accounts receivableCredit sales×365=264820×365 =118=221 days
Less the average settlement period for accounts payable (based on the closing balance, as the average
figure is not available):
The company can reduce the operating cash cycle in several ways. The average inventory holding period
seems quite long. At present, average inventory held supports more than three months’ sales. This may
be reduced by reducing the inventory held. Similarly, the average settlement period for accounts
receivable seems long. Accounts receivable represent nearly four months’ sales. This may be reduced by
imposing tighter credit control, offering discounts, charging interest on overdue accounts, etc. However,
any policy decisions on inventory and accounts receivable must take account of current trading
conditions.
The operating cash cycle could also be reduced by extending the period of credit taken to pay suppliers,
but this option must be given careful consideration.
Activity 13.8
The average inventories turnover period for the business represents more than three months’ sales
requirements and the average settlement period for trade receivables represent nearly four months’ sales.
Both periods seem quite long. It is possible that both could be reduced through greater operating
efficiency. Improving inventories control and credit control procedures may achieve the required reduction
in operating cash cycle (OCC) without any adverse effect on future sales. If so, this may offer the best
way forward.
The average settlement period for trade payables represents more than three months’ purchases. Any
decision to extend this period, however, must be given very careful consideration. It is quite long, and
may already be breaching the payment terms required by suppliers.
There is no reason why the 30 days’ reduction in the OCC could not come from a combination of altering
all three of the periods involved—inventories, trade receivables and trade payables.
Before a final decision is made, full account must be taken of current trading conditions.
Activity 13.9
1. Paying on delivery may not be administratively convenient for the seller. Most customers will take a
period of credit, so the systems of the seller will be geared up to receive payment after a
reasonable period of credit.
2. A credit period can allow any problems with the goods or service supplied to be resolved before
payment is made. This might avoid the seller having to make refunds.
Activity 13.10
a. Average creditors settlement period
= ( Average creditors × 365 ) /Credit purchases = ( $ 38 , 000 × 365 ) / $ 180 , 000 = 77.05 days
b. Offering 2% discount for payment within 30 days is equivalent to offering 2% for 47 days (77 days
−30 days)
Learning objectives
When you have completed your study of this chapter, you should be able to:
LO 1 Categorise sources of finance, and explain the main sources of internal finance
LO 2 Identify and explain the main external sources of finance available
LO 3 Explain the relationship between gearing and the financing decision
LO 4 Explain the ways in which long-term equity finance can be raised.
To examine the various sources of finance for a business it is useful to distinguish between external and
internal sources of finance. By internal sources, we mean sources that do not require the agreement of
anyone beyond the directors and managers of the business. Thus, retained earnings is considered an
internal source, because the directors have the power to retain earnings without the agreement of the
shareholders, whose earnings they are. Finance from the issue of new shares, on the other hand, is an
external source because it requires the compliance of potential shareholders.
Within each of these two categories just described, we can further distinguish between long-term and
short-term sources of finance. There is no agreed definition for each of these terms, but, for the purpose
of this chapter, long-term sources of finance are those that are expected to provide finance for at least
one year. Short-term sources typically provide finance for a shorter period. As we shall see, sources that
are seen as short-term when first used by the business are often used for quite long periods.
The reinvestment of earnings rather than the issue of new ordinary shares can be a useful way of
increasing equity capital. There are no issue costs associated with retaining earnings, and the amount
raised is certain. When issuing new shares, the issue costs may be substantial and the success of the
issue may be uncertain. Retaining earnings will have no effect on the control of the company by existing
shareholders. By comparison, where new shares are issued to outside investors there will be some
dilution of the existing shareholders’ control.
The retention of earnings is something that is determined by the directors of the company. They may find
it easier simply to retain earnings than ask investors to subscribe to a new share issue. Retained earnings
are already held by the company, and so it does not have to wait to receive the funds. Moreover, there is
often less scrutiny when earnings are being retained for reinvestment purposes than when new shares
are being issued. Investors and their advisers will examine closely the reasons for any new share issue.
Some shareholders may prefer earnings to be retained by the company rather than distributed in the form
of dividends. By ploughing back earnings, it may be expected that the company will expand and share
values will increase as a result. Income tax paid by shareholders only arises on realised profits, so an
unrealised capital gain in the form of a share price rise is normally not taxable. The shareholder has a
choice as to when the gain is realised. Research indicates that investors are often attracted to particular
companies according to the dividend/retention policies they adopt.
It would be wrong to assume that all businesses either retain all their earnings or pay them all out as a
dividend. When businesses pay dividends, and most companies do pay dividends, they typically pay no
more than 50–70% of the earnings, retaining the rest to fund expansion. Capital-intensive, high-growth
businesses may have dividend payout ratios rather lower than this. Dividend policy at an individual
company level is generally fairly stable. (See Real World 8.7 for examples of dividend payout ratios.)
However, it needs to be recognised that retained earnings and dividends are two sides of the same coin
(profits), and dividends tend to follow cycles. Generally it can be said that dividends increase in good
years, and are stable or decline in bad years. This reinforces the importance of retained earnings as a
major source of new finance for Australian companies, as a means of funding growth, and as a means of
dealing with problem periods.
Let us now briefly consider the three major sources of internal short-term finance.
The nature and condition of the inventory held determines whether it is possible to exploit this form of
finance. A business that is overstocked as a result of poor buying decisions may find that a significant
proportion of its inventory is slow-moving or obsolete, and therefore cannot be liquidated easily.
Activity 14.1
Traders Ltd is a wholesaler of imported washing machines. The business is partly funded by a bank
overdraft, and the bank is putting pressure on Traders to reduce this as soon as possible.
Sales revenue is $14.6 million a year, and is all on credit. Purchases and cost of sales are roughly equal
at $7.3 million a year. Current investment in the relevant working capital elements are:
$m
Inventories 1.5
Traders’ accountant believes that much of the overdraft could be eliminated through better control of
working capital. As a result, she has investigated several successful businesses that are similar to
Traders and found the following averages:
Concept check 1
Which of the following is NOT a source of internal finance?
A. Quicker payment to suppliers
B. Retained earnings
C. Company profits
D. Better credit control
E. Lower inventory levels.
Concept check 2
A major source of internal finance for most companies is which of the following?
A. Issue of ordinary shares
B. Issue of preferred shares
C. Bank borrowings
D. Finance leases
E. None of the above.
Concept check 3
The availability of financing from retained earnings will be affected by:
A. The profitability of the company
B. Company policy
C. Shareholder needs
D. All of the above
E. None of the above.
External sources of finance
LO 2 Identify and explain the main external sources of finance available
Figure 14.2 summarises the main sources of long-term and short-term external finance.
To choose the most appropriate form of external finance, we must be clear about the advantages and
disadvantages of each.
Ordinary shares
Ordinary shares form the backbone of a company’s financial structure, and ordinary share capital
represents its risk capital. There is no fixed rate of return, and ordinary shareholders receive a dividend
only if there are still profits available for distribution after other investors (preference shareholders and
lenders) have received their dividend or interest payments. If the company is wound up, the ordinary
shareholders will receive any proceeds from asset disposals only after lenders and creditors, and often
preference shareholders, have received their entitlements. Because of the high risks with this form of
investment, ordinary shareholders normally require a higher rate of return from the company.
Although ordinary shareholders have limited loss liability, based on the amount they have agreed to
invest, the potential returns from their investment are unlimited. Ordinary shareholders have control over
the company. Their voting rights give them the power to elect the directors, and also to remove directors
from office.
From the company perspective, ordinary shares can be a valuable form of financing, as at times it is
useful to be able to avoid paying a dividend. In the case of a new expanding company, or a company in
difficulties, the requirement to make a cash payment to investors can be a real burden. For a company
financed by ordinary shares, this problem need not occur. However, the costs of financing ordinary shares
may be high over the longer term for the reasons mentioned earlier.
Moreover, the company does not obtain any tax relief on dividends paid to shareholders, whereas interest
on borrowings is tax-deductible. This makes it more expensive for a business to pay $1 of dividends than
$1 of loan interest. A more detailed consideration of ways of increasing share capital will be found in a
later section.
Activity 14.2
From the business’s point of view, ordinary shares represent a less risky form of financing than borrowing.
Why is this?
Preference shares
Preference shares offer investors a lower level of risk than equity shares. Providing there are sufficient
profits available, preference shares are normally given a fixed rate of dividend each year, and preference
dividends are paid before ordinary dividends are paid. If the company is wound up, preference
shareholders may be given priority over the claims of ordinary shareholders. Because of the lower level of
risk with this form of investment, investors are offered a lower level of return than that for ordinary shares.
Preference shareholders are not usually given voting rights, although these may be granted where the
preference dividend is in arrears. Both preference shares and ordinary shares are, in effect, redeemable.
The business is allowed to buy back the shares from shareholders at any time, as long as certain
conditions are met.
Various types of preference shares may be issued by a company. Cumulative preference shares give
investors the right to receive arrears of dividends that arise when the company has had insufficient profits
in previous periods. The unpaid dividends accumulate and are paid when the company has generated
sufficient profits. Non-cumulative preference shares do not give investors the right to receive arrears
of dividends. Thus, if a company is not in a position to pay the preference dividend due for a particular
period, the preference shareholder loses the right to receive that dividend. Participating preference shares
give investors the right to a further share in the profits available for dividends after they have been paid
the fixed rate due on the preference shares and after ordinary shareholders have been awarded a
dividend.
Preference shares are no longer a major source of new finance for companies. An important reason why
this particular form of fixed-return capital has declined in popularity is that dividends paid to preference
shareholders are not allowable against taxable profits, whereas interest on loan capital is an allowable
expense. Also, over recent years interest rates on borrowing have been at historically low levels.
Borrowings
Many companies rely on borrowings as well as equity to finance operations. Lenders establish a contract
with the company clearly stating the rate of interest, the dates of interest payments and capital
repayments, and security for the loan. If the loan’s interest payments or capital repayments are not made
on the due dates, the lender usually has the right, under the terms of the contract, to seize the assets on
which the loan is secured and sell them to repay the amount outstanding. Security for a loan may take
the form of a fixed charge on particular assets of the company (freehold land and premises are often
favoured by lenders) or a floating charge on the whole of its assets. A floating charge will ‘crystallise’
(fix) particular assets if the company defaults on its obligations. A floating charge on assets allows
company managers greater flexibility in their day-to-day operations than a fixed charge does. Assets can
be traded without reference to the lenders.
security
Assets pledged or guarantees given to provide lenders with some protection
against default.
fixed charge
Where specific assets are pledged as security for a loan.
floating charge
Where all of a business’s assets, rather than specific assets, are pledged as
security for a loan. The charge will only fix on specific assets if the business
defaults on its obligations.
Not all assets are acceptable to lenders as security. They must normally be non-perishable, easy to sell,
and of high and stable value. (Property normally meets these criteria, and so is often favoured by
lenders.) In the event of default, lenders have the right to seize the assets pledged and to sell them. Any
surplus from the sale, after lenders have been paid, will be passed to the business. In some cases,
security offered may take the form of a personal guarantee by the owners of the business or, perhaps,
by some third party. This tends to be particularly the case with small businesses.
personal guarantee
A guarantee given by one person (the guarantor) to a lender, guaranteeing that in
the event of default by the borrower, the guarantor will make good the payment
due.
Lenders may seek further protection through the use of loan covenants . These are obligations, or
restrictions, on the business that form part of the loan contract. Covenants may impose:
loan covenants
Conditions contained within a loan agreement that are designed to help protect
the lenders.
Any breach of these covenants can have serious consequences. Lenders may demand immediate
repayment of the loan in the event of a material breach. Loan covenants and the availability of security
can lower the risk for lenders, and can make the difference between a successful and an unsuccessful
loan issue. They can also lower the cost of borrowing to the business, as the rate of return that lenders
require will depend on the perceived level of risk to which they are exposed.
Activity 14.3
Can you suggest how a loan covenant might specify minimum levels of liquidity (the last bullet point in the
list above) in the contract between the borrower and lender? (Hint: Think back to Chapter 8 .)
Real World 14.1 provides two examples of situations in which loan covenants were breached. The first
is an extract from a Financial Times article that describes how one well-known Japanese manufacturer,
Toshiba, has recently struggled to generate profits, which, in turn, has led to it breaching its loan
covenants. The second relates to the model train company Hornby.
Real world 14.1
FT
Toshiba in trouble
The extent of the problems faced by Toshiba—one of Japan’s biggest industrial names—had
initially surfaced in late December 2016 when the beleaguered conglomerate had requested a
one-month waiver from a group of lenders. The waiver had duly been granted in January 2017, but
the company’s shares saw a dive of up to 13% the following month with the news that Toshiba was
trying to get a further extension to a loan violation waiver, and faced potential de-listing from the
Tokyo Stock Exchange. In spite of this dramatic market reaction, eventually Toshiba managed to
get the relevant lenders to agree not to call in the business’s borrowings before 25 December
2017, giving it a bit more breathing space.
Source: Leo Lewis, ‘Toshiba shares plummet on new fears over future of business’, ft.com, 15 February 2017.
Source: Jack Torrance and Alan Tovey, ‘Hornby appeals to lenders amid profit fall’, The Daily Telegraph, 4 April 2018.
The risk–return characteristics of loan, preference share and ordinary share finance are shown
graphically in Figure 14.3 . Note that, from the viewpoint of the business (the existing shareholders), the
level of risk associated with each form of finance is in reverse order. Thus, borrowing is the most risky
because it exposes shareholders to the legally enforceable obligation to make regular interest payments,
and usually repayment of the amount borrowed.
Activity 14.4
Now consider these three forms of finance from the viewpoint of the business. Will a business rank them,
according to risk, in the same order?
We shall consider some of the issues surrounding the desirable level of borrowing (financial gearing) later
in the chapter.
One form of long-term loan is the term loan , which is offered by banks and other financial institutions,
and is usually tailored to a client’s needs. The amount of the loan, the time period, the repayment terms
and the interest payable are all open to negotiation and agreement, which can be very useful. For
example, if all of the funds to be borrowed are not required immediately, a business will not have to pay
interest on amounts borrowed that are temporarily surplus to requirements. Term loans tend to be cheap
to set up (from the borrower’s perspective) and their conditions can be quite flexible.
term loan
Finance provided by financial institutions, such as banks and insurance
companies, under a contract with the borrowing business that indicates the
interest rate and the dates of payments of interest and repayment of the loan. The
loan is not normally transferable from one lender to another.
Another form of long-term loan finance is loan notes (or stock) . It is frequently divided into units
(rather like share capital), and investors are invited to purchase the number of units they require. The loan
stock of public companies is often traded on the Australian Securities Exchange (ASX), with its listed
value fluctuating according to a company’s fortunes, movements in interest rates, and so on.
A debenture is simply a type of loan stock that is evidenced by a trust deed. Loan stocks and
debentures are usually referred to as ‘bonds’ in the United States, and increasingly elsewhere.
debenture
A long-term loan, usually made to a company, evidenced by a trust deed.
Activity 14.5
Would you expect the market price of ordinary shares or of loan notes to be the more volatile? Why?
Activity 14.6
Would you expect the returns on loan notes to be higher or lower than those of ordinary shares?
Another form of long-term loan finance is the eurobond . Eurobonds are issued by listed companies
(and other organisations) in various countries, and the finance is raised in countries other than the country
of the denominated currency. Despite their name, they are not necessarily linked to Europe or the euro
currency. They are bearer bonds , which are often issued in US dollars but may also be issued in other
major currencies, such as Australian or New Zealand dollars. Interest is normally paid on an annual basis.
Eurobonds are part of an emerging international capital market, and are not subject to the regulations
imposed by authorities in particular countries. A secondary market for eurobonds has been created by a
number of financial institutions throughout the world. Eurobonds are usually issued by placing them with
large banks and other financial institutions, which may either retain them as an investment or sell them to
their clients.
eurobond
A form of long-term borrowing where the finance is raised on an international
basis. Eurobonds are issued in a currency that is not that of the country in which
the bonds are issued.
bonds
See loan notes (stock).
Interest rates on loan finance may be either floating or fixed. A floating (variable) interest rate means
that the required rate of return from lenders will rise and fall with market interest rates. However, the
market value of the lenders’ investment in the business is likely to remain fairly stable over time. The
converse will normally be true for loans on a fixed interest rate and debentures. The interest
payments will remain unchanged with rises and falls in market rates of interest, but the resale value of the
investment (the loan) will fall when interest rates rise and will rise when interest rates fall.
A business may issue redeemable loan capital that offers a rate of interest below the market rate. In some
cases, the loan capital may have a zero rate of interest. Such loans are issued at a discount to their
redeemable value, and are referred to as deep discount bonds . Thus, a company may issue loan
capital at, say, $80 for every $100 of redeemable value. Although lenders receive little or no interest
during the period of the loan, they receive a gain when the loan is finally redeemed. The redemption yield,
as it is referred to, is often quite high, and when calculated on an annual basis may compare favourably
with returns from other forms of loan capital with the same level of risk. Deep discount bonds may have
particular appeal to companies with short-term cash flow problems. They receive an immediate injection
of cash, and the loan incurs no significant cash outflows until the maturity date. Deep discount bonds are
likely to appeal to investors who do not have short-term cash flow problems as they must wait for the loan
to mature before receiving a significant return.
Real World 14.2 provides some examples of bond issues, including a deep discount issue.
Source: Paul Harvey, ‘Cheap debt for Fortescue as investors snap up bonds’, The Australian Business Review, 11 May 2017.
A high-yield bond issue at an interest rate of 6.625% was used by mining services provider
Barminco to refinance debt worth US$350 million. The issue was three times oversubscribed.
Source: Bridget Carter, ‘Barminco rolls over debt ahead of initial public offering’, The Australian Business Review, 13 April 2017.
The Commonwealth Bank raised US$1.25 billion in US money markets ‘at a deep discount to its
initial offering’. The bank raised this money with a 30-year bond maturing in 2048. ‘The lengthy
maturity on the bond allowed the bank to cut the spread on the bond’s issue from 1.75 per cent to
1.53 per cent above the US Treasury bond rate of 2.8 per cent.’
Source: Michael Roddan, ‘CBA raises $1.6bn as costs fall’, The Australian Business Review, 5 January 2018.
A mortgage is a form of loan that is secured by freehold property. Financial institutions such as banks,
insurance companies and superannuation funds are often prepared to lend to businesses on this basis.
The mortgage loan may be extended over a long period, often over 25–30 years. In addition to the
possible capital gain from holding the freehold property, businesses also benefit from a decline in the real
value of the capital sum owing because of inflation.
mortgage
Borrowing secured on property.
Activity 14.7
Both preference shares and loan capital are forms of finance that require the company to provide a
particular rate of return to investors. What factors may be taken into account by a company deciding
between using these two sources of finance?
Rather than take out a loan before they need it, many businesses (and individuals) arrange a loan facility,
also known as a line of credit (or loan facility) . This is effectively a pre-arranged facility to borrow at
some future date an amount that is within the permitted amount of the facility given by the bank. Some
pre-arranged security is usually required.
The well-known Bank of Mum and Dad (BOMD) is frequently based on a loan facility associated with a
property. Many parents have paid off, or are close to paying off, their home mortgage and then embark on
a loan facility, secured on a mortgage on their property, so as to have funds available where appropriate
to help their children in various ways.
Reflection 14.1
You may already be well aware of the importance of help from the Bank of Mum and Dad. Turning
your thoughts around, what do you think are the key factors mums and dads need to consider in
setting up a facility, and then using it judiciously?
An investor may find this form of investment a useful hedge against risk, particularly when investment in a
new company is being considered. Initially, the investment is made in the form of a loan and regular
interest payments are made. If the company is successful, the investor can then decide to convert the
investment into equity shares.
The company may also find this form of financing useful. For a successful company the loan becomes
self-liquidating, as investors will exercise their option to convert. The company may also be able to offer a
lower rate of interest to investors because investors expect to gain future benefits from conversion.
However, there will be some dilution of both control and earnings for existing shareholders if holders of
convertible loans exercise their option to convert.
Convertibles are an example of a financial derivative . These are any form of financial instrument,
based on sha¡re or loan capital, that investors can use to increase their returns or reduce their risk.
financial derivative
Any form of financial instrument, based on share capital or borrowings, which can
be used by investors either to increase their returns or to decrease their exposure
to risk.
Source: Sharechat, ‘Investors see more Xero growth as convertible notes oversubscribed’, Sharecat.co.nz, 28 September 2018.
A finance lease is, in essence, a form of lending, because if the lessee had borrowed the funds and
then used them to buy the asset itself, the effect would be much the same. The lessee would have the
use of the asset but also a financial obligation to the lender—much the same position as the leasing
agreement would lead to.
finance lease
A financial arrangement where the asset title remains with the owner (the lessor)
but the lease arrangement transfers virtually all of the rewards and risks to the
business (the lessee).
A finance lease should be distinguished from an operating lease , where the rewards and risks of
ownership stay with the owner and where the lease is short term. An example of an operating lease
occurs when a builder hires earthmoving equipment for a week to do a particular job.
operating lease
An arrangement where a business hires an asset, usually for a short period of
time. Hiring an asset under an operating lease tends to be seen as an operating
decision rather than a financing decision.
In recent years, some of the important benefits of finance leasing have disappeared. Changes in the tax
laws no longer make it such a tax-efficient form of financing, and changes in accounting disclosure
requirements make it no longer possible to conceal this form of ‘borrowing’ from investors. From January
2019 the accounting treatment of leases has become the same, irrespective of the type of lease.
Nevertheless, the popularity of finance leases has grown, so there must be other reasons for businesses
to adopt this form of financing. These reasons are said to include the following:
Ease of borrowing. Leasing may be obtained more easily than other forms of long-term finance.
Lenders normally require some form of security and a profitable track record before making advances
to a business. However, a lessor may be prepared to lease assets to a new business without a track
record, and to use the leased assets as security for the amounts owing.
Cost. Leasing agreements may be offered at reasonable cost. As the asset leased is used as security,
standard lease arrangements can be applied, and detailed credit-checking of lessees may be
unnecessary. This can reduce administration costs for the lessor, and thereby help in providing
competitive lease rentals.
Flexibility. Leasing can offer flexibility when rapid changes in technology occur. If an option to cancel
can be incorporated into the lease, the business may be able to exercise this option and invest in new
technology as it becomes available, thus reducing the risk of obsolescence.
Cash flows. Leasing, rather than purchasing an asset outright, means that large cash outflows can be
avoided. The leasing option allows cash outflows to be smoothed out over the asset’s life. In some
cases it is possible to arrange for low lease payments to be made in the early years of the asset’s life,
when cash inflows may be low, and for these to increase over time.
A sale and lease-back arrangement involves a business selling an asset (typically freehold property)
to a financial institution to raise finance. However, the sale is accompanied by an agreement to lease the
asset back to the business so that it can still use it. The payment under the lease arrangement is
allowable against profits for taxation purposes. There are usually reviews at regular intervals throughout
the lease period, and the amounts payable in future years may be difficult to predict. At the end of the
lease agreement, the business must either try to renew the lease or, in the case of property, find
alternative premises. Although the sale of the premises will provide an immediate cash injection to the
business, it will lose benefits from any future capital appreciation on the property. Where a capital gain is
made by selling the premises to the financial institution, a liability for taxation may also arise. A sale and
lease-back agreement can be used to help a business focus on its core areas of competence.
sale and lease-back
An agreement to sell an asset (usually property) to another party, and
simultaneously to lease the asset back in order to continue using it.
Activity 14.8
What type of asset is best suited to a sale and lease-back arrangement?
Real World 14.4 provides an example of leased assets and of two sale and lease-back projects.
Source: Based on information in International Airlines Group Annual Report 2018, pp. 138, 147.
Source: Inside Retail Australia, ‘Bunnings sells $180m worth of retail portfolio,’ insideretail.com.au, 15 November 2017.
Malaysian-based international conglomerate Sime Darby owns Hastings Deering (Australia) Ltd,
which is a distributor of CAT earthmoving equipment and of power solutions for a number of
sectors. The company ‘wished to unlock the capital value of its property portfolio for reinvestment
elsewhere in the Hastings Deering business’. The resulting sale and leaseback spread over 30
years was ‘one of the largest sale-and-leaseback transactions in the Queensland industrial
property sector in 2017’.
Source: Tony Dhar, Adrian Rich, David Moore, David Inglis and Marcus Best, ‘Malaysia’s Sime Darby sale and leaseback of industrial property portfolio’,
Hire purchase
Hire purchase is a form of credit used to acquire an asset. Under the terms of a hire-purchase (HP)
agreement, a customer pays for the asset by instalments over an agreed period. Normally, the customer
will pay an initial deposit (down-payment) and then make instalment payments at regular intervals,
perhaps monthly, until the balance outstanding has been paid. The customer will usually take possession
of the asset after payment of the initial deposit, although legal ownership of the asset will not be
transferred until the final instalment has been paid. HP agreements will often involve three parties:
the supplier
the customer, and
a financial institution.
Although the supplier will deliver the asset to the customer, the financial institution will buy the asset from
the supplier and then enter into an HP agreement with the customer. This intermediary role played by the
financial institution enables the supplier to receive immediate payment for the asset but allows the
customer a period of extended credit.
HP agreements are perhaps most commonly associated with private consumers acquiring large
household items or cars. Nevertheless, it is also a significant form of financing for commercial purposes.
Businesses, particularly start-ups and small businesses, who do not have the funds to be able to
purchase desirable assets outright, often turn to commercial hire purchase (CHP).
HP agreements are similar to finance leases in so far as they allow a customer to obtain immediate
possession of the asset without paying its full cost. Under the terms of an HP agreement, however, the
customer will eventually become the legal owner of the asset, whereas under the terms of a finance lease
ownership will stay with the lessor. Other differences include: a lessor (not the lessee) can claim
depreciation benefit for tax purposes, whereas the hirer can claim the tax benefit under an HP deal; the
amount that can be funded for the asset can be up to 100% for a leasing arrangement, compared with
50–75% for an asset purchased on HP; maintenance using a lease is the responsibility of the lessor,
whereas it is the responsibility of the hirer under an HP agreement. A fixed-interest rate usually applies.
Balloons (final payments for any balances outstanding at the end of a contract period) are possible in
either method. This means that the cost of the asset can be spread over a longer period. We might start
with a five-year period, covering say 75% of the cost, with a 25% balloon that needs to be paid off at the
end of the term. This is frequently refinanced.
In Australia, most commercial hire purchase tends to relate to vehicles and commercial equipment. In
2017 the Australia commercial equipment finance market grew to a record level of $34.7 billion (John
Maslen, ‘Australian commercial equipment finance market breaks records’, Asset Finance International,
26 February 2018).
Reflection 14.2
Why might sale and lease-back be an attractive proposition to businesses like Bunnings or Sime
Darby?
How do you feel about using it as a future means of financing non-current assets in any business
that you might become involved in? What about Lucas’s restaurants?
Securitisation
Securitisation involves bundling together illiquid financial or physical assets of the same type to
provide financial backing for an issue of bonds. This financing method was first used by US banks, which
bundled together residential mortgage loans to provide asset backing for bonds issued to investors.
(Mortgage loans held by a bank are financial assets that provide future cash flows in the form of interest
receivable.)
securitisation
Bundling together illiquid physical or financial assets of the same type to provide
backing for issuing interest-bearing securities, such as bonds.
Securitisation has spread beyond the banking industry, and has now become an important source of
finance for businesses in a wide range of industries. Future cash flows from a variety of illiquid assets are
now used as backing for bond issues, including:
Securitisation may also be used to help manage risk. Where, for example, a bank has lent heavily to a
particular industry, its industry exposure can be reduced by bundling together some of the outstanding
loan contracts and making a securitisation issue.
Securitisation usually involves setting up a special-purpose vehicle (SPV) to acquire the assets from the
business wishing to raise finance. This SPV will then arrange the issue of bonds to investors. Income
generated from the securitised assets is received by the SPV and used to meet the interest payable on
the bonds.
Reflection 14.3
Assume that you inherited $1 million.
What factors would you consider in deciding whether to invest in bonds, and how much you might
invest?
Then assume that you have used your investment successfully and built up a business now worth
$25 million. You are looking to further expand.
What would your attitude be to taking on debt to further the expansion? What kind of debt would
you be most at ease with?
bank overdraft
debt factoring
invoice discounting, and
supply chain finance
These are discussed below, together with some sources typically associated with small businesses.
Bank overdraft
A bank overdraft enables a business to maintain a negative balance on its bank account. It represents
a very flexible form of borrowing. The size of the overdraft can be increased or decreased according to
the business’s financing requirements, subject to bank approval. It is relatively inexpensive to arrange,
and overdraft interest rates are often very competitive, although they vary according to how creditworthy
the bank perceives the customer to be. It is also fairly easy to arrange—sometimes an overdraft can be
agreed by a telephone call to the bank. In view of these advantages, it is not surprising that this is an
extremely popular form of short-term finance.
bank overdraft
A flexible form of borrowing that allows an individual or business to have a
negative current account balance.
Banks prefer to grant overdrafts that are self-liquidating—that is, the funds applied will result in cash
inflows that will extinguish the overdraft balance. The banks may ask for forecast statements of cash
flows from the business to see when the overdraft will be repaid and how much finance is required. The
bank may also require some form of security on amounts advanced.
One potential drawback with this form of finance is that it is repayable on demand. This may pose
problems for a business that is illiquid. In practice, many businesses operate on an overdraft, and this
form of borrowing, although theoretically short-term, can often become effectively a long-term source of
finance. Banks, however, are likely to put pressure on businesses to refinance to other long-term forms of
debt if the overdraft balance does not fluctuate sufficiently, or if the firm is unable to generate cash flows
to reduce overdraft debt periodically.
Debt factoring
Debt factoring is a form of service that is offered by a financial institution (a factor). Many of the large
factors are subsidiaries of commercial banks. Debt factoring involves the factor taking over a company’s
sales ledger (i.e. the accounts receivable). Besides operating normal credit control procedures, a factor
may offer to make credit investigations and to provide protection for approved credit sales. The factor is
usually prepared to make an advance to the company of up to 85% of approved accounts receivable. The
charge made for the factoring service is based on total turnover, and is often around 2–3% of
turnover. Any advances made to the company by the factor will attract a rate of interest similar to the rate
charged on bank overdrafts.
factoring
A method of raising short-term finance. A financial institution (factor) will manage
the accounts receivable of the business, and will be prepared to advance sums to
the business based on the amount of accounts receivables outstanding.
Debt factoring is, in effect, outsourcing the accounts receivable control to a specialist subcontractor. Many
businesses find a factoring arrangement very convenient. It can result in savings in credit management
and can create more certain cash flows. It can also give key personnel time for more profitable ends. This
may be extremely important for smaller companies relying on the talent and skills of a few key individuals.
However, some might see a factoring arrangement as an indication that the company is in financial
difficulties. This may have an adverse effect on people’s confidence in the company. For this reason,
some businesses try to conceal the factoring arrangement by collecting debts on behalf of the factor.
When considering a factoring agreement, the costs and likely benefits arising must be identified and
carefully weighed.
Invoice discounting
Invoice discounting involves a business approaching a factor or other financial institution for a loan
based on a proportion of the face value of credit sales outstanding. If the institution agrees, the amount
advanced is usually 75–80% of the value of the approved sales invoices outstanding. The business must
agree to repay the advance within a relatively short period—perhaps 60 or 90 days. The responsibility for
collecting the accounts receivable remains with the business, and repayment of the advance does not
depend on the accounts receivable being collected. Invoice discounting will not produce such a close
relationship between the client and the financial institution as factoring does. Invoice discounting may be
a one-off arrangement, whereas debt factoring usually involves a longer-term arrangement between the
client and the financial institution.
invoice discounting
Where a financial institution provides a loan based on a proportion of the face
value of a business’s credit sales outstanding.
Invoice discounting is a far more important source of funds to companies than factoring. There are
various reasons for the huge difference between the two methods. Generally, invoice discounting is
preferred for the following reasons:
It is a confidential form of financing that the client’s customers will know nothing about.
The service charge for invoice discounting is only about 0.2–0.3% of turnover, compared to 2–3% of
turnover for factoring.
Many companies are unwilling to relinquish control over their accounts receivable. Customers are an
important business resource, and many companies wish to retain control over all aspects of their
relationship with their customers.
Recall that we saw in Chapter 13 that larger companies have typically been stretching their payables
period.
Real World 14.5 provides information regarding reasons for using supply chain finance.
In a posting from PwC, the principal reasons given for implementing supply chain finance were:
Supply chain finance (SCF) programs were run by 65% of European companies with revenues
greater than $750 million.
So far only 7% of large Australian companies have run SCF programs.
Utilising cutting-edge fintech allows entry into global finance markets.
Successful SCF programs bridge the functional gaps and help develop a comprehensive
‘procure-to-pay’ strategy. This usually incorporates: minimising approval times; the extensive
use of e-invoicing; self-billing; cooperation with suppliers; enhancing systems regarding
agreement of payment terms; and enhancing payment runs.
Overall the system is considerate of small business suppliers and works for larger businesses.
SCF operates across a wide range of industries, including: consumer goods; automotive;
communications and IT; energy, utilities and mining; industrial manufacturing; transport and
logistics; and professional services.
Source: PwC, ‘Understanding supply chain finance: unlocking off-balance sheet benefits for buyers and suppliers’, pwc.com.au, July 2017.
Reflection 14.4
Assume that you work in the Human Resources section of a business that is a large consumer of
inventory supplied by a variety of small businesses. Your HR director can see merit in bringing
suppliers much closer to the company, arguing that better integration and operating efficiency will
result from this closer relationship. You have been asked to put together a paper that provides
some details relating to supply chain management in general, and supply chain finance in
particular, which will form the basis of a presentation to suppliers to bring them all on board.
Many small businesses use a credit card to make payments for items that might otherwise require an
immediate cash payment, but using the credit card allows them to settle at a later date. If the amount due
to the credit card provider is settled at the end of the month, normally no interest or fees will be charged to
the business. It is, of course, the supplier of the goods or services that is charged for the credit card
provider’s commission. Where the small business does not settle its credit card obligation at the end of
the credit-free period, interest charges are incurred at quite high rates.
Crowdfunding involves raising funds from a large number of investors (the crowd). Each investor will
normally pledge a relatively small sum. Although crowdfunding has been around for many years, the
Internet has lately made it a more feasible way of raising equity. It is particularly relevant to small
businesses for whom the more traditional approaches to equity financing are not available. Typically, the
small business requiring equity capital will approach a crowdfunding platform (such as Crowdcube in the
United Kingdom, or readyfundgo.com in Australia). In essence, the business sets out its plans and
financial requirements, which the platform puts on its website. Investors are invited to pledge funds in
amounts, typically as little as $10, to buy a share or shares in the small business. The platform provides
funders with access to start-ups or expanding companies looking for capital. The investors won’t get paid
back until the companies they invest in start to earn profit. The platform charges the small business a
commission, based on the amount of funds raised. Crowdfunding is becoming part of the established
small-business funding environment, and is expanding rapidly.
Crowdfunding
Where funds are raised from a large number of investors who typically pledge a
relatively small sum.
crowdlending
The non-equity equivalent of crowdfunding. Also known as ‘peer-to-peer lending’.
Fintech has been defined by Investopedia as ‘a portmanteau of “financial technology” ’, and refers to
new technology that ‘seeks to improve and automate the delivery and use of financial services’.
Specialised software and algorithms on computers and smartphones help ‘companies, business owners
and consumers better manage their financial operations, processes and lives’ (Julia Kagan, ‘Financial
technology—fintech’, Investopedia, 25 June 2019, www.investopedia.com).
fintech
New technology that seeks to improve and automate the delivery and use of
financial services.
After a predictable start in the systems end of large financial institutions, fintech has considerably
expanded its reach, so that little, if anything, can be said to be off-limits. Its focus has become the
consumer, and its aims seem to be disruptive. It now includes a raft of areas, including more traditional
areas such as wealth management, lending and borrowing, retail banking, and money transfer, along with
other more novel areas such as fundraising, advice and education, financial literacy, and the development
of crypto-currencies. Fintech businesses aim to be a threat to existing businesses and systems, and to
provide a faster or better service than currently exists. They aim to force change, and hence are seen as
‘disruptive’.
Providing sources of finance is an important part of the fintech sector, with many fintech businesses
having been set up to cater for non-traditional applicants. Obtaining loans through traditional sources can
be unpleasant and very time-consuming, as well as sometimes unsuccessful, especially if the applicant
doesn’t have a track record. So, many fintech organisations use different ways of approaching the giving
of credit, often by using information about the applicant’s transactions history from his or her smartphone.
Most offer unsecured loans—but at a cost. In an article in early 2019, the online lender Prospa was said
to have lent out more than $1 billion to local small and medium-sized businesses in 2018, with a total
customer base of 19,000. At the time the weighted annual percentage interest rate of its portfolio was
36%. ‘The company’s interest rates currently range between 8.5 per cent and 29.9 per cent based on
credit quality’ (Supratim Adhikari, ‘Prospa may revive listing plan after beating prospectus forecasts’, The
Australian Business Review, 13 March 2019). Nevertheless, the demand for unsecured loans is growing.
Fintech lenders seem to be filling a gap in the small and medium-sized business sector. In an article on
fintechs, commentator Susan Muldowney reports that fintechs are offering loans in the $5,000–$500,000
bracket more readily and faster, and on more favourable terms, than their traditional business banking
counterparts. They do this ‘by leveraging e-commerce and advanced analytics to enhance credit
underwriting’. However, the loans tend to be for shorter terms and at higher rates than the usual bank
loan. While banks are still lending to good customers, trends over many years—culminating in the global
financial crisis (GFC) and its fallout—have virtually destroyed traditional relationship-lending. Small
businesses have been forced by banks to go through more hoops than ever before, and lending costs are
increasing. In contrast, fintech has opted for another route, harnessing Big Data and predictive analytics
to enter markets where post-GFC the banks are not prepared to go. But, again, at a cost: Muldowney
reveals that interest rates can range from just under 10% per annum to above 45% (Susan Muldowney,
‘Fintechs: small business lenders fill a market gap’, INTHEBLACK, 1 July 2016).
Reflection 14.5
Tim, our agricultural engineer, has been talking with some of his entrepreneurial friends who are
engaged in fintech activities. He is now buzzing with excitement about the new opportunities
opening up to him. However, his uncle, who has been something of a mentor in the past, is
horrified at the prospect of Tim ever getting involved with such businesses. He obviously regards
them as charlatans charging excessive interest, and is using words like ‘morally bankrupt’ to
describe them. Tim is now confused. Advise him about both the advantages and the pitfalls that
might be associated with financing through a fintech.
Matching. The business may attempt to match the type of borrowing with the nature of the assets
held. Thus, assets that form part of the business’s permanent operating base—including non-current
assets and a certain level of current assets—are financed by long-term borrowing. Assets held for a
short period—such as current assets held to meet seasonal increases in demand—are financed by
short-term borrowing (see Figure 14.4 ). A business may wish to match the asset life exactly with
the period of the related loan; however, this may not be possible because of the difficulty of predicting
the life of many assets.
Flexibility. Short-term borrowing may be useful to postpone making a commitment to a long-term
loan, especially if interest rates are high but are forecast to fall in the future. Short-term borrowing
does not usually incur penalties if the business makes an early repayment of the amount outstanding,
whereas some form of financial penalty may be incurred if long-term borrowing is repaid early.
Re-funding risk. Short-term borrowing has to be renewed more frequently than long-term borrowing.
This may create problems for a business in financial difficulties or if there is a shortage of funds
available for lending.
Interest rates. Interest payable on long-term debt is often higher than for short-term debt, because
lenders require a higher return when their funds are locked up for a long period. This may make short-
term borrowing a more attractive source of finance for a business. However, there may be other
borrowing costs (e.g. arrangement fees) to take into account. The more frequently borrowings must be
renewed, the higher these costs will be.
Concept check 4
Which of the following is NOT a source of external finance?
A. Ordinary shares
B. Operating leases
C. Preferred shares
D. Term loans
E. Debentures.
Concept check 5
From the perspective of a potential provider of finance to a company, which of the following
is NOT true?
A. Lending is normally the least risky source of external funding.
B. Ordinary shares are the most risky source of external funding.
C. Term loans tend to be cheap to set up and their conditions can be quite flexible.
D. Preference shares have priority in terms of interest payments.
E. None of the above. All are true.
Concept check 6
Which of the following statements is false?
A. Invoice discounting is more widely used than factoring.
B. The global financial crisis had its origin in securitisation of low-quality (sub-prime)
loans.
C. A finance lease is, in effect, a kind of borrowing.
D. Hybrids give the investor the right to convert loan notes into shares at a specified
price at a specified time in the future (or on the occurrence of a particular event).
E. With a fixed-interest rate investment the interest rate will remain unchanged, but the
resale value of the investment will rise and fall in line with changes in interest rates.
Gearing and the long-term financing decision
LO 3 Explain the relationship between gearing and the financing decision
In Chapter 8 we saw that gearing occurs when a business is financed, at least in part, by
contributions from fixed-charge capital, such as loans, debentures and preference shares. We also saw
that a business’s level of gearing is often an important factor in assessing the risk and returns to ordinary
shareholders. In Example 14.1 we consider the implications of making a choice between a geared and
an ungeared form of raising long-term finance.
gearing
The existence of fixed-payment bearing securities (e.g. loans) in the capital
structure of a business.
EXAMPLE
14.1
Blue Ltd is a newly formed business. Although there is some uncertainty as to the exact amount,
an operating profit of $40 million a year seems most likely. The business will have long-term
finance totalling $300 million, but it has yet to be decided whether to raise:
all $300 million by issuing 300 million ordinary shares at $1 per share (the ‘all-equity option’), or
$150 million by issuing 150 million ordinary shares at $1 each, and $150 million from the issue
of secured loan notes paying interest at 10% a year (the ‘geared option’).
It might be instructive to look at the outcomes for the shareholders for a range of possible
operating profits for each financing option:
All-equity option
$m $m $m $m $m
Interest – – – – –
Geared option
$m $m $m $m $m
Let us now consider the impact of a change in operating profit from $40 million to $50 million. An obvious
point to note is that, with the geared option, the EPS values are more sensitive to changes in the level of
operating profit. An increase in $10 million from the most likely operating profit of $40 million will increase
the EPS with the geared option by 40% (from $0.1167 to $0.1633). With the all-equity option, the increase
is only 25% (from $0.0933 to $0.1167).
Activity 14.9
Given that a $40 million operating profit is the most likely, what advice would you give the shareholders as
to the better financing option?
Note in Example 14.1 that, with an operating profit of $30 million, the EPS figures are the same
irrespective of the financing option chosen ($0.07). This is because the rate of return (operating
profit/long-term investment) is 10%. This is the same as the interest rate for the loan notes. Where a
business is able to generate a rate of return greater than the interest rate on the borrowings, the effect of
gearing is to increase the EPS. Where the opposite is the case, the effect of gearing is to decrease the
EPS.
It is easy to see from this why some degree of financial gearing came to be seen as a good thing. The
rates of return expected by shareholders usually exceed the cost of borrowing. Borrowing part of the long-
term financing needs of the business therefore lowers the overall cost of capital and so increases the
value of the business. (Remember that the valuation of a business is essentially a net present value
calculation of expected future cash flows discounted by an appropriate discount rate—the weighted
average cost of capital.) The fact that interest payments attract tax relief makes borrowing even cheaper.
The tax element of gearing is clearly beneficial to shareholders. If we look at the $40 million operating
profit case in Example 14.1 , we can see that the business would pay $12 million in income tax with the
all-equity option, but only $7.50 million with the geared option.
This raises the question as to why businesses don’t just borrow more, given these advantages. The
answer is relatively straightforward: high levels of gearing give rise to high levels of commitment to make
cash payments of interest, and eventually to redeem borrowing. These commitments expose the business
to significant risk. If operating profits (and accompanying cash inflows) fall below the projected level, the
business may be forced into liquidation. Apart from anything else, this will tend to make potential lenders
avoid the business.
Being forced into liquidation has a significant cost to the business, so sensible financial gearing policy
tends to try to balance the benefit from the tax relief on interest with the potential cost of going bust. This
is known as the ‘trade-off’ theory of financial gearing, which is illustrated in Figure 14.5 .
As the level of gearing increases, the cost of equity rises to reflect the additional risk that gearing
engenders. Despite this, the tax-deductibility of interest means that the weighted average cost of capital
(WACC) decreases. Once the level of gearing reaches a level that is considered as being excessive, the
risk of forced liquidation causes both the cost of equity and the cost of borrowing to increase with further
elements of borrowing. This leads to a rise in the WACC.
The figure shows the cost of equity, the cost of borrowing, and the average of these two, weighted
according to how much of each there is in the financial structure. This average—the weighted average
cost of capital (WACC)—is the effective cost of capital for the business as a whole. These three are
plotted against the level of financial gearing. At a zero level of gearing, the cost of equity is at a minimum
because there is no risk arising from financial gearing. As borrowing becomes an increased part of the
total long-term finance, the cost of equity increases, but, because of the tax-deductibility of interest, the
WACC decreases. At the point where the level of gearing stops being moderate and starts being
excessive, the costs of both equity and borrowing start to increase sharply, and, with them, the WACC.
Logically, businesses should seek to have their gearing level as indicated by the dotted line. At this point
the benefit of the tax relief on loan interest is balanced by the cost of a potential forced liquidation. WACC
is at a minimum, and the value of the business is at a maximum.
The formal research evidence that businesses tend to follow the ‘trade-off’ theory is pretty strong. The
informal evidence is also quite powerful. Most businesses are financially geared, but few of them seem to
be very highly geared.
Concept check 7
Which of the following is true?
A. An increase in gearing will lead to an increase in profit.
B. Increased gearing is associated with greater variability in earnings to ordinary
shareholders.
C. A decrease in gearing will lead to an increase in profit.
D. High levels of gearing reduce the commitment to make cash payments of interest
and capital.
E. Given the tax advantages of borrowing, most businesses aim to borrow as much as
possible.
Concept check 8
Which of the following statements about the trade-off theory of financial gearing is false?
A. The cost of equity rises as gearing increases.
B. The cost of debt will be fairly stable at reasonable levels of gearing, and then rise as
these increase above a certain point.
C. The weighted average cost of capital will decrease continuously.
D. The benefit of the tax relief on interest increases the benefit of gearing.
E. Both formal research and informal evidence on the trade-off theory agree that, while
most businesses are financially geared, few seem to be highly geared.
SELF-ASSESSMENT QUESTION
14.1
Helsim Ltd is a wholesaler and distributor of electrical components. The most recent financial
statements of the company revealed the following:
HELSIM LTD
Statement of comprehensive income
for the year ended 31 May 2020
$m $m
Sales 14.2
Purchases 8.4
11.6
HELSIM LTD
Statement of financial position
as at 31 May 2020
$m $m
Current assets
Cash 0.1
Inventory 3.8
7.5
Non-current assets
Equipment 0.9
5.2
Current liabilities
5.4
Non-current liabilities
Debentures (secured on freehold land) 3.5
Shareholders’ equity
Share capital
3.8
Notes
1. Land and buildings are shown at their current market value. Equipment and motor vehicles
are shown at their written-down values.
2. No dividends have been paid to ordinary shareholders for the past three years.
Suppliers have been pressing for payment, so the managing director has decided to reduce the
level of accounts payable to an average of 40 days outstanding. To achieve this he has decided to
ask the bank to increase the overdraft to finance the necessary payments. The company is
currently paying 12% interest on the overdraft.
Before issuing shares or loan capital through the ASX, a company must be listed. This means that it must
meet fairly stringent requirements concerning size, profit history, disclosure, etc. Some share issues on
the ASX arise from the initial listing of the company, often known as an initial public offering (IPO) .
Other share issues are taken up by companies that are already listed and are seeking additional finance
from investors.
The secondary market role of the ASX means that shares and other financial claims are easily
transferable. This can bring real benefits to a company, as investors may be more prepared to invest if
they know their investment can be easily liquidated whenever required. Note, however, that investors are
not obliged to use the ASX as the means of transferring shares in a listed company. Nevertheless, it is
usually the most convenient way of buying or selling shares. Prices of shares and other financial claims
are usually determined efficiently by the market, and this should also give investors greater confidence to
purchase shares. The company may benefit from such investor confidence by finding it easier to raise
long-term finance and by obtaining this finance at a lower cost, as investors will view their investment as
less risky.
The ASX can be a useful vehicle for a successful entrepreneur wishing to realise the value of a business
that has been built up. By floating (listing) the shares on the exchange, and therefore making the shares
available to the public, the entrepreneur will usually benefit from a gain in the value of the shares held and
will be able to realise this gain easily.
The stock exchange is often cited as an example of an efficient capital market. This is a market where
share prices at all times rationally reflect all available, relevant information. It implies that any new
information coming to light that has a bearing on a particular business and its share price will be taken
into account quickly and rationally, in terms of the size and direction of share price movement. This helps
to promote the tendency for the price quoted for a share to reflect its true worth at that particular time,
based on the available evidence.
Activity 14.10
What benefits might a listed business gain from this tendency to be efficient?
The ASX imposes strict rules on listed companies, and requires levels of financial disclosure additional
to those already imposed by law and by the accounting profession (e.g. half-yearly financial reports
must be published).
The activities of listed companies are closely monitored by financial analysts, financial journalists and
other companies, and such scrutiny may not be welcome, particularly if the company is dealing with
sensitive issues or experiencing operational problems.
Increasingly listed companies are subject to pressure from activist groups, including superannuation
funds, to go in a particular direction which conflicts with what the company wants to do.
It is often suggested that listed companies are under pressure to perform well over the short term. This
pressure may detract from taking on projects that will yield benefits only in the longer term. If the
market becomes disenchanted with the company and the price of its shares falls, this may make it
vulnerable to a takeover bid from another company.
The costs of obtaining a listing are considerable, and this may be a real deterrent for some
businesses.
Share issues
A company may issue shares in various ways. It might appeal directly to investors or use financial
intermediaries. The most common methods of share issue are as follows:
rights issues
dividend reinvestment plans
offer for sale
public issue, and
private placing.
Note that it is possible to increase share capital by issuing bonus shares (see Chapter 4 ), but a bonus
issue does not raise any more funds. It simply changes reserves into capital.
Rights issues
The company may offer existing shareholders the right to acquire new shares in the company, in
exchange for cash. The new shares will be allocated to shareholders in proportion to their current
shareholdings. To make the issue attractive to shareholders, the new shares are usually offered at a price
significantly below their current market value. A rights issue is a common form of share issue. For
companies, it is a relatively cheap and straightforward way of issuing shares. Issue expenses are quite
low, and issue procedures are simpler than those of other forms of share issue. The fact that those who
are offered new shares already have an investment in the company that presumably suits their risk–return
requirements is likely to increase the chances of a successful issue.
rights issue
An issue of shares for cash to existing shareholders on the basis of the number of
shares already held, at a price that is usually lower than the current market price.
Control of the company by existing shareholders will not be diluted, providing they take up the rights offer.
A rights offer allows them to acquire shares in the company at a price below the current market price. This
means that the entitlement to participate in a rights offer is a source of value to existing shareholders.
Those who do not wish to take up the rights offer can sell their rights to other investors, so long as the
offer is made on a renounceable basis (the right to receive shares can be sold in the market). In contrast,
non-renounceable offers must either be taken up or be allowed to lapse.
The traditional approach to rights issues has been adapted in recent years by the introduction of
accelerated rights issues . Rights issues of this type are structured in two phases, with an initial
(accelerated) issue to institutional investors (who will pay quickly), followed by a (non-accelerated) issue
to the retail (non-institutional) component of the shareholders.
EXAMPLE
14.2
Shaw Holdings Ltd has 20 million ordinary shares which were issued at 50¢ each and are currently
valued on the ASX at $1.60 per share. The directors of Shaw Holdings believe the company
requires additional long-term capital and have decided to make a one-for-four issue (i.e. one new
share for every four shares held) at $1.30 per share.
The first step in the valuation process is to calculate the price of a share following the rights issue.
This is known as the ex-rights price, and is simply a weighted average of the price of shares before
the issue of rights and the price of the rights shares. In the Shaw example we have a one-for-four
rights issue. The theoretical ex-rights price is, therefore, calculated as follows:
7.70
7.70/5
As the price of each share, in theory, should be $1.54 following the rights issue and the price of a
rights share is $1.30, the value of the rights offer will be the difference between the two:
Market forces will usually ensure that the actual price of rights and their theoretical price will be
fairly close.
Suppose that an investor with 2,000 shares in Shaw Holdings Ltd has contacted you for investment
advice. She is undecided whether to take up the rights issue, sell the rights, or allow the rights offer to
lapse.
If the investor takes up the rights issue, she will be in the following position:
3,200
If the investor sells the rights, she will be in the following position:
3200
If the investor lets the rights offer lapse, she will be in the following position:
As we can see, the first two options should leave her in the same net wealth position, but she will be
worse off if she allows the rights offer to lapse. In practice, however, the company may sell the rights offer
on behalf of the investor and pass on the proceeds to ensure that the issue has not made her worse off.
When considering a rights issue, the directors of a company must first consider the amount of funds it
needs to raise. This will depend on the company’s future plans and commitments. The directors must
then decide on the issue price of the rights shares. Generally speaking, this decision is not crucial. In
Example 14.2 , the company made a one-for-four issue with the price of the rights shares set at $1.30.
However, it could have raised the same amount by making a one-for-two issue and setting the rights price
at $0.65, or a one-for-one issue and setting the price at $0.325, etc. The issue price that is finally decided
on will not affect the value of the company’s underlying assets or the proportion of its underlying assets
and earnings to which the shareholder is entitled. The Shaw directors must, however, ensure that the
issue price is not above the current market price of the shares if the issue is to be successful.
A variation of a rights issue is what is known as an entitlement offer . An entitlement offer is an offer
made to a specific investor to enable the purchase of a security or other asset; that offer cannot be
transferred to another party. An entitlement offer is offered at a specific price and must be used during a
set timeframe. Failure to use the offer will lead to it being withdrawn. Entitlement offers are most often
used to issue new shares in a company, and are often very similar to a rights issue. The essential
difference is that the existing shareholders cannot transfer the entitlement offer to anyone else. The
timeframe is usually one that should give existing shareholders the time to consider whether they wish to
take it up.
entitlement offer
An offer made to a specific investor to enable the purchase of a security or other
asset. The offer cannot be transferred to another party. An entitlement offer is
offered at a specific price and must be used during a set timeframe.
Real World 14.6 provides some detail regarding recent IPOs and their success, plus an example of a
rights and entitlement issue.
In 2018 95 companies listed on the ASX. By the end of the year the share prices of 73 of them
were lower than their listing price. This was not the only news that made 2018 a lack-lustre year for
IPOs on the ASX. The average return in terms of share price fell below what early-stage investors
would expect, at a pretty pedestrian 16.4%. However, the wider context is important here: the
ASX200 lost 7% over the year. Other points to note for 2018 are:
The year’s overall IPO take of $8.4 billion was a respectable 25% increase on 2017. Of this,
56% was for the year’s three $1 billion-plus cap IPOs; smaller companies—those with a market
capitalisation of less than $100 million—contributed only 8% of the funds.
A drop in performance from the previous two years saw only 72% of ASX debutants achieving
their desired raise amount.
The mining, resources and energy sector accounted for about 58% of the funds raised.
Most sectors had negative returns after three months.
Several IPOs did very well. The best had a return on the year of 188%, with the lowest returns
of the top 10 still achieving 40%.
Source: Filip Karinja, ‘Top 10 IPOs on the ASX in 2018’, Small Caps, 20 February 2019.
Rights issues
Woodside announced that it had concluded first part of its approximately $2.5 billion equity raising:
the institutional part of a one-for-nine fully underwritten accelerated renounceable entitlement offer
with retail rights trading. The funds will go towards acquiring more of the Scarborough gasfield.
Over 90% of eligible institutional shareholders took up their entitlements, raising about $1.57 billion
at $27.00 per share. Institutional investors and existing shareholders purchased the shortfall, with
a final clearing price of $29.60, representing a $2.60 premium, which was then paid to those
institutional shareholders who had not taken up their entitlements.
The retail component then followed, with a one-for-nine offer at the same price of $27 per share for
eligible retail shareholders. Any not taken up were to be sold off to the remaining retail investors.
The retail offer aimed to raise $0.96 billion.
Source: Woodside Petroleum, ‘Successful completion of institutional entitlement offer’, 19 February 2018, https://files.woodside/docs/default-source/asx-
announcements/2018-asx/19-02-2018-successful-completion-of-institutional-offer.pdf?sfvrsn=279077f2_6.
issuing house
A financial institution that specialises in the issuing of new securities.
offer for sale
An issue of shares that involves a public limited company (or its shareholders)
selling the shares to a financial institution, which will, in turn, sell the shares to the
public.
Public issue
A public issue involves the company making a direct invitation to the public to purchase shares in it,
usually via a newspaper or online advertisement. The shares may once again be a new issue or shares
already in issue. An issuing house may be asked by the company to help administer the issue of the
shares to the public, and to advise on an appropriate selling price. However, the company, rather than the
issuing house, will take on the risk of selling the shares. An offer for sale and a public issue will both
extend share ownership in the company.
public issue
An issue of shares that involves a public limited company making a direct
invitation to the public to buy shares in the company.
When making an issue of shares, the company or the issuing house usually sets a price for the shares.
However, establishing a share price may not be easy, particularly if the market is volatile or if the
company has unique characteristics. If the share price is set too high, the issue will be undersubscribed
and the company (or issuing house) will not receive the amount expected. If the share price is set too low,
the issue will be oversubscribed and the company (or issuing house) will receive less than it might have.
One way of dealing with the problem is to make a tender issue of shares. This involves the investors
determining the price at which the shares will be issued. Although the company (or issuing house) may
publish a reserve price to help guide investors, it will be up to the individual investor to determine the
number of shares to be purchased and the price the investor wishes to pay. Once the offers from
investors have been received, a price at which all the shares can be sold will be established (known as
the strike price). Investors who have made offers at, or above, the strike price will be issued shares at the
strike price, and offers received below this price will be rejected. Although this form of issue is adopted
occasionally, it is not popular with investors, and is therefore not in widespread use.
tender issue
Shares for sale to investors for which the investors must state the amount they
are prepared to pay for the shares.
Private placing
This method does not involve inviting the public to subscribe to shares. Instead, with private placing
the shares are ‘placed’ with selected investors, such as large financial institutions. This can be a quick
and relatively cheap way to raise funds, as it saves some advertising and legal costs. However, the
ownership of the company can end up being concentrated in a few hands. Usually, unlisted companies
seeking relatively small amounts of cash employ this form of issue. Moreover, both listed and unlisted
firms often follow a private placement with a rights issue to their shareholders to give them the opportunity
to increase their holdings on favourable terms. In passing, you should note that bonds can also be issued
by placement.
private placing
An issue of shares that involves a limited company arranging for the shares to be
sold to the clients of particular issuing houses or stockbrokers, rather than to the
general investing public.
The ASX imposes limitations on how much companies can raise by way of a non-pro-rata equity issue. It
allows them to issue up to 15% of their capital by non-pro-rata raisings in each 12-month period without
securing shareholder approval. Beyond this amount, shareholder approval is needed. However, the ASX
has relaxed the rule so that more than 15% of the capital can be issued, provided it is accompanied by a
share purchase plan (SPP) . Clearly, the most equitable form of capital raising is by way of a
renounceable rights issue, as there is no dilution of the shareholders’ proportion of equity. Share
purchase plans aim to try to balance shareholders’ rights with the need to be able to raise funds quickly
and efficiently. Essentially, share purchase plans are a means of issuing small amounts of shares to
existing shareholders without the need for a prospectus. The shares offered must be non-renounceable
and offered at a discount, and fall within the limits mentioned above. The risks of inequitable treatment
are seen as being small, while the reduction in costs, together with a discounted price, are seen as
providing an advantage to retail investors.
share purchase plan (SPP)
A plan that aims to balance shareholders’ rights with the need to be able to raise
funds quickly and cheaply.
Real World 14.7 provides some examples of placements. The Sienna example includes a placing and
a rights issue.
SelfWealth announced completion of a share placement worth almost $1.5 million, with strong
support from both existing institutional investors and a group of sophisticated local investors ‘keen
to participate in the future growth of SelfWealth’s online broking business’. The placement being
made under Listing Rule 7.1 regarding capacity saw a 10% dilution for existing shareholders. This
was compensated for by a rights issue to existing shareholders at the same price as subscribed by
investors in the placement. This allowed the money to be raised quickly and cheaply, while
preserving the ability for existing shareholders to participate at the same price as the new
shareholders. The money raised would be invested in technology, marketing and staff resources.
Source: ASX announcement, ‘SelfWealth completes share placement and launches $1.5m rights issue’, 12 December 2018.
Sienna Cancer Diagnostics issued a placement and rights issue in 2018 to raise $5.2 million in
order to ‘accelerate the Company’s portfolio expansion strategy via acquisition of complementary
technologies to expand the company’s commercialisation pipeline, and will also provide additional
working Capital’. The offer was a one-for-three pro-rata non-renounceable rights issue to raise
$3.6 million (60 million shares at 6¢ per share). The placement aimed to raise $1.6 million on
shares sold at 6¢ per share.
Source: ASX release, ‘Placement and rights issue to accelerate technology expansion program’, 20 July 2018.
For companies that are not included in the S&P/ASX300 index, with a market capitalisation equal to or
less than $300 million, a further 10% of their issued capital (over and above the 15% referred to above)
can be issued, within the next 12 months, as long as this is approved at the company’s annual general
meeting and passed by a 75% majority.
Activity 14.11
What do you consider is the fairest way of raising equity capital?
private equity
Equity finance, primarily for small or medium-sized businesses, provided by
venture capitalists, such as large financial institutions.
Venture capital is long-term capital provided by certain institutions to help businesses exploit profitable
opportunities. The businesses most likely to interest the venture capitalist will have higher levels of risk
(and hence higher potential earnings) than would normally be acceptable to traditional providers of
finance, such as the major clearing banks. Venture capital providers may be interested in a variety of
businesses for various purposes and reasons, including the following:
Business start-ups. Venture capital is available to businesses that are not fully developed and may
need finance to help refine their business concept, or for product development or marketing.
Early-stage capital. This is available for businesses ready to commence trading.
Expansion capital. This is additional funding provided to young existing or expanding businesses.
Buy-out or buy-in capital. This is used to fund the acquisition of a business by the existing
management team (buy-out) or by a new management team (buy-in). Management buy-outs (MBOs)
and management buy-ins (MBIs) often occur where a large business wishes to divest itself of one of
its operating units, or where a family business wishes to sell because of succession problems.
Sometimes one of the owners of an existing business is bought out.
venture capital
Long-term finance provided by certain institutions to small and medium-sized
businesses in order to exploit relatively high-risk opportunities.
The risks the business carries can vary, in practice, but are often due to the nature of its products or to
the fact that it is a new business which either lacks a trading record or has new management. Although
the risks are higher, the businesses also have potentially higher levels of return—hence their attraction to
the venture capitalist. The venture capitalist often makes a substantial investment in the business, and
this normally takes the form of ordinary shares. To keep an eye on the sum invested, the venture
capitalist usually requires a representative on the board of directors as a condition of the investment. The
venture capitalist may not be looking for a quick return, and may well be prepared to invest in a business
for five years or more. The return may take the form of a capital gain on the realisation of the investment.
Although venture capital is extremely important for some businesses, the vast majority of small
businesses obtain their finance from other sources.
Private equity is capital invested in a private company—one which is not, therefore, listed on the ASX (or
any other stock exchange)—in return for a stake in the company. While it can be venture capital, the more
common form in recent years has been a leveraged buy-out. Typically, the business being invested in is
then delisted and restructured, with the aim of improving management and cutting costs. Some time down
the track it is listed again and sold off at a substantial profit. Leading private equity groups have warned
stock-market investors in the past not to expect them to retain stakes in initial public offerings, arguing
that holding listed equities was not what they were paid for. Institutional investors paid private equity firms
to make profits from improving companies, not to hold public stock.
PwC produced a report on growth opportunities for private and family businesses. This included a number
of case studies that emphasised the importance of private equity. Real World 14.8 summarises three
of these cases, and also provides a broad indication of the importance of private equity.
Patties Foods, a leading business in the food sector, listed on the ASX in 2006, only to find over
the next 10 years its profit margins shrinking even as revenue doubled. Finding they ‘were making
less money and working twice as hard’, the owners decided to delist, instead going into partnership
with a leading private equity firm. The family was still involved, but the new partner brought in
‘experienced, intelligent and commercial directors’ who put in place ‘an outstanding management
team’. The partnership also enabled the business to make two major acquisitions.
V.I.P. Petfoods was a successful business that was reluctant to sell but needed input in order to
build on its success and realise its growth potential. At this point it was suggested that linking up
with a private equity partner might be worth exploring. This option meant the family could get the
requisite funds to grow the business, while retaining their involvement and values as they worked
towards a succession strategy and ultimate exit. It proved a good fit. The family got over $400
million from the sale, taking a minority stake with some of the proceeds. After two and a half years
later, ‘having accelerated a program of investment and international expansion, and having
acquired a number of complementary businesses’, the rebadged business was sold for $1 billion.
Partnering with private equity saw Geotech Group’s revenue quickly grow 600% to over $300
million, and employing more than 500 staff. A key contribution from the partner was objectivity. It
set up a professional board and appropriate governance structures and processes, and brought in
‘new skills and expertise and a large network’. These inputs and disciplines helped reinforce a
change in the original owner’s mindset from that of an owner to being one of a number of
shareholders, with a wider range of responsibilities. This proved to be another unexpected and
liberating bonus. Alongside this, though—and equally as important—was an alignment of values
and goals between the parties. In 2017 the business was sold for more than $260 million. The
original owner now heads the new company.
Source: PwC, Once in a Lifetime: Creating the Right Growth Chemistry for Australian Private and Family Businesses (PwC, Melbourne, March 2018).
Private equity ‘continues to be a key driver of growth, job creation and innovation across many
industry sectors’.
Private equity investment plays a significant role in businesses’ expansion plans and their
funding of investment activity.
‘[F]irms under private equity ownership in Australia accounted for $43 billion in total value
added to the economy (equal to 2.6% of GDP) and supported 327,000 FTE [full-time
equivalent] jobs.’
There were 375 companies under private equity ownership.
The average private equity business had annual turnover of $126 million, paid $39 million to
459 employees, generated $19 million in EBITDA (earnings before interest, tax, depreciation
and amortisation) for investors, and contributed $58 million in direct value added to the
economy.
Private equity fund managers typically helped with improving governance, developing the
business, and upskilling staff availability.
Source: Deloitte Access Economics, Private Equity: Growth and Innovation (Deloitte Access Economics [for Australian Private Equity and Venture Capital Assn Ltd],
Sydney, 2018), p. 4.
Activity 14.11
When examining prospective investment opportunities, what kind of non-financial matters do you think a
venture capitalist would be concerned with?
Business angels
A business angel is often a wealthy individual who has been successful in business. They are usually
willing to invest through a shareholding in a start-up or developing business. They will often invest for a
period of between three and five years, and sometimes longer. They normally have a close relationship
with the business, and act as a mentor or guide to the projects. Business angels fill an important gap in
the market, as the size and nature of the investment that they find appealing does not appeal to venture
capitalists. Business angels may be attractive to small businesses for a number of reasons, including:
they may be able to make investment decisions quickly, particularly if they are familiar with the
industry in which the business operates
they may also be able to offer a wealth of business experience to budding tycoons, and
some may be prepared to accept lower returns than those required by venture capitalists in exchange
for the opportunity to become involved in a new and interesting project.
business angel
An individual who supplies finance (usually equity finance) to a start-up business
or a small business wishing to expand. Often business angels take a close
interest in the running of the businesses in which they invest.
As business angels offer an informal source of share finance, it is not always easy to identify a suitable
angel. However, numerous business angel networks have now developed to help owners of small
businesses find their ‘perfect partner’.
Reflection 14.6
Assume that you are running a quite successful business. At what stage in the development of
your business might you consider using private equity?
Concept check 9
Which one of the following describes long-term capital that is invested by certain institutions
in usually new small businesses to exploit profitable opportunities?
A. High-yield capital
B. Opportunity capital
C. Venture capital
D. Investment capital
E. Any of the above.
Concept check 10
Tee Ltd, a geared company, will make a one-for-one bonus issue. Assuming no other
changes, which ONE of the following will occur as a result?
A. Reduction in the level of gearing
B. Increase in liquidity
C. Increase in total equity
D. Reduction in earnings per share
E. None of the above.
Concept check 11
Venture capital is capital provided to small and medium-sized businesses wishing to
grow, but which do not have access to stock markets.
A. Long-term
B. Short-term
C. Secured
D. Unsecured
E. None of the above.
This translates to broad rules covering the ratio of the loan to the annual salary/ies of the
borrower/s, and the proportion of the loan to the valuation associated with the asset. The global
financial crisis (GFC) certainly impacted on these required ratios, with the trend being towards
loans being smaller relative to a given salary, and larger deposits (and therefore greater equity in
the property) being required, thus improving the security for the lender. Careful consideration
needs to be given to the interest component, as variable rate mortgages have the potential to
reduce interest costs when interest rates decrease, but also to substantially increase costs when
rates rise. This, in turn, enhances the risks of subsequent foreclosure of the mortgage (i.e. forced
sale of the property and recovery of the money owed).
Other forms of loan are clearly available, the most common being a loan from your bank, which
can be a term loan or simply an overdraft. It needs to be recognised that overdrafts can be recalled
easily by the bank, but are probably convenient and relatively cheap. Lines of credit which are
secured on a property enable ready access to funds at a low (mortgage) rate of interest.
Fintech is a new and developing area which will undoubtedly lead to disruption of the way in which
business is done. Unsecured debt is almost certainly going to be available more easily and quickly
from this source. Whether it is sensible to pay the kind of costs that are likely to come with it is
something you need to think about very carefully.
Leasing is commonly used at an individual level, although leasing is typically operating leasing,
rather than finance leasing. It is relatively easy for a reasonable-sized business to enter into a
finance lease for a car fleet, but it is much more difficult for an individual to enter into a finance
lease for a vehicle.
The section on achieving an appropriate balance between short-term and long-term borrowing is
important at an individual level, as well as at a corporate level. The idea of matching the type of
loan with the type of asset being purchased is sound. It would, for example, generally not be
sensible to try to fund the purchase of an asset which you intend to hold for a long time by an
overdraft. The regular need to refinance the debt would be time-consuming and fairly risky. Before
the GFC, we saw that some consumers were using increases in a mortgage to fund short-term
use, such as holidays. This kind of approach was, and remains, potentially very risky. It is probably
much less easy to do this in post-GFC times.
Regarding the internal sources identified in this chapter, one possible way of reducing outflows of
cash is to delay payment of accounts payable. This is clearly a short-term, risky strategy and must
be seen as that.
Clearly, as an individual or an owner of a small business, it is important that you develop a sound
relationship with your bank. Major borrowings will probably need some sort of plan, some security,
and evidence that you can stick with the plan and fulfil your commitments. This, in turn, requires
careful consideration of your own personal view on levels of debt.
Summary
In this chapter we have achieved the following objectives in the way shown.
Categorise sources of finance, and Categorised sources as internal or external, and long-term or short-term
explain the main sources of internal Identified the main internal sources of finance and their significance, including retained profit,
finance tighter credit control, reduced inventory levels, and delayed payment to suppliers (accounts
payable)
Identify and explain the main external Identified and discussed the main sources of long-term finance available to businesses,
sources of finance available including ordinary shares, preference shares, loans, debentures and leases
Identified and discussed the main external sources of short-term finance, including overdraft,
factoring and invoice discounting
Explained the advantages and disadvantages of each form
Identified forms of finance particularly of use to small business
Identified the main factors that influence the choice between short-term or long-term finance,
and between the various forms of finance available
Explain the ways in which long-term Examined the role of the ASX, and saw that it performs two main roles: the primary role of
equity finance can be raised raising finance for companies, and the secondary role of ensuring that investors can buy and
sell securities
Identified the main forms of share issue
Explained the advantages and disadvantages of each
Explained venture capital
Identified the main purposes to which venture capital is usually put
Discussion questions
Easy
14.1 LO 1 Briefly describe each of the two categories of finance.
14.3 LO 2 Provide at least one advantage for each of the main external sources of finance available.
14.5 LO 4 Nyeve Company wants to raise funds with a bonus share issuance. Discuss.
14.6 LO 1/2 What factors should be taken into account when determining the balance between short-term and long-term debt finance?
14.8 LO 1/3 Given the economic volatility of the past few years, what pattern of dividends and retentions would you expect to have
occurred over this period?
14.9 LO 4 For a company, a rights issue makes a lot of sense when additional capital is required. Why?
Intermediate
14.10 LO 1 Apple Corporation is a good example of a successful company that does not pay very much in the way of regular dividends.
Review Apple’s dividend policy.
14.11 LO 2 Provide details of three means by which lenders can gain further protection for their loan.
14.12 LO 3 As increased gearing results in greater earnings per share, why don’t businesses borrow more to achieve this benefit to the
maximum?
14.13 LO 4 Provide one advantage and one disadvantage for each of the various means by which long-term equity finance can be
raised.
14.15 LO In recent years, many banks have sold their freehold property and entered into long-term lease-back arrangements.
2/4
a. Why would they do this?
b. How would the transaction be recorded in their financial statements?
14.16 LO 3 How would you determine the appropriate level of gearing for a specific business?
14.17 LO 4 Why might a public company with an ASX listing revert to being an unlisted company?
a. investors?
b. corporate regulators?
c. business entrepreneurs?
14.20 LO What are the principal sources of finance that are available to you as an individual or a small business owner?
1/2/4
Challenging
14.21 LO 2 Describe in detail a ‘deep discount’ bond, including the benefits for the issuer and the investor.
14.22 LO 2 Compare and contrast the reasons for borrowing by the businesses in Real World 14.2 .
14.23 LO 2 Identify the growth patterns over time, and any other trends, for both factoring and invoice discounting.
What kind of industries might you expect to use factoring or invoice discounting? What advantages might a business get
from the use of factoring or invoice discounting?
Application exercises
Easy
14.1 LO 1/2 Tulo Company provides the following financial information:
Times/year Days
Purchases $ 40,000
Tulo is thinking about improving its cash flow by taking longer to pay its creditors.
Calculate the increase in Average Creditors with a creditors turnover of (a) 45 days, (b) 60 days and (c) 90 days.
Times/year Days
A strict credit policy allows Pineda to maintain a debtor’s turnover rate of 30 days. Pineda is considering a more relaxed
credit policy to hopefully increase sales.
Calculate the increase in the average debtors for a debtors’ turnover of (a) 45 days, (b) 60 days and (c) 90 days.
Times/year Days
Calculate the decrease in average inventory with an inventory turnover of (a) 40 days, (b) 30 days and (c) 20 days.
14.4 LO 4 a. Why do companies make rights issues of equity, rather than raising the equity in some other way?
b. Phoenix Ltd has issued 20 million ordinary shares at 10¢ per share. On 7 June the ASX closing price of the shares
was $1.20. Early on the morning of 8 June, the business publicly announced that it had just secured a new contract to
build some hospitals in the Middle East. For Phoenix, the contract had a net present value of $4 million. On 9 June it
announced its intention to raise the necessary money to finance the work, totalling $10 million, through a rights issue
priced at 80¢ per share.
Determine for how much, in theory, a shareholder could sell the right to buy one of the new shares. (Assume that the
events described above were the only influence on the share price.)
c. The directors of Phoenix Ltd are reconsidering their decision on the rights issue price. They are now contemplating
an issue price of $1 per new share. One of their concerns is the effect that the issue price will have on their
shareholders’ wealth. You have been asked to advise them.
Calculate the financial effect on a person who owns 200 shares in Phoenix before the rights issue, assuming, in turn,
a rights price of 80¢ and $1 in each case, both on the basis that the shareholder takes up the rights and, second, that
he/she sells them.
Taking account of all the factors, advise the business what to do about the rights issue price.
14.5 LO 4 Rugs Galore Ltd wishes to increase its number of retail outlets in southern Queensland. The board of directors has decided
to finance this expansion program by raising the funds from existing shareholders through a one-for-four rights issue. The
most recent statement of comprehensive income for the company is as follows:
$m
Interest 6.2
The company’s share capital consists of 60 million ordinary shares issued at $0.50 per share. Its shares are currently being
traded on the ASX at a price/earnings ratio of 11 times, and the board of directors has decided to issue the new shares at a
discount of 20% on the current market value.
a. Calculate the theoretical ex-rights price of an ordinary share in Rugs Galore Ltd.
b. Calculate the price at which the rights in Rugs Galore Ltd are likely to be traded.
c. Identify and evaluate, at the time of the rights issue, each of the options arising from the rights issue for an investor
who held 4,000 ordinary shares before the rights announcement.
14.6 LO 3 Nudelhie Partners Pty Ltd is a new start-up company trying to decide how to finance the organisation. The partners are
considering a mix of equity and long-term debt. Use the values below to calculate the projected earnings per share (EPS) for
each of the proposed financing alternatives.
On completion of the table, the trend in the EPS as the financing structure changes should be apparent. What does this
illustrate?
Interest expense ? ? ? ? ?
Tax expense ? ? ? ? ?
Intermediate
14.7 LO 2/3/4 Business is going well for Optic Technology Ltd. The board of directors of this family-owned company believes that it could
earn an additional $800,000 in profit before interest and taxes each year by expanding its range of products. However, the
$4 million that the business needs for growth cannot be raised by the family. The directors, who strongly wish to retain
family control of the firm, must consider issuing securities to outsiders. They are considering three financing plans:
Optic presently has 500,000 ordinary shares issued. All three plans will raise the required $4 million. The income tax rate
is 30%.
14.8 LO 2 Goya Ltd is a small engineering business that has annual credit sales revenue of $2.4 million. In recent years, the
business has had credit-control problems. The average collection period for credit sales has risen to 50 days, even though
Goya’s stated policy is for payment to be made within 30 days. In addition, 1.5% of sales are written off as bad debts each
year.
Goya has recently been in talks with a factor, which is prepared to make the firm an advance equivalent to 80% of
receivables, based on the assumption that customers will in future adhere to a 30-day payment period. The interest rate
for the advance will be 11% per annum. The accounts receivable are currently financed through a bank overdraft carrying
an interest rate of 12% per annum. The factor will take over Goya’s credit-control procedures, and this will save it $18,000
a year; however, the factor will make a charge of 2% of sales revenue for this service. Goya’s use of the factoring service
is expected to eliminate its bad debts.
Calculate the net cost of the factor agreement to the business, and state whether or not Goya should take advantage of
the opportunity to factor its accounts receivable. (Hint: To answer this question, compare the cost of existing trade policies
(the cost of investment in accounts receivable and the cost of bad debts) with the cost of using a factor (interest and other
charges less the credit control savings).)
14.9 LO 2/3 Pilworth Engineering Ltd wishes to invest in robotic equipment that will cost $4 million. This investment is expected to
increase annual profits before interest and tax by $1.2 million from 1 January 2021. The summarised statement of financial
position and income statement of the business for 2020 are shown.
Assets $m
Current assets
Inventories 4.4
Cash 1
9.2
Total assets 12
Current liabilities
Equity
Retained earnings 3
$m
Taxation (0.6)
The business paid a total dividend of $0.4 million in respect of 2020. In order to raise the finance for the new equipment,
one of two options will be selected.
The first option involves a rights issue of 2 million shares at $2.00 per share. (The current market price of the shares is
$2.50.)
The second option involves the issue of 10% loan notes totalling $4 million. Capital repayments of equal annual
instalments of $500,000 starting on 1 January 2022 would be required for the loan notes.
Whichever financing option is chosen, the business intends to maintain the existing dividend per share for the foreseeable
future.
a. Prepare a forecast income statement for 2021 under the loan notes and share capital financing options.
b. Compute the earnings per share for 2021 and the long-term capital employed at the end of that year under the loan
notes and the share capital options.
Challenging
14.10 LO 3 Chamberton Ltd is a stock-exchange-listed business that wishes to raise $100 million to invest in a new project that is
expected to generate operating profit of about $20 million each year.
The most recent financial statements of the business can be summarised as follows:
CHAMBERTON LTD
Income statement
for the year ended 31 December 2020
$m
Interest (20)
Taxation (30)
Profit for the year 60
CHAMBERTON LTD
Statement of financial position
at 31 December 2020
$m
Non-current liabilities
Equity
220
a. Outline the important features of each of the three proposed types of financing from the point of view of the existing
shareholders.
b. To the extent that you have the information, assess the suitability of the three proposed types of finance, in the
business’s circumstances.
14.11 LO 3 Telford Engineers Ltd, a medium-sized manufacturer of car parts, has decided to modernise its factory by introducing
robots. These will cost $20 million, and will reduce operating costs by $6 million per year for their estimated useful life of 10
years. To finance this scheme the company can either:
2020
2017 2018 2019 (Estimated)
$m $m $m $m
Current assets 55 67 57 55
Non-current assets 48 51 65 64
Accounts payable 20 27 25 18
Overdraft 5 – 6 8
25 27 31 26
Non-current liabilities 30 30 30 30
2020
2017 2018 2019 (Estimated)
$m $m $m $m
Interest payable 4 3 4 5
Income tax 12 16 0 4
Dividends 6 8 3 4
For your answer, assume that the company tax for 2019 is 40%; that sales and operating profit will be unchanged except
for the $6 million cost saving made by the robot technology; and that Telford Engineers will pay the same dividend per
share in 2021 as in 2020.
a. Prepare, for each scheme, Telford Engineers’ statement of comprehensive income for the year ended 31 December
2021 and a statement of its share capital, reserves and loans on that date.
b. Calculate Telford Engineers’ earnings per share for 2021 for both schemes.
c. Calculate the level of earnings (profit) before interest and tax at which the earnings per share for each scheme is
equal.
d. Which scheme would you advise the company to adopt? Support your answer with reasons, and state what
additional information you would require.
14.12 LO 1/2 All 4 U Ltd operates a small chain of fashion shops in Auckland. In recent months the company has been under pressure
from its suppliers to reduce the average credit period taken from three months to one month. To be able to comply with the
creditors’ demands, the directors of the company have asked the bank to increase its overdraft for one year. The
company’s most recent accounts are as follows:
ALL 4 U LTD
Statement of financial position as
at 31 May 2020
$ $
Current assets
Inventory 198,000
201,000
Non-current assets
67,000
7,000
74,000
Current liabilities
194,000
Non-current liabilities
Shareholders’ equity
41,000
ALL 4 U LTD
Abbreviated statement of comprehensive income
for the year ended 31 May 2020
Sales 740,000
Taxation (10,000)
Dividend proposed (10,000)
Notes
2. Access the website for the EY Fintech Australia census. This provides an overview of what is
happening in this area in Australia. Using the 2018 report we can see that there are a number of
types of fintech being developed. These include: payments, wallets and supply chain; wealth and
investment; data, analytics and information management/Big Data; lending; business tools;
insurance/insurtech; marketplace-style or peer-to-peer solution; regtech; asset management and
trading; blockchain/distributed ledger solutions; digital/crypto-currencies and exchanges; identity,
security and privacy; challenger/neo bank. Other headings are used elsewhere, including: co-
working; robo advice; and peer-to-peer lending.
a. Identify three areas that you are particularly interested in, and prepare a 10-minute
presentation for your class. You should try to ensure that the majority of the areas are
covered by your class.
b. What do you see as the future for fintech?
c. What might be the major issues confronting fintech?
d. Alan Kohler, in the article ‘It’s peak freedom for social media and tech companies’ (The
Australian Business Review, 1 April 2019) raised some doubts about some of the directions
we are going in. For example, he talked about an IPO by ‘taxi company’ Lyft, which closed
with a market capitalisation of US22.4 billion, even though on revenue of US$2.2 billion the
previous year it had lost US$911 million. He commented: ‘Oh, it’s not a taxi company? It’s a
technology/ridesharing disrupter? Right. It’s a taxi company with an app, then.’ What are
your initial thoughts on the reasons for the very high valuations associated with some of the
disrupters? Are they sustainable?
Concept check answers
CC1 A CC4 B CC7 B CC10 D
Activity 14.1
The cash that could be generated is as follows:
$m $m
Inventories
Accounts receivable
Accounts payable
Total 3.0
Activity 14.2
With borrowing, the obligation to make interest payments and capital repayments could put the business
in financial jeopardy. There is no such risk with ordinary shares.
Activity 14.3
The contract might specify a minimum level of current ratio or, perhaps, acid-test ratio.
Activity 14.4
For a business, the level of risk associated with each form of finance is in reverse order. Borrowing is the
most risky because it is exposed to a legally enforceable obligation to make regular interest payments
and, usually, repayment of the amount borrowed.
Activity 14.5
Price movements will normally be much less volatile for loan notes than for ordinary shares. The price of
loan notes and ordinary shares will reflect the expected future returns from each. Interest from loan notes
is fixed by contract over time. Returns from ordinary shares, on the other hand, are very much less
certain.
Activity 14.6
Loan note holders will expect to receive a lower level of return than ordinary shareholders. This is
because of the lower level of risk associated with this form of investment (loan interest is fixed by
contract, and security will often be available).
Activity 14.7
The main factors are as follows:
Preference shares have a higher rate of return than loan capital. From the investor’s point of view,
preference shares are more risky. The amount invested cannot be secured, and the return is paid after
the returns paid to lenders.
A company has a legal obligation to pay interest and make capital repayments on loans at the agreed
dates. A company usually makes every effort to meet its obligations, as failure to do so can have
serious consequences (as mentioned earlier). Failure to pay a preference dividend, on the other hand,
is less important. There is no legal obligation to pay a preference dividend if profits are not available
for distribution. Although failure to pay a preference dividend may prove an embarrassment to the
company, the preference shareholders will have no redress against the company if there are
insufficient profits to pay the dividend due.
We have said that the taxation system in Australia and New Zealand permits interest on loans to be
allowable against profits for taxation, whereas preference dividends are not. Because of the tax relief
that loan interest attracts, servicing loan capital usually costs a company much less than the cost of
servicing preference shares.
The issue of loan capital may mean that a company has to accept some restrictions on its freedom of
action. We have seen earlier that loan agreements often contain covenants (conditions) which can be
onerous. However, no such restrictions can be imposed by preference shareholders.
Activity 14.8
Property is often subject to such an arrangement.
Activity 14.9
The geared option will give the shareholders $0.0234 more earnings per share (EPS), and so appears to
be more attractive. If the operating profit proves to be greater than $40 million, shareholders would be still
better off than under the all-equity option. If, however, the operating profit falls below $40 million, the
reduction in EPS would be much more dramatic under the geared option.
Activity 14.10
If investors believe that shares can easily be sold for prices that tend to reflect their true worth, they will
have more confidence to invest. The business may benefit from this greater investor confidence by finding
it easier to raise long-term finance. It may also obtain finance at a lower cost as investors will regard their
investment as being less risky.
Activity 14.11
A pro-rata rights issue is generally regarded as the fairest method of capital raising. Suggested reference:
Stuart Wilson, ‘Equity raising should be equitable’, The Australian, 8 December 2009.
Activity 14.12
The venture capitalist will be concerned with the quality of management, the owners’ personal stake in or
commitment to the business, the quality and nature of the product, the plans made to exploit the business
opportunities, and financial matters.
Management accounting capstone case 2 Young’s
venture ltd
It was November 2019, Annie Young had recently earned an MBA degree from a university and decided
to run a start-up, Young’s Venture, together with two fellow classmates. She has done some market
research and conducted a pilot sale of the product into the market with positive results. She travelled to
Asia and secured a reliable supplier, who has demonstrated high-quality manufacturing and responsible
supply-chain practices, and has now signed a contract including terms for volumes, prices, delivery
schedule and quality clauses.
As an importing retailer, Young’s Venture will initially purchase a single type of teeth-whitening kit from a
supplier and sell it in Australia, with online and New Zealand expansion options available. Annie is excited
about the new venture, and the three of them plan to expand into more product ranges once the first
product establishes its market.
Based on the contract with the supplier, the purchase cost of each teeth-whitening kit is $12 for the initial
two years. Additional import taxes and inward transport costs will total $3 each item.
Forecasted sales
Young’s Venture’s market forecast indicates that an initial monthly sales volume of 1,500 items, which is
through the dental clinics operating at shopping centres. These sales arrangements have already been
negotiated. The dental clinics will charge a commission of 10% of all sales value made through their
outlets. The sales commission is paid in the month of sales. They estimate, somewhat conservatively,
that sales for the first three months will be 1,500 items in each month. After the first three months,
Young’s Venture forecasts that a 5% volume increase is reasonable based on market research, to be
followed by a further 5% increase in the 10th month.
For the second year, they expect the sales will stay at a 10% increase; that is, 1,650 items per month,
throughout the year.
The initial selling price will be $20 per unit, and this will remain so in the first two years.
The dental clinics insist on 30-days credit terms to pay for the stock due to the industry practice, and
Young’s Venture has accepted this request. However, research based on the payment experience of
other suppliers to dental clinics shows the realistic payment pattern is:
Capital expenditures
Young’s Venture estimates that initial requirement for capital expenditures will be:
The assets will be depreciated using the straight-line method with an estimated residual value of nil. The
capital expenditures for the above items are planned to be paid in the first month.
Young’s Venture plans to pay cash for all of these items as they are incurred, except for the office rent.
The office rent will be paid in arrears one month after the occupation.
For the second year, Young’s Venture is planning to spend $300 per month on market research to
explore further markets in addition to the dental clinics. However, they expect the real sales for the online
and New Zealand markets to pick up in the third year.
Young’s venture financing
Young’s Venture has registered a Pty Ltd to run the business with a registration fee of $120. The three
founders agreed to each contribute a third of the equity required for the business and receive an equal
number of shares. They estimate that the initial total funds for the venture must be sufficient to cover the
capital expenditures, and to provide sufficient cash for three months of the estimated cash operating
expenses and three months of planned inventory purchases.
Financing for small business ventures is difficult to raise in 2019, so the three shareholders agreed that
equity would be 60% of the required funds, and the balance would be debt funded by Annie’s parents.
The loan is for three years, with principal to be paid at the end of each year. The interest on debt will be at
4% annual rate, but Annie’s parents have agreed that the first year’s interest can be paid in full on the
final day of the year, and interest will be paid monthly for years 2 and 3.
Required
1. How much debt will need to be borrowed from Annie’s parents?
2. Prepare the monthly cash budget for Young’s Venture for the first two years. Please round your
numbers to two decimal places.
3. Prepare the budgeted income statements for Young’s Venture for the first two years, and comment
on the feasibility of the business plan.
4. Calculate the break-even point for year 1 in the number of teeth-whitening kits, and also in sales
dollars. Calculate the margin of safety in units and sales. Assuming a target profit before tax of
$6,000 for the year, what level of sales will be needed?
5. Calculate the net working capital at the end of year 1 and the operating cash cycle for year 1.
Comment on its management of the working capital.
6. Why do you think it is important to for Annie to check if the Asian supplier has responsible supply
chain practices?
7. What changes, if any, in the assumptions and/or venture funding situation would you recommend
for the business?
Glossary
A
ABC system of inventories control
A method of applying different levels of inventories control, based on the value of each category of
inventories.
absorption costing
A method of costing in which a ‘fair share’ of manufacturing/service provision overhead is included
when calculating the cost of a particular product or service.
accelerated depreciation
An approach to the calculation of depreciation expense that results in depreciation expenses being
higher in the early years of an asset’s life than in later years.
accounting
The process of identifying, measuring and communicating information to permit informed judgements
and decisions by users of the information.
accounting standards
Rules established by the professional or statutory accounting bodies, which should be followed by
preparers of the annual accounts of companies.
accruals accounting
The system of accounting that adheres to the accruals convention. This system is followed in
preparing the statement of financial position and the income statement.
accruals convention
A convention that asserts that profit is the excess of revenue over expenses for a period, not the
excess of cash received over cash paid.
accrued expenses
Expenses which are outstanding at the end of the accounting period.
adverse variance
The difference between planned and actual performance, where the difference will cause the actual
profit to be lower than the budgeted one.
amortisation
The writing-down of an asset—usually an intangible asset—as its benefit is used up; the equivalent of
the depreciation for a non-current asset.
asset
A present economic resource controlled by the entity as a result of past events.
associate company
A company that is partly owned by another company, such that the ownership does not give the
investor company control, but does give it the opportunity to exert considerable influence. Typically,
the ownership is between 20% and 50%.
audit
A process in which a range of activities are checked to ensure that the activities have been completed
in accordance with a set of rules or guidelines.
auditors
Professionals whose main duty is to make a report as to whether, in their opinion, the accounting
statements of a company do what they are supposed to do; namely, to show a true and fair view, and
comply with statutory and accounting standard requirements.
Australian Accounting Standards Board (AASB)
Australian body responsible for developing accounting standards for application to Australian entities.
AVCO
See weighted average cost .
B
bad debts
Amounts owed to the business that are considered to be irrecoverable.
balance sheet
A statement that shows the assets of a business and the claims on the business. Assets must always
equal claims. Claims will relate to external liabilities and owners’ claims (known as ‘equity’).
balanced scorecard
Both a management system and a system for measuring and reporting performance, which includes
information relating to financial aspects of the business, business processes, customers, and learning
and growth, thus giving a more comprehensive (and strategic) view of the business.
bank overdraft
A flexible form of borrowing that allows an individual or business to have a negative current account
balance.
batch costing
A technique for identifying full cost, where the production of many types of goods and services,
particularly goods, involves producing a batch of identical or nearly identical units of output, but where
each batch is distinctly different from other batches.
board of directors
The team of people chosen by the shareholders to manage a company on their behalf.
bonds
See loan notes (or stock) .
bonus shares
Reserves which are converted into shares and given ‘free’ to shareholders.
bottom–up
A term applied to decisions in which great weight is given to the views of relatively junior staff, who
often have good experience and detailed knowledge of what is going on in the business and its
markets. The term is often used in budgeting, where budgets are driven by the views of staff such as
sales representatives.
break-even analysis
A way of analysing cost behaviour and revenues so as to enable the break-even point (and other
target levels of profit) to be calculated.
break-even point
A level of activity where total revenue will exactly equal total cost, so there is neither profit nor loss.
budget
A financial plan for the short term, typically one year.
budget committee
A group of managers formed to supervise and take responsibility for the budget-setting process.
budget holder
The person who is responsible for working towards and implementing a particular section of a budget.
budget officer
An individual, often an accountant, appointed to carry out, or take immediate responsibility for having
carried out, the tasks of the budget committee.
budgetary control
Using the budget as a yardstick against which the effectiveness of actual performance can be
assessed.
business angel
An individual who supplies finance (usually equity finance) to a start-up business or a small business
wishing to expand. Often business angels take a close interest in the running of the businesses in
which they invest.
business ethics
A form of applied ethics or professional ethics that deals with ethical principles and moral or ethical
problems in the context of a business environment. They typically deal with policies and practices
relating to all aspects of business conduct, including governance, insider trading, bribery and a range
of other issues. Business ethics are central to the conduct of individuals and entire organisations.
These ethics are influenced by both national and corporate cultures, by the legal system, and by
businesses, professional organisations and individuals.
C
capital
Another name for owners’ equity, often associated with sole proprietorships or partnerships. The
owner’s claim on the assets of the business.
carrying amount
The net book value shown in the statement of financial position at a point of time.
cash discount
A reduction in the amount due for goods or services sold on credit in return for prompt payment.
Ceres Principles
A set of principles, which is effectively a 10-point code of environmental conduct.
claim
An obligation on the part of the business to provide cash or some other economic resource to an
outside party.
common costs
See indirect costs .
common size reports
Statements which try to set the key magnitude at 100 and then express everything else as a
percentage. Also known as ‘vertical analysis’.
comparability
A quality that helps users identify similarities and differences between items of information.
conservatism convention
See prudence convention .
consistency convention
The accounting convention which holds that when a particular method of accounting is selected to
deal with a transaction, this method should be applied consistently over time.
contingent liability
A potential liability that might arise by the occurrence of one or more uncertain future events. It will
become a liability contingent on that event happening.
control
To compel events to conform to the plan.
conventions
Rules that have been devised over time in order to deal with practical problems experienced by
preparers and users of financial reports.
corporate governance
The system by which corporations are directed and controlled.
cost
The amount of resources, usually measured in monetary terms, sacrificed to achieve a particular
objective.
cost behaviour
The manner in which costs alter with changes in the level of activity.
cost centre
Some area, object, person or activity for which costs are separately collected.
cost drivers
Activities that cause costs.
cost of capital
The cost to a business of long-term finance needed to fund its investments.
cost of sales
The cost attributable to the sales revenues.
cost pool
The sum of the overhead costs that are seen as being caused by the same cost driver.
cost unit
The object for which the cost is being deduced, usually an individual product.
crowdfunding
Where funds are raised from a large number of investors who typically pledge a relatively small sum.
crowdlending
The non-equity equivalent of crowdfunding. Also known as ‘peer-to-peer lending’.
current assets
Assets that are not held on a continuing basis. They include cash and other assets which are
expected to be consumed or converted to cash, usually within the next 12 months or within the
operating cycle.
current liabilities
Amounts due for repayment to outside parties within 12 months of the statement of financial position
date, or within the operating cycle.
current ratio
A liquidity ratio that relates the current assets of the business to the current liabilities.
D
debenture
A long-term loan, usually made to a company, evidenced by a trust deed.
depreciation
A measure of that portion of the cost (less residual value) of a fixed asset that has been expensed
during an accounting period.
direct costs
Costs that can be identified with specific cost units, to the extent that the effect of the cost can be
measured in respect of each particular unit of output.
direct method
The method of calculating operating cash flows by analysing the cash records to identify cash
payments and receipts by type.
directors
Individuals who are elected to act as the most senior level of management of a company.
disclosing entity
An entity that issues securities that are quoted on a stock exchange or made available to the public via
a prospectus.
discount factor
The rate applied to future cash flows to derive the present value of those cash flows.
discretionary budget
A budget that is entirely at the discretion of management; that is, it is not linked directly to output or
sales (e.g. research and development).
double-entry book-keeping/accounting
The formal system of recording using ledger accounts which reflect the dual aspect of financial
transactions.
dual-aspect convention
The accounting convention which holds that each financial transaction has two aspects, and that each
aspect must be recorded in the financial statements.
E
earnings per share (EPS)
An investment ratio that relates the earnings generated by the business during a period, and available
to the shareholders, to the number of shares on issue.
entitlement offer
An offer made to a specific investor to enable the purchase of a security or other asset. The offer
cannot be transferred to another party. An entitlement offer is offered at a specific price and must be
used during a set timeframe.
entity approach
An approach to the layout of the statement of financial position which emphasises that the report is
focusing on the entity as a whole.
equity
The share of the business that represents the owners’ interests.
ethics
A code of behaviour considered correct, especially that of a particular group, organisation or
individual.
eurobond
A form of long-term borrowing where the finance is raised on an international basis. Eurobonds are
issued in a currency that is not that of the country in which the bonds are issued.
expense
A measure of the outflow of assets (or increase in liabilities) incurred as a result of generating
revenues.
F
factoring
A method of raising short-term finance. A financial institution (factor) will manage the sales ledger of
the business and will be prepared to advance sums to the business based on the amount of accounts
receivable outstanding.
fair values
Exchange values in an arm’s length transaction.
faithful representation
A quality that says that accounting information should represent what it is supposed to represent—it
should be complete, neutral and free from error.
favourable variance
The difference between planned and actual performance where the difference causes the actual profit
to be higher than that budgeted.
FIFO
See first in, first out .
finance lease
A financial agreement where the asset title remains with the owner (the lessor) but the lease
arrangement transfers virtually all the rewards and risks to the business (the lessee).
financial accounting
Financial accounting provides financial information for a variety of users, with the information being of
a general-purpose nature.
financial assets
Securities issued by other organisations (e.g. bonds).
financial derivative
Any form of financial instrument, based on share capital or borrowings, which can be used by
investors either to increase their returns or to decrease their exposure to risk.
financial gearing
The existence of fixed payment-bearing sources of finance (e.g. borrowings) in the capital structure of
a business.
financial management
A subject area concerned with the financing and investing decisions of a business.
fintech
New technology that seeks to improve and automate the delivery and use of financial services.
five Cs of credit
A checklist of factors to be taken into account when assessing the creditworthiness of a customer.
fixed charge
Where specific assets are pledged as security for a loan.
fixed cost
A cost that stays fixed (the same) in total when changes occur to the volume of activity.
flexed budget
A budget which is modified to reflect the costs that would have been expected for the actual
activity/level of output.
floating charge
Where all of a business’s assets, rather than specific assets, are pledged as security for a loan. The
charge will only fix on specific assets if the business defaults on its obligations.
full cost
The total amount of resources, usually measured in monetary terms, sacrificed to achieve a particular
objective.
full costing
Deducing the total direct and indirect (overhead) costs of pursuing some objective or activity of the
business.
fundamental qualities
The two most important qualities underlining the preparation of accounting reports; namely, relevance
and faithful representation.
G
gearing
The existence of fixed-payment bearing securities (e.g. loans) in the capital structure of a business.
gearing ratio
A ratio that relates the long-term, fixed-return finance contributed (such as borrowings) to the total
long-term finance of the business.
goodwill on consolidation
The amount paid by an investing company for the purchase of sufficient shares to acquire a controlling
interest in another company, less the value of the equity or net assets, usually calculated on a fair
value basis.
gross profit
The difference between the revenue from sales and the cost of those sales.
H
historic cost convention
The accounting convention that holds that assets should be recorded at their historic (acquisition)
cost.
holding company
See parent company .
I
impairment
The amount of loss that must be written-off for an asset in the situation where the carrying amount of
the asset exceeds its recoverable amount.
income
Increases in economic benefits for the accounting period in the form of inflows of assets or decreases
in liabilities that result in increases in equity, other than those relating to ownership contributions.
income statement
The statement that measures and reports how much wealth (profit) has been generated in a period.
Also called a ‘statement of financial performance’, or a ‘profit and loss (P and L) statement’.
income tax
An amount levied on income, which is payable to the government.
incremental budgeting
An approach to budgeting that uses what happened in the previous year as the starting point for
negotiating the budget for the next year.
indirect costs (or overheads)
All costs except direct costs; that is, those that cannot be directly measured in respect of each
particular unit of output.
indirect method
An approach to deducing the cash flows from operating activities, in a cash flow statement, by
analysing the business’s financial statements.
inflation
A tendency for a currency to lose value over time owing to increasing prices of goods and services.
intangible assets
Assets that, while providing expected future benefits, have no physical substance (e.g. copyrights,
patents).
integrated reporting
A process founded on integrated thinking, which results in a periodic ‘integrated report’ by an
organisation about value creation over time, and related communications regarding aspects of value
creation.
issuing house
A financial institution that specialises in the issuing of new securities.
J
job costing
A technique for identifying the full cost per unit of outputs, where outputs are not similar.
just-in-time (JIT)
A system of inventories management that aims to have supplies delivered just in time for their required
use in production or sales.
L
last in, first out (LIFO)
A method of inventory valuation based on the assumption that the last inventory received is the first to
be used.
lead time
The time lag between placing an order for goods or services and their delivery to the required location.
liabilities
A present obligation to transfer an economic resource as a result of past events.
LIFO
See last in, first out .
limited company
An artificial legal entity that has an identity separate from that of those who own and manage it.
limited liability
The situation in which an investor in a business (a limited company) has his or her liability limited to a
maximum specified amount; namely, the maximum that he or she has agreed to subscribe to the
business.
limiting factor
Some aspect of the business (e.g. lack of sales demand) that will stop it from achieving its objectives
to the maximum extent.
loan covenants
Conditions contained within a loan agreement that are designed to help protect the lenders.
M
management accounting
An approach that aims to provide managers with the information they require to run the organisation.
management by exception
The term used to describe a system of control in which attention is given to areas which are out of line
with plans; that is, which are exceptional.
margin of safety
The extent to which the planned level of output or sales lies above the break-even point.
marginal cost
The addition to total cost which will be incurred by making/providing one more unit of output.
master budget
A summary of the individual budgets, usually consisting of a budgeted income statement, a budgeted
statement of financial position, and a budgeted statement of cash flows.
matching convention
The accounting convention which holds that, in measuring income, expenses should be matched to
the revenues they helped generate in the same accounting period as those revenues were realised.
materiality
The quality of information that has the potential to alter the decisions that users make.
materiality convention
The convention that says items need to be separately disclosed if they will be seen as important
(material) by users. Items not deemed to be important enough to justify separate disclosure can be
grouped together.
minority interests
See non-controlling Interests .
money measurement
The accounting convention which holds that accounting should deal with only those items that are
capable of being expressed in monetary terms.
mortgage
Borrowing secured on property.
N
net assets
The difference between assets and external liabilities.
non-controlling interests
The proportion of a subsidiary company that is owned by other than the parent company. Also known
as ‘minority interests’.
non-current liabilities
Those amounts due to other parties which are not liable for repayment within the next 12 months after
the statement of financial position date.
O
offer for sale
An issue of shares that involves a public limited company (or its shareholders) selling the shares to a
financial institution, which will, in turn, sell the shares to the public.
operating cycle
Normally represents the time between the acquisition of the assets and their ultimate realisation in
cash or cash equivalents.
operating gearing
The relationship between the total fixed costs and the total variable costs for some activity.
operating lease
An arrangement where a business hires an asset, usually for a short period of time. Hiring an asset
under an operating lease tends to be seen as an operating decision rather than a financing decision.
operating profit
The increase in wealth for a period that is generated from normal operations.
opportunity cost
The cost of the best alternative strategy.
ordinary shares
Shares of a company owned by those who are due the benefits of the company’s activities after all
other stakeholders have been satisfied.
other gains
Gains from non-operating activities.
outlay cost
A cost that involves the spending of money or some other transfer of assets.
owners’ equity
The residual interest in the assets of the entity after deducting all its liabilities.
P
parent company
A company that invests in another company by purchasing sufficient shares to obtain a controlling
interest. Also known as a ‘holding company’.
partnership
The relationship that exists between two or more persons carrying on a business with a view to profit.
periodic budget
A budget that is prepared for a specific period, typically a year.
personal guarantee
A guarantee given by one person (the guarantor) to a lender, guaranteeing that in the event of default
by the borrower, the guarantor will make good the payment due.
preference shares
Shares which have a fixed rate of dividend that must be paid before any ordinary dividend can be
paid. Often preference shares have higher priority than ordinary shares in the event of the company
going into liquidation.
prepaid expenses
Expenses that have been paid in advance at the end of the reporting period.
private equity
Equity finance, primarily for small or medium-sized businesses, provided by venture capitalists, such
as large financial institutions.
private placing
An issue of shares that involves a limited company arranging for the shares to be sold to the clients of
particular issuing houses or stockbrokers, rather than to the general investing public.
process costing
A technique for deriving the full cost per unit of output, where the units of output are the same or very
similar, or it is reasonable to treat them as being so.
proprietary approach
An approach to the layout of the statement of financial position which emphasises that the report is
focusing on the proprietors (owners).
provisions
An estimated liability for which there is greater uncertainty regarding the amount or the timing of the
amount than for a normal liability.
public company
A company that can offer shares to the general public. Shares can be traded on a public stock
exchange.
public issue
An issue of shares that involves a public company making a direct invitation to the public to purchase
shares in the company.
R
reducing-balance method
A method of depreciation in which a fixed percentage is applied to the written-down value of the asset.
relevance
A quality that states that, in order to be relevant, accounting information must be able to influence
decisions.
relevant cost
The cost which is relevant to any particular decision.
reporting entity
An entity that is required, or chooses, to prepare financial statements is known as a reporting entity. A
reporting entity need not be a legal entity, and can be a single entity, a portion of a larger entity, or be
made up of more than one entity.
reporting period
The particular period for which the accounting information is prepared.
reserves
Amounts reflecting increases in owners’ claims.
residual value
The expected value at the end of the useful life of a non-current asset.
retained profit
The amount of profit made over the life of a business which has not been taken out by owners in the
form of drawings or dividends.
return
The gain that results from a particular event or occurrence.
revenues
Increases in the owners’ claim as a result of operations.
reverse factoring
See supply chain finance.
rights issue
An issue of shares for cash to existing shareholders on the basis of the number of shares already
held, at a price that is usually lower than the current market price.
risk
The likelihood that what is projected to occur will not actually occur.
risk premium
A rate of return in excess of what would be expected from a risk-free investment, to compensate the
investor for bearing that particular risk.
rolling (or continual) budget
A budget (typically covering a year) that is modified regularly (typically monthly) by changing the dates
covered by the budget. For example, an annual budget might be prepared to cover the period
January–December. At the end of January, the budget is reviewed and revised to cover the period
February to January of the next year.
S
sale and lease-back
An agreement to sell an asset (usually property) to another party and simultaneously to lease the
asset back in order to continue using it.
securitisation
Bundling together illiquid physical or financial assets of the same type to provide backing for issuing
interest-bearing securities, such as bonds.
security
Assets pledged or guarantees given to provide lenders with some protection against default.
sole proprietorship
An individual in business on his or her own account. Also known as a ‘sole trader’.
stakeholder theory
A theory which argues that organisations have a variety of interested parties, and that these interests
need to be considered and incorporated in a harmonised manner in order to achieve the best overall
outcomes.
standard costing
A more detailed system of flexible budgeting that enables more detailed variance analysis to occur.
standards
Planned quantities and costs (or revenues) for individual units of input or output. Standards are the
building blocks used to produce the budget.
stock exchange
A market where ‘second-hand’ shares may be bought and sold and new capital raised.
straight-line depreciation
A method of accounting for depreciation that allocates the amount to be depreciated evenly over the
useful life of the asset.
strategic management
An approach that seeks to provide a business with a clear sense of purpose, and to ensure that
appropriate action occurs to achieve that purpose.
subsidiary company
A company that is controlled by another, by the fact that this other company owns a controlling interest
in the company concerned.
sunk cost
A cost that has already been incurred and, as such, is not relevant for future decisions.
sustainability reporting
A system of reporting that attempts to report on key issues that impact on environmental and social
sustainability.
T
takeover
Where one company buys enough shares in another company to obtain a controlling interest.
tangible assets
Those assets that have a physical substance (e.g. plant and machinery, motor vehicles).
tender issue
Shares for sale to investors for which the investors must state the amount they are prepared to pay for
the shares.
term loan
Finance provided by financial institutions, such as banks and insurance companies, under a contract
with the borrowing business that indicates the interest rate and the dates of payment of interest and
repayment of the loan. The loan is not normally transferable from one lender to another.
timeliness
Being available early enough to be of use to users.
top–down
An approach to budgeting where the senior management of each budget area originates the budget
targets, perhaps discussing them with lower levels of management.
total cost
The sum of the variable and fixed costs of pursuing some activity.
trend analysis
A form of analysis that uses trends, usually graphically or by percentage analysis.
U
understandability
Clearly set out to facilitate understanding.
V
variable cost
A cost that varies according to the volume of activity.
variance
The financial effect, on the budgeted profit, of the particular factor under consideration being more or
less than budgeted.
variance analysis
A system of comparing differences between budget and actual by reason.
venture capital
Long-term capital provided by certain institutions to small and medium-sized businesses in order to
exploit relatively high-risk opportunities.
verifiability
A quality that enables something to be checked and verified.
voluntary liquidation
A situation in which a business is closed on a voluntary basis.
W
weighted average cost (AVCO)
A method of inventory valuation based on the assumption that the valuation attached to cost of sales
is based on an average cost of inventory.
written-down value
The cost or fair value of an asset less the accumulated amount written off as depreciation to date.
Z
zero-based budgeting (ZBB)
A budget process that starts with the assumption that everything must be justified. There can be no
reliance on needs from earlier periods.
Additional topic 1 Recording transactions—the
journal and ledger accounts
Learning objectives
When you have completed your study of this topic, you should be able to:
For hundreds of years the basic system used has been ledger accounting,
which uses a system of double entry, hence the common name of double-
entry bookkeeping. This has been supplemented by a system of what are
known as subsidiary records, which is a way of ensuring that every
transaction is identified and noted so as to make sure that the correct
entries are made in the accounts. There are also very good reasons
relating to internal control and efficiency for the use of subsidiary records.
Subsidiary records are also known as books of original entry.
From the early 1960s the emphasis has changed almost continually to the
use of computer systems. Over the years these have become more
sophisticated, with far greater integration of systems and provision of
almost all documentation needed. While this is not always obvious,
underlying all of these systems are the principles of double-entry
bookkeeping, or ledger accounting. This topic deals with a simple
subsidiary record (the general journal) and the ledger accounting system in
some detail. The next topic then deals with principles of internal control and
explains the principles underlying subsidiary records before finishing with a
brief review of computerised systems and accounting information systems.
The recording process—an overview
LO 1 Provide an overview of the recording process, including the nature of business transactions,
steps in the recording process, the role of the general journal and ledger accounts, through to the final
accounts
We recorded a range of typical transactions onto a statement of financial position (balance sheet) and
statement of financial performance (income statement), using a series of pluses and minuses. We were
able to use this first-principles approach to produce a statement of financial position and a statement of
financial performance for the particular business organisation. We briefly indicated how a basic worksheet
approach could lead to the same result. In neither case, however, would the approach handle large
volumes of data. So, the first-principles approach needs to be modified to be able to handle these large
volumes.
Mentioned above, the system of double-entry bookkeeping, which was developed many hundreds of
years ago, provides us with a starting point. This is the primary focus of the rest of this topic. The system
of ledger accounts uses what amounts to a system of pluses and minuses to record transactions.
Essentially, every type of asset, liability, equity, revenue or expense that is needed in the financial
statements has an individual account, in which everything that affects it is recorded. Each account has
two sides, a debit side and a credit side. A debit entry is effectively a plus to an asset or expense account
and a minus to an equity, liability or revenue account. A credit entry is the opposite. These will be dealt
with in detail in the next section.
Of course, identifying just what needs to go into a set of accounts raises other questions. In practice, a
preliminary record is kept. This is known as a subsidiary record, or book of original entry. In this record, all
the relevant details that are needed to record the transaction in the ledger accounts must be entered. A
variety of ways of doing this are available, but at this stage we will limit ourselves to using a simple
general journal. Example AT1.1 shows the way in which the journal works.
EXAMPLE
AT1.1
Assume that we have two transactions:
The journal is used to describe the transaction and to turn it into an accounting entry, i.e. it
identifies the accounts to be debited and credited. The general form of the journal appears as
follows, using the above transactions for illustration purposes.
General Journal
Date Account name and narrative reference Posting Debit Credit
Loan 1250
5,000
The recording in the journal should be comprehensive, giving sufficient detail to provide both an
audit trail and assurance that the subsequent entry to the ledger account is correct. The transfer to
the appropriate account is known as ‘posting’ to the account. All transactions should then be
incorporated in the set of ledger accounts. From these, the final accounts, i.e. the income
statement and the balance sheet, can be produced, after incorporating adjustments.
Try with Activity AT1.1 to identify the effect of a set of transactions and the entries needed in the
ledger accounts.
Activity AT1.1
Complete the table for the following transactions:
The next step is to make a record of each transaction. This is done in the general journal. Try Activity
AT1.2 .
Activity AT1.2
Enter the transactions in Activity AT1.1 in the general journal.
Figure AT1.1 summarises the links between the various parts of the recording process.
While the ledger accounting system remains at the core of the recording system, a range of other factors
has meant that the recording process has become more complex, with the result that the systems
supporting the double-entry system have become rather more varied. These other factors include the
following:
The principal aim of Additional Topics 1 and 2 is to provide you with a broad understanding of the
underlying principles of the recording process in general, and the ledger accounting process in particular.
Additional Topic 1 will cover the general journal and ledger accounts. Ultimately, the ledger accounting
process will underpin the recording of transactions and the preparation of final accounts. Additional
Topic 2 will address internal control generally, and then go on to discuss some of the complications
identified in this section. The focus throughout is on general principles of transaction analysis and
recording. By the end of Additional Topic 2 you should have a reasonable understanding of the
underlying principles, and an insight into how these principles can be applied. It is impossible to include in
this book the multitude of alternative approaches used in practice.
Concept check 1
Which of the following statements is false?
A. The system of ledger accounts uses what is, in effect, a system of pluses and
minuses.
B. Each account in the ledger is able to record both aspects of each single transaction.
C. Each account has two sides, a debit side and a credit side.
D. A debit entry in an asset or expense account will effectively increase the figure in the
account.
E. A debit entry in a liability or revenue account will effectively reduce the figure in the
account.
Concept check 2
Which of the following statements is most likely to be false?
A. All transactions need to be recorded in some kind of subsidiary record.
B. The general journal acts like a well-kept diary, recording transactions and providing a
narrative that aids understanding of what has happened.
C. Subsidiary records are an essential part of the audit trail and internal control.
D. Advances in computer technology mean that the principles underlying the journal are
no longer valid.
E. Competition between the accounting software packaging businesses means that
packages will always tend to have some different features.
Double-entry bookkeeping
LO 2 Explain how the use of double-entry bookkeeping mirrors the first-principles approach, and use
the general journal and ledger accounts to record a set of basic business transactions
The principal aim of the earlier chapters was to provide a broad understanding of the basic principles of
accounting, particularly the statement of financial position and income statement. In doing this, we have
shown how a set of final accounts can be derived from a set of transactions. While the system used in
previous chapters is relatively simple and straightforward, we have so far only been dealing with small
volumes of transactions. This system of pluses and minuses will not cope with high volumes of
transactions. In practice, businesses usually record their transactions in one, or a combination, of the
following ways:
Students who are going on to major in accounting need to understand these. Others may find the
remainder of this additional topic and Additional Topic 2 , which together provide an overview of both
approaches, useful in gaining a better understanding of just how the figures that they will use are actually
prepared. Additional Topic 2 will discuss a range of topics, which should be of interest and use to
both accounting majors and non-majors, including internal control and development of integrated
systems, as well as provide some real world examples of how various types and sizes of businesses
manage the recording process.
Assets+Expenses=Liabilities+Equity+Revenues
In fact, the equity could include drawings and injections, so a more complete equation would be:
ledger
The book which contains the detailed accounts for an organisation.
An account is a record of one or more items, relating to a person or thing, kept under an appropriate
heading. The number of accounts will be dependent on their usefulness. For example, a variety of small
items of expenditure might be collected in an account called ‘miscellaneous expenses’, simply because
no really useful purpose is served by breaking the account down further. Not surprisingly, the decision
comes back to a cost–benefit analysis. The more detailed the accounts, the more information is available.
But keeping more accounts generally costs more.
Each transaction is recorded in the relevant accounts. Transactions are entered in date order. Each
account therefore provides a history— necessary for the income statement. It is also able to provide a
current picture—necessary for the statement of financial position. At this stage it may be useful to refer to
the statement of financial position as the balance sheet, and the income statement as the profit and loss
account. You will see in due course that the profit and loss account is actually an account in which
revenues and expenses are summarised, and that the statement of financial position is a summary of
year-end balances on accounts held. The actual statements of financial position and the income
statement can be seen to be clearly derived from the ledger accounts.
Each account has two sides, a debit side and a credit side. In the equation shown above, the left-hand of
the list is generally recorded on the debit side, while the right-hand side is generally recorded on the credit
side. Hence, accounts for assets, drawings and expenses are generally recorded on the debit side, while
capital, liabilities and revenues are generally recorded on the credit side. The debit side simply means the
left-hand side and the credit side means the right-hand side. To debit an account means to enter it on the
left-hand (debit) side. To credit an account means to enter it on the right-hand (credit) side.
Let us now work through Example AT1.2 using the general journal and double-entry bookkeeping.
EXAMPLE
AT1.2
The following transactions occurred in the first week of trading of Paul & Co.
January 4 Cash sales amount to $1,200. The cost of these sales is $700.
January 7 Cash sales of $800 and credit sales of $200 are made to A. Driver. The cost of sales is $700.
January 7 Paul takes out $400 cash for his personal use.
1 January: The effect of this transaction is to increase cash and increase capital/equity. This will be
achieved by a debit to the cash account and a credit to the capital/equity account. The entry in the
general journal will be:
Date Account name and narrative Folio Debit side Credit side
Equity 30,000
Using ledger accounts you can see that the date is recorded, providing a history; a cross-reference is
used, namely the title of the other account; and the amount is recorded. The folio column provides a
numerical cross-reference. While important in practice, it is unimportant for our purposes and will not be
used in the remainder of the text. This column is sometimes headed journal or posting reference.
Typically, the folio will be a reference back to the journal page. You should note that, in using ledger
accounts, the dual effect of a single transaction is achieved by entering in two accounts, hence the name
‘double-entry bookkeeping’.
2 January: The effect of the first transaction for 2 January is to increase an asset, vehicle, and reduce
cash. As you might expect from what has been said before, the vehicle account needs to be opened and
debited with $10,000 and the cash account will be credited. The journal entry will appear as shown below:
Date Account name and narrative Folio Debit side Credit side
Cash 10000
Vehicle
Next we turn to the reduction in cash. This can be achieved by crediting the cash account as below:
Cash
Cash
30,000 30,000
The letters c/d mean ‘carried down’ to the next section. The letters b/d mean ‘brought down’ from the last
section.
In passing, it is worth noting that some people prefer a modified form of account which keeps a running
balance, as shown below:
Cash
Balance
2 January: The second transaction on 2 January results in an increase in inventory and an increase in
creditors. The journal entry would appear as shown below:
Date Account name and narrative Folio Debit side Credit side
Creditors/payables 8,000
Inventory
Creditors—J Spratt
Date Account name and narrative Folio Debit side Credit side
Cash 50
Cash
30,000 30,000
Vehicle expenses
Jan 3 Cash 50
4 January: This transaction really two transactions. The first is the sale, which results in an increase in a
revenue account, sales, and an increase in cash, both of $1,200. The second is the use of inventory,
which leads to a reduction (a credit) in inventory and an increase in an expense (a debit), cost of sales,
both of $700. The journal entry is as follows:
Date Account name and narrative Folio Debit side Credit side
Sales 1,200
Inventory 700
Sale for cash of inventory, which had cost $700, for $1,200
Cash
30,000 30,000
Jan 2 Balance b/d 20,000 Jan 3 Vehicle expense 50
Sales
Inventory
Cost of sales
5 January: The transactions are similar to those of 4 January. The journal entry is shown below:
Date Account name and narrative Folio Debit side Credit side
Sales 800
Inventory 560
Cash
30,000 30,000
Sales
Cost of sales
6 January: This transaction results in a decrease in cash (a credit to cash) and a decrease in creditors (J.
Spratt) (a debit). The journal would appear as follows:
Date Account name and narrative Folio Debit side Credit side
Cash 5,000
Cash
30,000 30,000
Creditors—J. Spratt
7 January: The payment of sundry expenses by cash will result in a decrease in cash (a credit) and an
increase in an expense (a debit). The cash sales follow the same pattern as earlier. The credit sales
result in an increase (a debit) to debtors rather than cash. The drawing leads to a reduction in capital and
a reduction in cash. Typically, the reduction in capital is recorded initially in a drawings account and
transferred to the capital account at the year-end. The journal entry would appear as follows:
Date Account name and narrative Folio Debit side Credit side
Sales 800
Sales 200
Inventory 700
Cash 400
Cash
30,000 30,000
Sales
Inventory
Debtors—A. Driver
Drawings
Sundry expenses
We have recorded the transactions in the journal, which should mean that we have captured all of the
transactions in one subsidiary book. We have then posted the journal to the accounts. This gives us a
logical way of providing a comprehensive record of transactions that can then be used to build a set of
final accounts. In passing, it is worth noting that duality, as applied in double-entry bookkeeping, has led
to every transaction needing two entries, one a debit, one a credit.
The complete set of accounts, balanced off where necessary, is set out below.
Asset accounts
Vehicle
Inventory
8,000 8,000
Debtors—A. Driver
Jan 7 Sales 200
Cash
30,000 30,000
22,800 22,800
Liability accounts
Creditors—J. Spratt
8,000 8,000
Equity accounts
Capital/equity
Drawings
Expense accounts
Cost of sales
Vehicle expenses
Jan 3 Cash 50
Sundry expenses
Revenue accounts
Sales
3,000
At this stage, you will probably have noticed that where an account has only entries on one side it has not
been balanced, but simply totalled.
If we were to summarise the balances using the format discussed earlier, reproduced below, we would
have the basis of a set of final accounts.
Assets Liabilities
Expenses Revenues
Vehicle expenses 50
35,600 35,600
In passing, note that at this point you should be able to calculate the net profit of $490 ($3,000 – (1,960 +
50 + 500)) for the week, and simply insert this figure into the balance sheet to complete the balancing
process.
Concept check 3
Which of the following is false?
A. Debits and credits are the accountant’s method of pluses and minuses.
B. A debit to an asset account is an increase to the account.
C. A credit to a liability account will increase the account balance.
D. A debit to an equity account will increase the account balance.
E. None of the above. All are true
Concept check 4
A business makes a sale on credit. Which is the correct double entry?
A. Debit sales, credit receivables
B. Debit cash, credit sales
C. Debit receivables, credit cash
D. Debit receivables, credit sales.
Concept check 5
Which of the following could not have a credit balance unless there had been an error?
A. Sales
B. Interest
C. Cash
D. Vehicles.
Activity AT1.3
Journalise the following transactions:
You may have already decided that you do not want to become an accountant, so knowledge of
double-entry bookkeeping is unnecessary or irrelevant to you. So why might it be useful for you to
know the basics? Several reasons spring to mind.
Many experienced business people still use (or refer to) the traditional terminology.
There are examples of documents where figures are represented using debits and credits (e.g.
bank statements). Do you find it confusing that, if your bank statement shows a credit balance
on your account, it means that you have money in your account. How can that be, given what
was said earlier? The answer is straightforward. The bank statement sent to you is prepared
from the bank’s viewpoint. If you have cash in the bank, the bank would show this as a liability
(credit) in its accounts. In your own ledger accounts, cash in hand would be shown as a debit.
In practice, of course, manual ledger systems are rare, with most businesses using
computerised systems such as MYOB. Many of these systems still use traditional terminology,
so a broad understanding of them might be useful. For example, many computer systems still
refer to the ‘sales ledger’ or ‘debtors ledger’, which is simply the place where detailed individual
records relating to customers are kept.
The next stage of the double-entry bookkeeping process (before calculating profit) is a checking stage.
With high volumes of transactions, the chance of errors increases. This involves completion of a trial
balance , which is simply a listing of account balances. The form of the trial balance is given in
Example AT1.3 (page 18), with the figures prepared to date included.
Trial balance
A listing of all accounts in a ledger as a check to see whether they balance.
EXAMPLE
AT1.3
Trial balance as at 7 January
Debit Credit
$ $
Assets
Vehicles 10,000
Inventory 6,040
Debtors 200
Cash 16,850
Liabilities
Creditors 3,000
Equity
Capital 30,000
Drawings 400
Expenses
Vehicle expenses 50
Revenues
Sales 3,000
36,000 36,000
The fact that the totals for each column agree provides some indication that we have not made
bookkeeping errors.
We cannot, however, have total confidence that there are no errors simply because the totals of a trial
balance agree. Suppose, for example, that we paid rent for the month of $900. In each of the following
cases, all of which are an incorrect treatment of the transaction, the trial balance would still have agreed:
The transaction was completely omitted from the accounts, that is, no entries were made at all.
The amount was misread as $9,000, but then (correctly) debited to the rent account and credited to
cash.
The correct amount of $900 was (incorrectly) debited to cash and credited to rent.
Nevertheless, a trial balance, where the totals agree, provides some assurance that the accounts have
been correctly recorded.
While the fact that a trial balance balances does not mean that there are no mistakes, a trial balance that
does not balance does indicate that mistakes have been made. Preparation of a trial balance is therefore
usually an important stage in the internal control process.
Concept check 6
At the end of a period a trial balance is drawn up and the totals agree. Does this imply:
A. That the business has made a profit for the year?
B. That the accounting entries have all been correctly made?
C. That there has been a debit entry for every credit entry?
D. That a set of final accounts should now be produced for the period?
Concept check 7
A balance of $580 has been put on the wrong side of the trial balance. Assuming everything
else is correct, what would be the difference in the two totals in the trial balance?
A. $580
B. $1,160
C. $280
D. $850
Activity AT1.5
a. What kind of errors can be made that do not prevent the trial balance agreeing?
b. Which of the following errors would prevent the trial balance agreeing?
i. A payment for heat and light that was incorrectly debited to insurance
ii. A payment for improvements in a building that was debited to repairs and maintenance
iii. A sale that was debited to sales and debited to receivables
iv. A payment for wages that was debited as $9,900 and credited to cash as $990
v. A bad debt written off as a debit to the bad debts account and debited to receivables
vi. Two mistakes were made:
a. A receipt from a customer of $1,000, which was in satisfaction of a debt of $1,040,
the difference being discount allowed, was debited to cash $1,000, and to discount
allowed $20, and credited to payables $1,040.
b. A payment of rent amounting to $2,200, which was debited to rent as $2,220 and
credited to cash as $2,200.
Closing off the accounts
LO 4 Close off a simple set of accounts using the profit and loss account and complete a balance
sheet from the ledger accounts
The next stage is to ‘close off’ the accounts. Basically, this involves transferring the revenues and
expenses to a profit and loss account, and then transferring the balance of the profit and loss account,
and the drawings account, to the capital account. The purpose of the detailed revenue and expense
accounts is to provide a detailed ‘story’, but that story needs to be summarised into a profit and loss
account for the period. Essentially, the next step is to transfer the revenues and expenses to the profit
and loss account, as shown below. The process is completed by transferring the balance of the profit and
loss account (as either a profit or loss for the year) to the capital (equity) account, and also transferring
the drawings account balance to the capital account. You should note that we have not included any
period-end adjustments at this stage. This will follow in the next section.
Date Account name and narrative Folio Debit side Credit side
Vehicle expenses 50
Drawings 400
1,960 1,960
Vehicle expenses
Sales
3,000 3,000
Sundry expenses
3,000 3,000
At this stage, only the accounts that represent assets, liabilities or equity remain. These form the basis of
the balance sheet. The balance sheet, technically, is a listing of those accounts that have a balance on
them at the balance sheet date. The accounts that remain are listed below.
Asset accounts
Vehicle
8,000 8,000
Debtors—A. Driver
Cash
30,000 30,000
22,800 22,800
Liability accounts
Creditors—J. Spratt
8,000 8,000
Equity accounts
Capital/equity
Jan 7 Drawings 400 Jan 1 Cash 30,000
30,490 30,490
Drawings
Balance sheet
The balance sheet can now be drawn up in two-sided format as shown below:
Debtors 200
Non-current assets
Vehicle 10,000
33,090 33,090
More conventionally, the narrative format is used for presentation purposes. Normally the capital/equity is
broken down as shown below:
Cash 16,850
Receivables/debtors 200
Inventory 6,040
Non-current assets
Vehicle 10,000
33,090
Current liabilities
Payables/creditors 3,000
Capital/equity
Profit 490
30,490
Less Drawings 400
30,090
33,090
The profit and loss account will also typically be presented as an income statement in the narrative style
described previously.
Concept check 8
Which of the following will be closed off by transferring the amount due for the year to the
profit and loss account as an expense?
A. Accumulated depreciation
B. Sales
C. Drawings
D. Doubtful debts provision
E. Wages.
Concept check 9
Which of the following will remain on the accounts and be shown on the balance sheet?
A. Equipment
B. Equipment—depreciation
C. Payables
D. Receivables
E. Equity.
Activity AT1.6
The following is the trial balance of a sole trader as at 30 June 2020. Close the accounts to include a
profit and loss account and extract a balance sheet from the accounts.
Capital 160,000
Purchases 205,000
Sales 387,100
Premises 90,000
Cash 7,000
Wages 52,000
Equipment 50,000
Receivables 56,000
Payables 27,000
Drawings 25,000
574,100 574,100
The example so far has not included any period-end adjustments for prepayments, accruals, bad debts
and depreciation. The entries in the journal, and the postings to the ledger accounts, to deal with these
and related adjustments are detailed next.
EXAMPLE
AT1.4
Suppose, in Example AT1.3 , that sundry expenses included a payment of $200 which related to
a later period.
The sundry expenses figure would need to be reduced and an asset account set up. The expense
would then be transferred to the profit and loss account.
Date Account name and narrative Folio Debit side Credit side
Being closing off of the sundry expenses account to the profit and loss account
Sundry expenses
500 500
Prepaid expenses
It is possible to simply carry forward a debit balance on the sundry expenses account, rather than open a
separate prepayment account. However, the opening of a separate prepayment account is entirely
appropriate if a new set of ledgers is to be opened at the start of a new accounting period.
Similar adjustments are necessary if there are accruals, though obviously the balance will be on the other
side (see Example AT1.5 ). If some of the expense due remains unpaid at the end of the period, the
expense needs to be increased (debited) and a liability account (accrued expenses) set up and credited.
The expense account is then transferred to the profit and loss account.
EXAMPLE
AT1.5
Suppose that the vehicle expenses included in the account shown in Example AT1.3 had not
included the cost of servicing, which was completed, but not billed, on 6 January. The cost was
$250. This needs to be included as an expense, but also shown as a liability—accrued vehicle
expenses—in the balance sheet. This would be journalised as follows:
Debit Credit
Date Account name and narrative Folio side side
Increasing vehicle expense by the amount unpaid. Setting up an accrual for the amount
due to Townsend Servicing
Being the closing off of the vehicles expense account to the profit and loss account
300 300
EXAMPLE
AT1.6
A publishing business sells magazines on subscription. It has a financial year that ends on 30
June. Over the course of the last year it has received subscriptions totalling $500,000. Most annual
subscriptions cover the calendar year. On 30 June it estimates that it has received subscriptions,
totalling $200,000, which cover the period starting on 1 July. The necessary adjustment will be
journalised as follows:
Date Account name and narrative Folio Debit side Credit side
Being transfer of revenue from magazine subscriptions to the profit and loss account
June 30 Deferred revenue—subscriptions 200,000 June 30 Cash over the year 500,000
500,000 500,000
Deferred revenue—subscriptions
Revenues in arrears will be added to the appropriate revenue account and debited to an asset
account called something like ‘Revenue in arrears’.
Activity AT1.7
Journalise the year-end adjustments relating to the following transactions and then post them to the
ledger accounts (incorporating any balances from the year). Show clearly any transfers to the profit and
loss account. You should assume that the financial year of the business is 1 January to 31 December.
a. Electricity bills, totalling $3,000, were paid during the year ending 31 December 2020. All these
bills related to 2020. One bill, amounting to $600, remains unpaid, covering the period 1 November
2020 to 31 January 2021.
b. Stock of writing materials and stationery costing $5,000 was purchased during the year. On 31
December 2020, $500 worth remained in hand.
c. Rates amounting to $5,800 were paid on 30 September, covering the period 1 July 2020 to 30
June 2021.
Depreciation
Another adjustment that is needed is for depreciation (see Example AT1.7 ). Depreciation is an
expense. Accumulated depreciation (or depreciation provision) is what is known as a contra account, one
which is useful to identify separately, but which offsets another account, in this case a non-current asset.
EXAMPLE
AT1.7
Suppose that at the end of an accounting period the cost of non-current assets totals $100,000
and that a judgement has been made (based on ideas covered previously) that depreciation
should be calculated based on 10% per annum straight line, resulting in an annual expense
totalling $10,000. This would typically be journalised as shown below:
Date Account name and narrative Folio Debit side Credit side
Closing off of the depreciation expense account to the profit and loss account
Non-current assets
Depreciation (expense)
Dec 31 Non-current assets—Acc dep 10,000 Dec 31 Profit and loss 10,000
We can see that the profit and loss account will include the depreciation figure and the balance
sheet will include the non-current assets at cost, less the associated accumulated depreciation.
In later years the depreciation provision figure will accumulate, up to the point at which the written
value is the residual value. So, for the next year the accounts would appear as follows:
Depreciation (expense)
Year 2
Dec 31 Non-current assets—Accumulated depreciation 10,000 Dec 31 Profit and loss 10,000
Non-current assets—Accumulated depreciation
Year 1
Year 2 Year 2
20,000 20,000
The asset will be shown in the statement of financial position under the heading of non-current
assets:
80,000
Frequently non-current assets are sold. They are seldom sold at book value, so an adjustment to
reflect this needs to be made.
EXAMPLE
AT1.8
A vehicle was purchased for $30,000 three years ago. It has been depreciated at 20% per annum
straight line, resulting in a net book value of $12,000. It was sold for $14,000. Using a first-
principles approach, we can see that the depreciation has been overcharged by $2,000. The
estimated depreciation over the three years was 60% of cost—$18,000—while the actual
depreciation is $16,000. So, when the vehicle is disposed of, it will result in a reduction in the
expense, which effectively increases the profit figure.
It is common when disposing of non-current assets to use a disposal account. The two amounts
relating to the particular asset being sold, namely cost and accumulated depreciation, are
transferred to the disposal account. The entries in the journal and ledger accounts are therefore:
Debit disposal account, credit vehicle account—with the cost of the vehicle being disposed of,
$30,000.
Debit cash, credit disposal account—with the amount of the proceeds, $14,000
Debit an asset account (whatever you are trading in for) with the agreed value, credit disposal
account, $14,000.
The balance on the disposal account will then be transferred to the profit and loss account, as
shown below:
Disposal account
32,000 32,000
In this case the double entry would be a credit to the profit and loss account, representing a
surplus on disposal:
It would be quite common for ‘profits’ or ‘losses’ on disposal to be netted off to the depreciation expense
account, rather than written directly to the profit and loss account, as they should be seen as final
adjustments to the depreciation figure, rather than as profits or losses.
EXAMPLE
AT1.9
Let us assume that a business has, at its year-end (31 December), receivables totalling
$1,028,000. After careful consideration, it comes to the conclusion that debts totalling $28,000 will
not be recovered and need to be written off. The journal entry would be:
Date Account name and narrative Folio Debit side Credit side
Dec 31 Bad debts 28,000
Receivables 28,000
Receivables
1,028,000 1,028,000
Bad debts
The double entry to the bad debts account is to the profit and loss account:
These entries mean that the balance on the receivables account is $1,000,000. Remember that
this balance reflects the amount left after specific decisions (i.e. write-offs) have been made about
specified debtors. It is probably unrealistic to expect all of the debtors included in this total to pay.
We can be fairly certain that some won’t pay, but we don’t know which ones, so we cannot credit
the debtors account (which will be the sum of a host of individual debtor accounts). Instead, we
can set up another contra account, ‘provision for doubtful debts’.
Suppose that, on the basis of past experience, we decide that approximately 2.5% of the debtors
will not pay. This gives us an estimate of $25,000, which is journalised as follows:
Debit Credit
Date Account name and narrative Folio side side
The increase in the size of the doubtful debt provision for the year
Dec 31 Doubtful debts provision 25,000 Dec 31 Profit and loss 25,000
Note that this is an expense account, which will be charged to the profit and loss account.
The profit and loss account will then reflect both expenses relating to bad and doubtful debts, as
shown:
These two amounts may appear in the income statement separately, or as a single figure for bad
and doubtful debts, $53,000.
Receivables 1,000,000
975,000
In future years it is only the actual bad debts plus the amount of change in the required doubtful
debts provision that needs to be transferred to the profit and loss. For example, if
receivables/debtors at the end of the next financial year had reduced to $800,000, the doubtful
debts provision needed would reduce to $20,000. So, for this second year there would be the
actual bad debts and a revenue—’reduction in doubtful debts’—provision that would appear in the
profit and loss account.
Activity AT1.8
Journalise the following adjustments and record them (and any opening balances) in ledger accounts.
Show clearly any transfers to the profit and loss account. You should assume that the financial year of the
business is 1 January to 31 December.
a. A vehicle shown in the books at cost of $40,000, less accumulated depreciation of $20,000, was
sold for $18,000.
b. At the end of the financial year the receivables balances totalled $154,000. Bad debts amounting
to $4,000 were written off. The accounts show an opening doubtful debts provision amounting to
$3,500, based on an estimate of 2.5% of receivables. This percentage is to be retained for the
current year.
Inventory
The perpetual inventory approach is relatively easily handled using ledger accounts, though some
modification to the format helps.
EXAMPLE
AT1.10
Suppose that a particular line of inventory had the following transactions for a period.
Sold 30 tonnes
Sold 50 tonnes
The business uses FIFO as its way of dealing with inventory flow assumptions.
Inventory
Quantity Cost/unit Total cost Quantity Cost/unit Total cost Quantity Cost/unit Total cost
60 20 1,200 60 20 1,200
30 20 600 30 20 600
30 20 600
30 22 660 30 22 660
30 20 600
20 22 440 10 22 220
The double entry to the debit side would be a credit to cash or (more likely) to creditors/payables.
The double entry to the credit side would be a debit to the cost of sales account. All of these
transactions would be journalised prior to posting in the accounts.
If using the periodic method of recording inventory, a physical stock count and valuation is required. This
is then used to calculate the cost of sales. This approach is relatively straightforward using journal and
ledger accounts.
EXAMPLE
AT1.11
Let us assume that we have a system of ledger accounts which on June 30, the year end, includes
opening stock ($150,000) and purchases ($900,000). The value of closing stock has been
determined as $200,000, but this has not yet been recorded. We need to transfer the two current
balances to a cost of sales (CoS) account, then incorporate the closing stock adjustment, and then
transfer the cost of sales to the profit and loss account. Journal entries needed to reflect this are as
follows:
Date Account name and narrative Folio Debit side Credit side
Purchases 900,000
Inventory (opening)
Purchases
June 30 Balance b/f 900,000 June 30 Cost of sales 900,000
Inventory (closing)
Cost of sales
1,050,000 1,050,000
An alternative to the above treatment is to bypass the cost of sales account and transfer the opening
stock, purchases and closing stocks straight to the profit and loss account. Of course, the cost of sales
account can become more complicated with the addition of extra costs including such things as carriage
in, and by purchases returns.
Activity AT1.9
A business has the following balances relating to inventory at its year-end:
Purchases $450,000
Sales $900,000
Close off these accounts to the profit and loss account. The closing stock has been counted and valued at
$52,000.
Concept check 10
Which of these statements is true?
A. Accrued expenses result in a debit to the profit and loss account and a credit to an
accrual account.
B. Bad debts are set off against receivables in the balance sheet.
C. Expense accounts are debited to drawings.
D. When a non-current asset is sold at a price which is greater than its book value, the
result is a debit to the profit and loss account.
E. A business collects subscriptions in advance. These prepayments are shown as a
current asset.
Concept check 11
At the end of a financial period the provision for doubtful debts account is:
A. Closed by transfer to the profit and loss account
B. Carried forward and shown under current liabilities
C. Closed by transfer to the balance sheet
D. Carried forward and shown as a deduction from receivables.
Manufacturing and trading accounts
LO 6 Use a manufacturing account and a trading account where appropriate
Many trading businesses use a separate trading account, prior to the profit and loss account, in which
they calculate gross profit on trading (see Example AT1.12 ).
EXAMPLE
AT1.12
Trading account
Purchases x Sales x
x x
Similarly, a manufacturing business will record costs of production in a manufacturing account prior to the
trading account.
A typical manufacturing account will include the kind of entries shown in Example AT1.13 .
EXAMPLE
AT1.13
Manufacturing account
Opening balance of raw materials b/d x Closing balance of raw materials c/d x
Carriage in x
*
Direct labour x Cost of production to trading account x
Royalties x
Direct expenses x
Production overheads
Indirect labour** x
***
Indirect expenses*** x
Power x
Depreciation x
x x
*
Direct labour covers the costs of labour worked directly on production.
**
Indirect labour covers ancillary labour costs related to production.
***
Indirect expenses are typically small items that cannot be related to individual jobs.
Trading
x x
The information contained in the manufacturing, trading and profit and loss accounts is typically presented
in a more useful way. An example of how a manufacturing, trading and profit and loss suite of accounts
can be presented internally is given in Example AT1.14
EXAMPLE
AT1.14
Manufacturing, trading and profit and loss accounts for the year ending ...
Sales x
Raw materials
Opening balance x
x
Less closing balance (x)
Royalties x
Indirect labour x
Indirect materials x
Power x
*
Heat and light x
Cost of sales x
Gross profit x
Plus
Other revenues
Discount received x
Rent x
Interest x
Administration x
*
Wages/salaries x
Stationery x
*
Heat and light x
*
Rent and rates etc. x
*
Depreciation of fixtures x
Finance
Interest x
Bad debts x
Selling/distribution
Sales salaries x
Packaging distribution x
Advertising x
*
Note that these items need to be allocated to the appropriate section. Expenses relating to
production should appear in the manufacturing section, while expenses relating to administration
should appear in the profit and loss section.
Concept check 12
Which of the following combinations of expenses might you expect to find in a
manufacturing account?
A. Carriage in, direct labour, administration
B. Factory overheads, discount received, distribution
C. Depreciation of plant and equipment, indirect production labour, power
D. Factory rent and rates, depreciation of plant and equipment, depreciation of fixtures
E. Raw materials, packaging and distribution, factory power.
Activity AT1.10
The following information was provided from the accounts of a manufacturer on 30 June.
Stock 1 July
Stock 30 June
Receivables 120,000
Payables 40,000
Sales 1,500,000
Drawings 50,000
Cash 125,500
Advertising $3,000
b. Amounts prepaid
General expenses $22,000
c. $5,000 of the receivables are considered bad, while a general provision for doubtful debts is to be
set up—2% of receivables.
d. Depreciation is to be charged on plant and machinery and furniture and fittings at 10% of cost—
straight line.
Prepare a manufacturing, trading and profit and loss statement for the year ending 30 June, and a
balance sheet as at that date. Use a vertical form of presentation.
SELF-ASSESSMENT QUESTION
AT1.1
The following is the balance sheet of Jonathan & Co., a retailer, as at 1 January 2020.
$ $
Current assets
Cash 15,000
Debtors/receivables 20,000
Inventory 25,000
60,000
Non-current assets
Fixtures 10,000
Premises 50,000
60,000
120,000
Current liabilities
Payables/creditors 25,000
Non-current liabilities
Loan 40,000
Capital/equity 55,000
120,000
1. Purchases of inventory on credit amounted to $200,000, half being for cash and half on
credit.
2. Payments to creditors amounted to $105,000.
3. Sales amounted to $330,000, with credit sales being $120,000 and the remainder being for
cash.
4. Receipts from debtors were $110,000.
5. Bad debts of $5,000 were written off.
6. Cost of sales amounted to $200,000.
7. Interest on the loan at 7% was paid.
8. Wages amounting to $40,000 were paid.
9. Other expenses amounting to $15,000 were paid.
10. During the year the owner withdrew cash drawings totalling $15,000.
11. At the end of the year the owner transferred his private vehicle to the business. Its value
was estimated at $14,000.
At the end of the year the following information is provided to enable a range of year-end
adjustments to be made:
Premises $5,000
2. $1,000 of wages was unpaid, insurance of $100 was prepaid, and rates of $900 were
outstanding. Insurance and rates are included in other expenses.
Record this example in the ledger accounts, prepare a trial balance, close off the accounts for the
year, and prepare a profit and loss account and balance sheet.
Several things are worth noting at this stage:
The profit and loss account (with manufacturing and trading sections where appropriate) is part of the
ledger accounting system and all revenues and expenses are channelled through this account.
The balance sheet is effectively nothing more than a list of balances at a particular point in time.
These balances must represent assets or claims at that time.
Accounts can be asset, expense, liability or revenue depending on circumstances. For example, in the
answer to Self-assessment Question AT1.1 (available online), the ‘other expenses’ account has
cash payments that are expenses, cash payments that are prepayments (assets), and expenses that
are unpaid and therefore remain as liabilities.
In the answer to Self-assessment Question AT1.1 the trial balance was drawn up before the year-
end adjustments took place. It is quite possible (indeed desirable) for a further trial balance to be
drawn up after the adjustments.
Many examiners use the trial balance as a starting point for final account questions.
Adjusted trial balance and worksheet
LO 7 Use an adjusted trial balance and a worksheet to complete a set of final accounts
Let us use Self-assessment Question AT1.1 to work through the idea of a second trial balance after
the adjustments have been completed.
We can see from the solution (available online) that the trial balance before any adjustments are made
will be as follows:
Cash 57,200
Receivables 25,000
Inventory 25,000
Fixtures 10,000
Vehicle 14,000
Premises 50,000
Payables 20,000
Loan 40,000
Equity 69,000
Sales 330,000
Interest 2,800
Wages 40,000
Drawings 15,000
459,000 459,000
Depreciation will be recorded in expense accounts and accumulated depreciation accounts as follows:
Depreciation—fixtures (expense)
Accumulated depreciation—fixtures
Dec 31 Depreciation—fixtures 2,000
Depreciation expense—premises
Accumulated depreciation—premises
Wages
Cash 40,000
41,000
Accrued wages
Other expenses
15,900 15,900
At this point, rather than closing off the revenue and expense accounts to the profit and loss account, we
draw up an adjusted (final) trial balance, as a check on the correctness of the adjustments, before moving
to the closing-down stage. The adjusted trial balance would appear as shown below:
Cash 57.200
Receivables 25,000
Inventory 25,000
Fixtures 10,000
Premises 50,000
Payables 20,000
Loan 40,000
Equity 69,000
Sales 330,000
Interest 2,800
Wages 41,000
Drawings 15,000
467,900 467,900
This approach can easily be incorporated into a spreadsheet or worksheet as shown in Table AT1.1 .
Debit Credit Debit Credit Debit Credit Debit Credit Debit Credit
Assets
Current assets
Non-current assets
Current liabilities
900
Non-current liabilities
Profit 58,400
Income statement
Profit 58,400
459,000 459,000 9,000 9,000 467,900 467,900 330,000 330,000 196,300 196,300
This is a neat and efficient way of dealing with the preparation and checking of final accounts. We can
see clearly how we can move from a trial balance through the adjustments to an adjusted trial balance,
thus facilitating a further check on the accounts. From the adjusted trial balance we can then determine
whether the accounts are accounts which will be closed to the profit and loss account or whether they are
accounts which will be shown in the balance sheet. The final accounts are contained in the last two main
column headings (i.e. profit and loss and balance sheet). All that is needed is some tidying up for
presentation purposes.
You should note that in this example the figure for cost of sales is shown, which presupposes that a
perpetual system of inventory control has been used. Where the periodic method is used, we would
expect to find the opening balance of inventory in the trial balance, together with purchases, and the
closing inventory adjustment would be made in the adjustments column. In Activity AT1.11 you will
need to do the adjustment for inventory.
Concept check 13
Which of the following is the least likely to be found in the adjustment column of a
worksheet?
A. Drawings
B. Accruals
C. Disposals of a non-current asset
D. Depreciation
E. Doubtful debts provision.
Activity AT1.11
The following is the trial balance of a sole trading business at the end of its financial year.
$ $
Capital 803,800
Purchases 1,037,000
Sales 1,798,000
Insurance 7,000
Cash 32,000
Receivables 284,000
Payables 131,000
Drawings 52,000
2,843,400 2,843,400
1. Inventory at 30 June 2020 was physically counted and was valued at $263,000.
2. Rates of $5,700 were owing as at 30 June 2020.
3. A motor vehicle repair carried out on 1 June 2020, costing $2,200, was still unpaid at year-end.
4. The doubtful debts provision is to be adjusted to 5% of receivables at 30 June 2020.
5. Depreciation is to be provided at the rate of 25% per annum on cost for vehicles and 15% per
annum on cost for fixtures and fittings.
Prepare a profit and loss account for the year ended 30 June 2020 and a balance sheet as at 30 June
2020 for the business, using a worksheet.
The chart of accounts
LO 8 Describe a chart of accounts and explain its importance
However, before starting down this path, it is useful to consider the role and importance of the chart of
accounts .The chart of accounts is a list of all of the accounts kept by the organisation, grouped in
ways which link to the balance sheet and income statement. With manual systems, detailed folio
references are used. With computerised systems, detailed systems of coding are typically found.
chart of accounts
A listing of all of the accounts contained in the ledger accounts, usually with a
system of coding, which links with the balance sheet and income statement.
For a small business the chart of accounts is likely to look something like Table AT1.2 .
Other expenses
The chart of accounts must include all of the accounts that are necessary to complete the final accounts.
The list above covers most of the items found in the accounts used in this topic.
Clearly, a list of this small size could only be applicable to a small organisation. Great care is needed to
identify all of the items that might be needed in order to produce the necessary final accounts, but also to
provide all of the historical accounting needed for management accounting purposes. The above list will
not suffice for a multi-sector organisation, where detailed reports
will be needed in order to measure performance of sections of the organisation. We saw earlier that
Wesfarmers includes a range of activities, all of which need reporting on to shareholders and managers.
The chart of accounts would need to be substantially expanded to deal with a business of this complexity.
Even a small company will very soon need dozens of accounts in its chart of accounts.
With larger organisations, the chart of accounts becomes effectively a coding system, which enables all of
the relevant information to be collected and reported on. There are no hard and fast rules as to how a
coding system is developed; this will be dependent on the size and nature of the organisation. However,
the following are useful factors to bear in mind in designing a chart:
Reporting requirements may well affect how a company structures its chart of accounts.
It is important to create a chart of accounts that is unlikely to change for several years. Consistency is
important if comparisons are to be useful. Having said this, circumstances do change, and when
devising a coding system, you should always make sure that there is room for more codes, as
activities change or develop.
It is useful to periodically review the account list to see whether any of the accounts are redundant, in
the sense that they are not producing information which is material, and, if so, move them into a
larger, more general account.
An interesting perspective on the chart of accounts is provided on the Investopedia website. The chart of
accounts is compared with the list of balances you find when you log into your bank accounts online. The
summary shows the balance on each account, which enables you to get the big picture as to what is
happening with the management of your accounts. In the same way, the chart of accounts aims to
separate assets, liabilities, equity, revenues and expenses so that users can quickly get a sense of the
financial health of the organisation.
The coding system can take a variety of forms, mostly numeric, sometimes alpha-numeric. The aim is to
be able to break down activity into sub-parts or sections in sufficient detail to be able to produce
meaningful reports on as many sections of the business as is deemed necessary and appropriate.
Example AT1.15 aims to provide some guidance as to how this might occur.
EXAMPLE
AT1.15
Assume that you currently run a restaurant in a coastal town in Victoria. This has been quite
successful and you wish to expand into the next town, about 30 kilometres away. This town is
inland and is heavily dependent on the dairy industry. The clientele and circumstances associated
with the two restaurants are quite different. It would seem sensible to keep separate records for
each of them.
This could easily be done by simply setting up a second set of ledger accounts relating to the
second restaurant, with an income statement for each and the profits or losses from each being
then transferred to equity. However, it is likely that, as you expand, you will consider using an
accounting package.
The more complicated your business becomes, the more important the chart of accounts
becomes. After several years of running the two restaurants, you are looking at further expansion.
You have decided that expansion into the holiday rental business might provide a better link with
the restaurants than opening more restaurants further away. It could also link with provision of food
for conferences and related activities. This would necessitate some different types of accounts and
separate reporting, all of which could be done manually, but probably would be better done using
an accounting package.
A possible chart of accounts for the business is shown in Table AT1.3 . The first column includes
a reasonable chart of accounts for the single restaurant business. The second column sets out a
4-digit code which could work for this single business. The third column revises the coding system
to facilitate separate record-keeping for the second business. The fourth column does the same for
the third area of business and also adds some new accounts.
Mortgage 3261
Deposits 3281
Cleaning 3500
There is no reason to suppose that the type of accounts needed to include the second restaurant
would need to change. However, in order to keep track of the second restaurant separately, some
means of identification would be needed. This could simply be done by changing a single digit of
the code, as shown in the third column of the chart.
When we come to the third area of the business, we need to add some more accounts so as to
ensure that we are able to record the information necessary to enable us to see clearly how this
section of the business has performed, to provide information which can be used to assess its
success, and to identify ways in which improvements can be made. So, the first column includes
any extra accounts needed, which are shown in italic, while the fourth column includes new codes
for these new accounts and a change in the initial digit of the code to identify the third area of the
business. The last three numbers of the code will identify a particular type of account, while the
first number will identify which of the three sections of the business a particular transaction relates
to.
You should note that the preceding example uses a 4-digit code. This was a quite arbitrary choice.
The coding system can take many different forms, but the general approach is very similar, no
matter what codes are actually used. What is important is that considerable thought goes into the
original chart, so that little needs to be added or changed in the short-term. A complete change in
an area of the business, such as in the third area in the example, may well lead to some new
accounts and associated codes being required, but if a chart is imaginatively thought through from
the outset, and developed alongside a strategic plan, changes should be relatively small. Even the
adding of a well-developed subsidiary company, as the result of a takeover or acquisition, should
be capable of being quickly absorbed within a well-designed chart of accounts.
It would be easy to see the chart of accounts as financial accounting oriented, but this would be a
mistake. The regulations regarding limited companies are considerable, especially regarding the
financial accounts. But much of the information required is corporate-level, big-picture information.
Some of it relates to segments, but very little of it comes near the detail that we would expect a
management accountant (and his or her associated managers) to require in order to assess
performance and develop improvement and growth strategies. The development of an appropriate
chart of accounts goes to the heart of managing a business. It requires a clear strategic
perspective, a detailed understanding of planning and control, and an ability to develop a sound
information system.
Activity AT1.12
a. From Table AT1.3 , what codes would give you a total figure for the three sections of the
business for receivables and wages?
b. How easy would it be to prepare a profit and loss account for the entire business in Table
AT1.3 ?
c. Why do you think that it is important that the chart of accounts facilitates reporting of the separate
sections of the business?
d. Can you think of any areas of the restaurant business that might need more detailed reporting?
Identify the accounts and suggest a code or codes for these in line with those in Table AT1.3
e. For a retailer with a huge range of inventories, such as a supermarket, how might the chart of
accounts reflect the need for a detailed system of coding for sales and cost of sales?
An example chart of accounts for a very small business can be found by a web search under:
Example chart of accounts—Business Victoria
QUT, through the Australian Centre for Philanthropy and Nonprofit Studies, developed a Standard
Chart of Accounts to assist non-profit organisations and funders, including government
departments and agencies. The document is comprehensive and includes references to the
Accounting Standards. It also uses MYOB account numbers. It was handed over to the Australian
Charities and Not-for-profits Commission (ACNC) in 2013.
4e9e-412a-96c3-e0db53e0acfe.
It may appear that the computerised systems now so commonly found have moved away from double
entry. This is not correct. The underlying principles of ledger accounts underpin computerised accounting
systems. However, ledger accounting was developed at a time when businesses were smaller and easier
to keep track of. Large, complex businesses require more involved record-keeping approaches.
Inevitably, they will use a system which effectively uses a system of pluses and minuses or debits and
credits, and which produces the same kind of final accounts as a traditional ledger system. The main
advantage of the newer systems is the ease and speed with which they can produce a large amount of
additional information. Also, as we shall see in the next topic, the document flows associated with
business transactions can be fully integrated into these systems.
Concept check 14
Which of the following statements is false?
A. As the volume of transactions and the complexity of a business increases, the ledger
accounting system, as described in this topic, is unlikely to be able to cope without
further modification.
B. The chart of accounts is effectively a detailed system of coding for accounts.
C. The chart of accounts should be sufficiently detailed to enable meaningful reports on
as many sections of the business as is deemed necessary.
D. The chart of accounts should facilitate obtaining a ‘big picture’ as to what is going on.
E. The chart of accounts will need to change on a regular basis as the business
changes.
Summary
In this topic we have achieved the following objectives in the way shown.
LO1: Provide an overview of the recording process, including the nature of Identified the basic steps in the recording process as
business transactions, steps in the recording process, the role of the general identification of the effect of each business transaction,
journal and ledger accounts, through to the final accounts recording it in a journal, and posting it to the ledger
Identified a range of complications which lead to
variations in the way accounting systems operate in
practice
LO2: Explain how the use of double-entry bookkeeping mirrors the first- Illustrated how the double-entry system can be linked
principles approach, and use the general journal and ledger accounts to with a first-principles approach
record a set of basic business transactions Explained the form and purpose of the general journal,
and used it to record a range of transactions
Detailed the method of ledger accounting
Used the double-entry system to record a selection of
transactions
Balanced off a set of accounts
LO3: Explain the importance of a trial balance and use one as part of the Explained the role of the trial balance
accounting process Identified its limitations
LO4: Close off a simple set of accounts using the profit and loss account and Closed off the revenue and expense accounts to the
complete a balance sheet from the ledger accounts profit and loss account
Saw that the balance sheet was a summary of the
account balances as shown in the ledger accounts
Illustrated a series of period-end adjustments including:
LO5: Record a series of period-end adjustments in the accounts, relating to Prepayments and accruals
prepayments and accruals, deferred revenues and revenues outstanding, Revenues due and prepaid
depreciation, bad and doubtful debts, and transactions relating to inventory. Depreciation and asset disposals
Bad and doubtful debts
Inventory
LO6: Use a manufacturing account and a trading account where appropriate Prepared a set of final accounts for a trading business
and a manufacturing business
LO7: Use an adjusted trial balance and a worksheet to complete a set of final Explained and used an adjusted trial balance to assist in
accounts developing a set of final accounts
LO8: Describe a chart of accounts and explain its importance. Described the purpose and importance of a chart of
accounts
Illustrated the development of a chart of accounts
Explained how important clear definition of a chart of
accounts is, so as to be able to obtain as much
information as is needed to assess performance of all
parts of a business
Discussion questions
Easy
AT1.1 LO1 Outline the purpose of the general journal. How likely is it that it will be used for all transactions? Is it a necessary part of
the recording process?
AT1.2 LO1 Discuss the importance of the narrative and folio sections of the journal.
AT1.3 LO2– What are the main advantages of the double-entry system?
5
AT1.4 LO2– What are the main disadvantages of the double-entry system?
5
AT1.5 LO1/2 What is the typical range of accounts kept in a ledger accounting system?
AT1.6 LO1/2 What is the difference between journalising a transaction and posting it?
Intermediate
AT1.7 LO3/7 Explain the role of a trial balance.
AT1.8 LO3 List the kind of errors in record-keeping that might prevent a trial balance from agreeing.
AT1.9 LO7 Discuss the reasons for use of an adjusted trial balance.
Challenging
AT1.10 LO7 How useful is the worksheet approach?
AT1.12 LO8 How might you design a chart of accounts for the exciting business ventures that you plan? How might you deal with
uncertainty regarding future directions?
AT1.13 LO6 Identify and explain the way in which the expenses of a manufacturing business will be split into the manufacturing, trading
and profit and loss accounts in deriving profit.
Application exercises
Easy
AT1.1 LO2 Show how the following would be recorded in the general journal.
January 6 It sells inventory, which had cost $4,000, for $7,000 on credit.
AT1.2 LO2 The opening balance on the receivables account of a business was $40,000.
Journalise these transactions, post the appropriate amounts in the receivables account, and balance off the account.
AT1.3 LO2 D. Harvey started business on 1 April with $150,000. He also borrowed $50,000 from A. Veck on a long-term loan. Both
amounts were paid into a business bank account. During the next three months, the following business was transacted:
a. Rented buildings for $24,000 per annum, and paid four months rent on 1 April.
b. Purchased by cash furniture and equipment for $100,000 and a motor vehicle for $8,000.
c. Purchased inventory amounting to $80,000 on credit.
d. Sales for cash amounted to $50,000. The cost of these goods was $30,000.
e. Credit sales amounted to $40,000. The cost of these goods was $25,000.
f. Paid the creditors (payables) $60,000.
g. Received cash from debtors (receivables) of $30,000.
h. Business expenses paid, excluding rent, amounted to $5,000.
i. On 30 June expenses outstanding amounted to $500.
i. calculate, using ledger accounts, the value of inventory at cost, receivables, and payables as at 30 June
ii. prepare accounts to show the balance in the bank, the gross profit, and the profit for the period
iii. prepare a balance sheet as at 30 June to show the total of fixed assets, current assets, and current liabilities.
AT1.4 LO2–5 On 30 November Martin Webb extracted the following trial balance from his ledger.
Debit Credit
Capital 23,000
Drawings 20,000
Receivables 16,000
Payables 14,000
Sales 250,000
Purchases 180,00
Cash 26,500
Fixtures 10,000
287,000 287,000
Open accounts for each of the above items and insert the balance as at 30 November.
Drawings 2,000
Journalise the December transactions and post them to the above accounts. All receipts are paid into the bank and all
payments are made by cheque.
Martin Webb balances his accounts on 31 December each year. Balance the accounts, taking into account the
adjustments given below, and prepare trading and profit and loss accounts and a balance sheet.
Adjustments
$660,000 $670,000
During 2020 plant costing $90,000 (accumulated depreciation $60,000) was sold for $10,000.
AT1.6 LO2/5 Tiger Trucks purchases a truck on 1 July 2018 for $90,000. The business decides that the truck ought to last for 5 years,
after which it is likely to be sold for 10,000. Tiger Trucks’ accounting year is from January to December.
a. Assuming straight-line depreciation, show the entries in the ledger accounts relating to the truck and depreciation
for 2018 and 2019, clearly identifying the expense for each year, and the entries relating to vehicles that would
provide the basis for the figures in the balance sheet for vehicles. Assets are to be shown at cost with associated
accumulated depreciation.
b. On 31 December 2020, the truck is sold for $40,000. Show the 2020 account entries.
AT1.7 LO2/5 The following items appear in the balance sheet of a business as at 31 December 2019:
Current assets
Current liabilities
During the year to 31 December 2020, the following cash receipts and payments occurred:
Cash receipts
Cash payments
Wages $250,000
Insurance $12,000
Heating $10,000
At 31 December 2020 there are $5,000 of wages and $2,000 of heating bills that remain outstanding.
Prepare ledger accounts that show the entries for rent receivable, insurance, heating, and wages, showing clearly the
transfer that would be made to the profit and loss account. Also, indicate what figures relating to these accounts would be
included in the balance sheet of the business as at 31 December 2020.
AT1.8 LO2/5 From the information given below, you are required to show the ‘Rent and insurance’ account for the business for the
year ended 30 June 2020, indicating clearly the prepayments and accruals at that date and the transfer to the profit and
loss account for the year.
AT1.9 LO2/3/5 From the following information, show the ledger accounts for receivables, bad debts, provision for doubtful debts, and
relevant sections of the profit and loss for 2019 and 2020.
Intermediate
AT1.10 LO2/4/5 On 31 March 2019 the balance brought forward in the books of a business included the following:
Debit Credit
Receivables 50,000
You are given the following information in respect of the year to 31 March 2020.
a. The top floor office has been let since 1 January at a rental of $12,000 per annum, and the tenant should pay in
advance in two instalments on 1 January and 1 July in each year. Payment for the first four months of 2019 was
made on 1 January. A further $4,000 was paid on 1 October and a further $4,000 was paid on 1 March 2020.
The tenant was in occupation for the entire year.
b. On 1 January 2020 a new piece of equipment was purchased at a cost of $8,000—$4,000 was paid in cash and
the rest was satisfied by part exchange of a piece of equipment which had cost $5,000 and which had been
depreciated by $2,500 by 31 March 2019. Depreciation on equipment is provided at 10% per annum straight line.
c. On 1 December 2019 rates were paid for the year ending 30 June 2020, amounting to $2,500.
d. The total of receivables as at 30 March 2020 amounted to $55,000. It was decided that one debt of $1,000 was
irrecoverable, and that the provision for doubtful debts should remain at 5% of outstanding debtors.
Show the following ledger accounts for the year to 31 March 2020:
i. Rent receivable
ii. Rates
iii. Equipment
iv. Accumulated depreciation—equipment
v. Provision for doubtful debts
vi. Disposal account.
No other accounts are required, but all entries in the above accounts should be cross-referenced to the other
accounts affected.
AT1.11 LO2/4/5 A firm makes up its accounts each year to 31 December, and the following transactions took place in respect of motor
vehicles:
Cash $4,000
AT1.12 LO2/5 On 1 January loose tools to the value of $4,000 were held by a business. During the year wages of $200,000 were paid,
of which $2,000 related to work on loose tools for the business’s own use. Raw material costing $3,000 was used in this
process. At the year-end the value placed on the stock of tools was $3,200. Complete the loose tools account and the
depreciation account for the year.
AT1.13 LO2–5 The following items appear in the balance sheet of a business as at 31 December 2020:
Current assets
Current liabilities
During the year to 31 December 2021 the following cash payments were recorded:
Cash payments $
Wages 50,000
Insurance 1,200
Administration 10,000
At the year-end (31 December 2021) you ascertain that $1,000 of wages and $1,200 of administration bills remain
outstanding, and that $400 of insurance has been prepaid.
Prepare ledger accounts showing the entries for insurance, administration and wages, clearly showing the transfer that
would be made to the profit and loss account.
What figures, if any, relating to these transactions, would be included in the balance sheet as at 31 December 2021,
and under what heading would they appear?
AT1.14 LO3–5 The following trial balance was extracted from the accounts of Wiggs Ltd as at 31 December 2020.
Wiggs Ltd
Trial balance as at 31 December 2020
$ $
Sales 800,000
Purchases 500,000
Advertising 20,000
Capital 640,000
Debtors 145,000
Creditors 120,000
Drawings 50,000
Cash 45,000
1,585,000 1,585,000
Use a worksheet to prepare trading and profit and loss accounts for the year ending 31 December 2020 and a balance
sheet as at that date, incorporating the following adjustments:
AT1.15 LO3–5 The following trial balance was prepared from the accounts of a business as at 30 June 2020.
$ $
Sales 270,000
Purchases 140,000
Wages 40,000
Drawings 20,000
Capital 100,000
Premises 50,000
Equipment—cost 10,000
Debtors 30,000
Creditors 20,000
Cash 24,000
394,000 394,000
At year-end the following information is available:
AT1.16 LO3–5 The following is the trial balance of a sole trading business at the end of its financial year.
Debit Credit
$ $
Debtors 25,000
Creditors 14,780
Capital 120,000
Purchases 105,000
Sales 181,800
Cash 23,200
Drawings 5,200
$320,940 394,000
1. Stock/inventory at 30 June 2020 was physically counted and was valued at $26,300.
2. Rates of $1,500 were owing at 30 June 2020.
3. Insurance of $200 was prepaid at 30 June 2020.
4. A motor vehicle repair carried out in June 2020 costing $500 was still unpaid at the end of the year.
5. Bad debts of $2,000 are to be written off.
6. Depreciation is to be provided at the rate of 25% per annum on cost for vehicles and 15% per annum on cost for
furniture and fittings.
Prepare a profit and loss account for the year ended 30 June 2020 and a balance sheet as at that date for the business.
Challenging
AT1.17 LO3–5 The balance sheet as at 1 January 2020 of Xena and Hercules (Wargames) was as follows:
$ $ $ $
Inventory 21,000
69,000
Premises 90,000
150,000
219,000 219,000
Notes
The prepaid insurance relates to a premium which covered the three months to 31 March 2020.
The following represents a summary of the transactions which took place during 2020.
At the end of the year the following items of additional information were obtained:
Record the above in a set of ledger accounts, prepare a trial balance, close off the accounts incorporating the
adjustments and prepare a set of final accounts
AT1.18 LO3/4/5/7 The following balances appeared in the records of James Golding’s furniture business at 31 May 2020:
Capital 300,000
Creditors 54,000
Premises 150,000
Inventory 90,000
Debtors 40,000
Cash 71,400
Part of the premises are let to a firm of accountants at an annual rental of $24,000.
You are given the following data concerning the year to 31 May 2021:
Many business people are not very good at doing this and stories abound of accountants being
confronted with a shoebox full of bits of paper, from which they are expected to produce a set of final
accounts. Under these circumstances the stock approach to calculating capital or profit dealt with
previously is useful, but so is use of double-entry bookkeeping (at least in part) to try to work out what has
happened.
Invariably there are some records, bank statements, credit or debit card summaries, details of assets, etc.
These provide a starting point.
The normal process to prepare an estimate of how you are travelling is along the following lines:
1. Try to make as accurate an estimate of your position at the start of the year as you can.
2. Do the same for the end of the year.
3. Try to estimate the level of drawings for the year, and any capital injections.
4. This should enable you to calculate the profit for the year in total.
5. Then turn to bank and cash transactions (and credit card slips/summaries, etc.). Analyse them to
separate any personal transactions from business transactions (or vice versa), and fill in as much
detail as possible. Typically, it is useful to prepare cash and bank accounts and a credit card
account, built up from the analysis.
6. Use both receivables and payables accounts to try to work through to sales and purchases figures.
7. Put it all together into a profit and loss and balance sheet as far as is possible.
The above situation is usually referred to as incomplete records, and the process suggested above can
be used to fill in as much information as possible. This same approach can also be used when records
are lost, or inventory and non-current assets are destroyed by fire or are stolen.
From the information below, provided by a business, try to produce a statement of claim for the insurance
company, together with a profit and loss statement for the nine-week period to 2 June and a balance
sheet as at 2 June.
Alan Jameson is a sole trader who undertakes sales on both a cash basis (including cards) and a credit
basis. After the close of business on 2 June 2020 a fire occurred in the rented premises, which resulted in
the complete loss of the furniture and fittings, which were owned by the business, and its stock. All
detailed records were lost, although Alan had taken home the cash box, which contained a float of
$2,000, and the invoices for bills outstanding. These totalled $20,000, $18,000 of which related to
creditors for purchases, with $2,000 being due for electricity.
Over the next few days Alan proceeded to collect as much information as he could, to help in assessing
the extent of his loss. This is summarised below:
a. After many telephone calls, Alan estimates that the receivables outstanding on 2 June totalled
$50,000.
b. All takings were banked intact (directly for cash, indirectly for card sales), except for weekly wages
paid to staff, totalling $1,500 per week, and weekly drawings of $1,000, both of which are taken
from the till.
c. The business balance sheet as at 31 March 2020 was as follows:
Current assets
Cash 2,000
Bank 20,000
Receivables 60,000
Inventory 100,000
187,000
Non-current assets
237,000
Current liabilities
Payables 25,000
26,500
Capital 210,500
237,000
d. An analysis of the bank and credit card statements for the nine weeks to 2 June is summarised
below:
Balance 31 March 20,000
Receipts
170,000
Payments
Expenses 20,000
Creditors 104,500
124,500
Activity AT1.1
(a) Plus inventory Debit inventory/purchases
Or more likely:
Activity AT1.2
General Journal
Date Account name and narrative Folio Debit side Credit side
Inventory 10,000
Creditors/payables 10,000
Debtors/receivables 5,000
Sales 5,000
Sales on credit
Wages 2,500
Cash 2,500
Cash 5,000
Repayment of loan
Vehicle 30,000
Cash 30,000
Debtors/receivables 550
Activity AT1.3
General Journal
Date Account name and narrative Folio Debit side Credit side
G. Patel—creditor 5,000
Cash 2,000
Loan 20,000
Cash 1,000
Cash 4,000
Sales 1,500
Inventory 1,000
Cash 500
Activity AT1.4
Cash
Wages 1,200
Drawings 2,000
216,000 216,000
Capital
Cash 150,000
Loan
Cash 50,000
Cash 30,000
Vehicles
Cash 20,000
Inventory
50,000 50,000
Payables
50,000 50,000
Cash 3,000
Cost of sales
Inventory 10,000
Sales
Cash 16,000
Wages
Cash 1,200
Drawings
Cash 2,000
Activity AT1.5
a. The following errors would not prevent the trial balance agreeing:
where both entries are on the wrong (i.e. opposite) side
where incorrect figures are used in both entries
where a wrong class of account has been correctly entered, e.g. a motor vehicle has been
debited to motor vehicle expenses
compensating errors, where an error in one area is compensated by another error in the
opposite direction.
b. iii, iv, v
Activity AT1.6
Inventory
Capital
251,000 251,000
Purchases
Sales
Office expenses
General expenses
Premises
Cash
Wages
Equipment
Receivables
Payables
Bad debts
Drawings
Wages 52,000
346,100
437,100 437,100
The balance sheet consists of a listing of the accounts which remain open at the year-end.
Cash 7,000
Receivables 56,000
Inventory 50,000
Premises 90,000
Equipment 50,000
253,000
Payables 27,000
Capital 226,000
253,000
Activity AT1.7
Journal
Date Account name and narrative Folio Debit side Credit side
Being an addition to the electricity expense to cover the amount due in the current year but
unpaid
Rates 2,900
Being transfer from rates expense account to prepaid rates to adjust for the amount due for the year
Electricity
3,300 3,300
Accrued electricity
Stationery
5,000 5,000
Rates
5,800 5,800
Prepaid rates
Activity AT1.8
a. Journal
Date Account name and narrative Folio Debit side Credit side
Disposal 40,000
Disposal 20,000
Cash 18,000
Disposal 18,000
Disposal 2,000
Vehicle cost
Vehicle—accumulated depreciation
Disposal
40,000 40,000
b. Journal
Date Account name and narrative Folio Debit side Credit side
Debtors/receivables 4,000
Receivables
154,000 154,000
Bad debts
Dec 31 Doubtful debts provision 250 Dec 31 Profit and loss 250
Dec 31 Balance c/d (new provision) 3,750 Dec 31 Balance b/d 3,500
3,750 3,750
Activity AT1.9
Inventory
Purchases
Sales
Sales returns
Activity AT1.10
Manufacturing, trading and profit and loss statement for the year ended 30 June
Opening stock of raw materials 40,000 Cost of production transferred to trading account 1,195,000
280,000
1,195,000 1,195,000
1,355,000
1,500,000 1,500,000
Depreciation—fittings 5,000
233,300
Current assets
Cash 125,500
Receivables 115,000
112,700
Prepayments 22,000
Inventory
420,200
Non-current assets
45,000
360,000
405,000
825,200
Current liabilities
Payables 40,000
Accruals 8,000
48,000
Capital
Profit 51,700
827,200
825,200
Activity AT1.11
Trial balance Adjustments Adjusted TB Profit and loss Balance sheet
Debit Credit Debit Credit Debit Credit Debit Credit Debit Credit
Purchases 1,037,000
1,521,700
2,843,400 2,843,400 1,637,300 1,637,300 2,905,700 2,905,700 1,798,000 1,798,000 1,384,000 1,384,000
An alternative approach to dealing with inventory and cost of sales is to simply include opening inventory
and purchases in the profit and loss column and then make a final adjustment between the profit and loss
and balance sheet columns for the closing inventory—a credit in the profit and loss, and a debit in the
balance sheet column.
Activity AT1.12
a. 115–199, 2151–99, 3151–99, and 1301, 2301 and 3301.
b. The figures for the entire business can be summarised by adding all the codes which end between
301 and 651.
c. Care needs to be taken to ensure that it is clear just what information is needed, and how it is to be
presented. The chart of accounts is an integral part of this process.
d. Separate reporting of the costs of special events might be needed or useful. The revenue could be
identified with a range of codes in the 1600–1799 category. All the associated expenses could be
coded by modifying the codes from say 2300 to 2400, etc.
e. Most supermarkets use barcodes to keep track of sales, inventory and inventory levels. The
question as to how detailed this needs to be is one which needs to be addressed. While the detail
is needed for management control purposes, and for micro-managing at the product level, it will
probably not be necessary to record all of the detail in the accounts. So there is a reasonably high
probability that the chart of accounts will be more selective.
Additional topic 2 Accounting systems and internal
control
Learning objectives
When you have completed your study of this topic, you should be able to:
LO 1 Identify the main elements of internal control and explain the need for sound internal
control in accounting systems
LO 2 Explain why in a typical manual system the ledger needs to be split up, identify
common ways of doing this, and outline the purpose and structure of a traditional manual
system of subsidiary records
LO 3 Explain the nature and role of sales and purchases journals and show how they are
used in posting figures to the accounts in a traditional manual system
LO 4 Explain the nature and role of the cash book and cash journals and show how they are
used in posting figures to the accounts in a traditional manual system
LO 5 Explain the nature and role of the journal and show how they are used in posting
figures to the accounts
LO 6 Explain the importance of control accounts and reconciliations, and prepare control
accounts for debtors and creditors and a bank reconciliation
LO 7 Explain the major elements of computerised accounting systems and explain how
these systems still use the same basic principles of accounting and internal control used by
a manual system, but that they deal with large volumes of transactions more effectively, and
can be linked with appropriate documentation or file production and maintenance.
In the previous topic, you learnt about the double-entry recording process
from transaction entry through to producing basic financial statements. This
process can be thought of as the fundamental accounting system, with
some internal control present at points such as the trial balance checking
stages. The Additional Topic 1 recording process can be summarised
using a train analogy: each stage in the process is a carriage on the train,
and you progress to the next carriage only by moving through the
preceding carriage. The carriages move forward, beginning with journal
transactions (general and special journals), which will be dealt with in this
topic, and once completed can be posted to the general ledger. Once
posted to the general ledger, an unadjusted trial balance can be prepared
as one form of internal control over the accuracy of the recording process.
Adjusting entries can then be prepared and recorded in the general journal,
and then posted to the general ledger. Once posted, an adjusted trial
balance can be prepared to once again provide a check point. From this
adjusted trial balance, the Profit and Loss Statement and the Statement of
Changes in Equity can be prepared. Closing entries can then be prepared
and recorded in the general journal, and then posted to the general ledger.
Finally, a post-closing trial balance can be prepared and, if satisfactory, the
Balance Sheet can be completed, providing a set of Financial Statements
for use by stakeholders. All accounting systems, manual and computerised,
undergo this fundamental recording process.
Accounting is at the heart of business, and inevitably this means that its
systems must generate the documents that are an essential part of
business and commerce. Documents include: invoices, statements, credit
notes, receipts, wages slips and PAYG Payment Summaries (previously
widely known as ‘Group Certificates’). The systems devised must ensure
that these kinds of documents flow quite naturally from the accounting
process.
This topic starts with a discussion of internal control and includes a number
of practical ways in which internal control can be facilitated. Learning
Objectives 2 to 6 deal with the basic principles of a fully manual
accounting system. You may feel that the system described does not
reflect what is currently happening in practice, and in some ways you would
be correct. There are many examples where computerised systems appear
to have moved a long way from the manual system, but in practice most
use principles which are very similar to those of a manual system. It would
also be incorrect to assume that everyone uses computerised accounting
systems, or that they are inherently different from manual systems. The
final section identifies the main elements of a computerised system.
It is not the aim of this book to go into this area in detail, but rather to give
you a flavour of the process and to identify the main principles used. In
practice, you will find many variants of the systems described in this
chapter, from purely manual systems to computerised systems run for large
corporations. In fact, as we discussed in Additional Topic 1, computerised
accounting systems still use the same basic principles (and often the same
language), but generally facilitate more detail in record-keeping, which in
turn opens up greater opportunities for detailed analysis.
What is internal control?
LO 1 Identify the main elements of internal control and explain the need for sound internal control in
accounting systems
Internal control is a process, effected by an entity’s board of directors, management, and other personnel, designed to provide reasonable
assurance regarding the achievement of objectives relating to operations, reporting and compliance.
Committee of Sponsoring Organizations of the Treadway Commission (COSO), Internal Control—Integrated Framework, May 2013, p. 3.
Systematic measures (such as reviews, checks and balances, methods and procedures) instituted by an organisation to (1) conduct its
business in an orderly and efficient manner, (2) safeguard its assets and resources, (3) deter and detect errors, fraud, and theft, (4)
ensure accuracy and completeness of its accounting data, (5) produce reliable and timely financial and management information, and (6)
ensure adherence to its policies and plans.
Business Directory, www.businessdictionary.com/definition/internal-control.html.
Internal controls are methods put in place ... to ensure the integrity of financial and accounting information, meet operating and profitability
targets, and transmit management policies throughout the organisation. ... Internal controls should be documented to create an audit
trail .
audit trail
A step-by-step record by which accounting data can be traced back to their
source.
Investopedia, www.investopedia.com/terms/i/internalcontrols.asp.
The main difference between the first definition and the other two is that the first one is a broad definition,
which encompasses the entire organisation from top to bottom. The Integrated Framework approaches
internal control from a broad perspective, and is written from an organisational perspective—with an
implicit emphasis on large corporations. However, many organisations are either non-business
organisations or small organisations, yet internal control remains very important to them. The approach of
these smaller non-corporates is generally more clearly focused on financial aspects of internal control.
There is clearly some overlap between them, but also a marked difference in emphasis.
COSO sees internal control as having five integrated components, relating to the following:
Control environment. The set of standards, processes, and structures that provide the basis for carrying out internal control across
the organisation ... This comprises the integrity and ethical values of the organisation; the parameters enabling the board of directors
to carry out its governance oversight responsibilities; the organizational structure and assignment of authority and responsibility; the
process for attracting, developing, and retaining competent individuals; and the rigor around performance measures, incentives, and
rewards to drive accountability for performance.
Risk assessment. A precondition of risk assessment is the establishment of objectives, linked at different levels of the entity.
Management specifies objectives within categories relating to operations, reporting, and compliance ... to be able to identify and
analyze risk to these objectives... Risk assessment also requires management to consider the impact of possible changes in the
external environment and within its own business model that may render internal control ineffective.
Control activities. The actions established through policies and procedures that help ensure that management’s directives to mitigate
risks ... are carried out. Control activities are performed at all levels of the entity, at various stages within business processes, and
over the technology environment. They may be preventive or detective in nature and may encompass a range of manual and
automated activities such as authorizations and approvals, verifications, reconciliations, and business performance reviews.
Segregation of duties is typically built into the selection and development of control activities.
Information and communication. Information is necessary for the entity to carry out internal control ... Internal communication is the
means by which information is disseminated through the organisation ... It enables personnel to receive a clear message from senior
management that control responsibilities must be taken seriously. External communication is twofold: it enables inbound
communication of relevant external information, and it provides information to external parties in response to requirements and
expectations.
Monitoring activities. Ongoing evaluations, separate evaluations, or some combination of the two are used to ascertain whether
each of the five components of internal control ... is present and functioning.
COSO, Internal control – Integrated Framework: Executive Summary, May 2013, pp. 4 and 5.
The framework then goes on to set out 17 components and principles and the requirements for an
effective system of internal control. It emphasises that judgement is a key component. It also makes clear
that internal control cannot prevent bad judgement or decisions, or prevent external events from causing
a failure to achieve objectives. Internal control gives reasonable, but not absolute, assurance.
The second definition, while dealing with the same issues of principle, approaches internal control from a
narrower perspective. It possibly reflects more of an emphasis on policies and procedures, particularly
financial policies and procedures. While the financial control issues are important, they reflect only one
part of internal control. Key elements implicit in the integrated approach of COSO are management
integrity, good communication and competent personnel, which should apply to all areas of the
organisation, not just the financial.
Segregation of duties. This reduces the risk of mistakes, by making responsibility and specialism
clearer. It also makes fraud and embezzlement, and a range of other inappropriate activities, more
difficult. No individual should be able to initiate a transaction, then approve it, record it and control the
proceeds that result. Payroll preparation, distribution and cheque writing should not be done by the
same person.
Good records maintenance. This ensures that proper documentation exists that can back up
transactions. This requires storing and safeguarding paper or electronic records, and eventually
ensuring that they are destroyed. Good records maintenance requires appropriate backup, with paper
copies or, more commonly, backup computer files.
Safeguards. These prevent loss of valuable business assets. Safeguards can be physical items such
as security locks or safes, closed circuit cameras and restricted staff areas, or other things such as
computer passwords and access controls.
Approval authority. This is related to safeguards and requires specific managers to authorise certain
types (or sizes) of transactions before they can go ahead.
Within the accounting system there are a number of things which are typically the focus of attention.
These include the following:
Physical audits. These audits, for example counting cash or checking that asset balances shown in
the accounts actually exist in physical form, can reveal discrepancies in the system. A physical
stocktake is an important part of the checking process. Records of what is owned, known as asset
registers, are a necessary prerequisite of some of these checks.
Standardised documents. The range of documents needed, for example invoices, material
requisitions and inventory receipts, require careful linkage and standard approaches. Standardisation
of document forms and types can make it easier to check forms for consistency, and pre-numbered
documents enable better control to be achieved.
Trial balances. The use of double-entry systems and drawing up of a trial balance, as we saw in
Additional Topic 1 , while not guaranteeing that no errors have been made, does permit some
added reliability to the figures. Drawing up a trial balance on a regular basis, say weekly, would
identify some discrepancies and enable them to be investigated quickly.
Reconciliations. These are necessary when comparing figures from the accounts with figures for the
same category, but drawn up by someone other than the accountant. Probably the most common is
the bank reconciliation statement. How often, when you get your bank statement, do you wonder why
the figure shown in your bank account is different from what you thought it should be? You should
then reconcile the two sets of figures—your expectations with the figures shown in the bank account.
This requires identification of differences such as cheques not presented, forgotten (by you) standing
orders or direct debits, or payments recorded by you as having been paid into your bank account but
have not materialised—yet! Such reconciliations are (or should be) a regular feature of an
organisation’s (and your) internal control system. Another important area where control is needed
relates to the need to keep track of individual accounts for areas such as debtors, creditors and payroll
systems, yet we also want to keep a big-picture perspective on these areas. As we shall see later,
control accounts, which are effectively total accounts, are regularly prepared for debtors and creditors,
and often for wages. The main aim is to ensure that the balance on the control account agrees, or
reconciles with, the sum of all of the individual accounts.
Internal controls can be grouped as preventive or detective. Preventive controls are policies and
procedures that are designed to prevent errors, inaccuracy or fraud before it occurs. Detective internal
controls are designed to identify problems that already exist. They require examination of information and
include things such as the use of performance reviews, including comparisons of actual figures with
budgets, forecasts and benchmarks; reconciliations and subsequent analysis of discrepancies; and
internal or external audits.
Accounting systems are clearly an important part of the internal control system. They should aim to
deliver accurate records, free from errors and the effects of fraud. This requires appropriate processes to
be set up, which have a good chance of identifying and ideally preventing errors, as well as identifying
where things have gone wrong. Such systems will include procedures and techniques that help to prevent
errors.
Summarising the discussion so far, we can say that key elements of internal control include the following:
Develop an organisation chart and clear job descriptions such that responsibility is clear for all
functions and supervisory relationships.
Make sure that a procedures manual (or similar) is prepared.
Ensure that an appropriate authorisation process exists and actually occurs.
Prepare a budget of expected results.
Develop comparative financial statements.
Complete regular reconciliations in relevant areas.
Number documents where appropriate.
Hire good people with good references.
Ensure staff are appropriately trained.
Ensure that a staff feedback process is in place.
Assign responsibility for compliance where appropriate (e.g. safety officer, fire wardens).
Separate record-keeping from custodianship of assets (i.e. don’t give the cashier access to records).
Separate authorisation of expenditure from record-keeping.
Have a policy that all payments above a specified amount need two signatures.
Separate purchasing from receiving.
Rotate key jobs.
Run spot checks.
Process customer complaints.
Make sure that detailed records of assets (an asset register) are kept and limit access to those
records.
Ensure that all assets and liabilities actually exist.
Have clear guidelines on personal use of assets.
Regularly check that your records of assets reflect the assets in your possession.
Have sound safeguards to protect documents and computer files, with appropriate backup and test
programs.
Change passwords regularly.
Have firewalls and protective devices on computer systems.
Conduct an annual audit and/or have regular inspections by internal audit.
Deposit receipts intact so as to ensure a clear audit trail.
Reconcile bank statements independently.
Require annual vacations to be taken.
Ensure there is a conflict of interests policy.
Activity AT2.1
From an internal control perspective:
a. Why is it important to develop a clear job specification and ensure that there is a clear separation
of duties?
b. Why is it important that authorisation of expenditure is closely controlled?
c. Why should a cashier not have access to the accounts?
d. Why is it important that staff are required to take their annual leave?
e. What problems can arise regarding conflict of interests?
f. Why is an inventory of assets owned an important part of the system of internal control?
g. Why is it important that staff are well trained?
h. Why is an audit important?
i. What safeguards regarding documents and computer files might be appropriate?
1. Commercial transactions are made electronically in an environment which does not have the
traditional paper trail.
2. There is a need to expand an internal control system, which has traditionally been seen as intra-
organisational, to one which can be seen as inter-organisational.
3. Use of the internet introduces new elements of risk. These include loss of transaction integrity,
pervasive security risks and the possibility of improper accounting policies.
4. The internet is a public network, in contrast to a private network that only allows access to
authorised persons or entities.
5. Many businesses do not have the technical expertise to be able to establish and operate in-house
systems that are needed to undertake e-commerce. These businesses then have to use various
service agencies. This has potentially serious implications for the success of the business, and for
the auditor.
6. There are many legal and regulatory issues that arise, including different legal frameworks in
various jurisdictions around the world regarding the recognition of e-commerce, differing privacy
rules, the enforceability of contracts and the legality of particular activities (e.g. internet gambling),
which thrives in some countries and is illegal in others.
For a more comprehensive coverage of these ideas you might read the International Auditing Practice
Statement 1013, Electronic Commerce—Effect on the Audit of Financial Statements.
Internal control should be seen as generic. However, applying the principle of internal control to e-
commerce requires some modification to the traditional approach. Some tentative suggestions of areas
that need consideration are given next.
1. Ensure that staff have the appropriate knowledge and skills to understand the effect of e-
commerce.
2. Use an expert to test controls of the system by trying to break through the security system. The
use of specialist fraud prevention tools should assist in reducing risk.
3. Ensure compliance with the Payment Card Industry (PCI) Data Security Standards, which provides
merchants with standards, procedures and tools for protecting sensitive account information.
4. Ensure access to adequate records for audit purposes. These may be different from those used for
a traditional business.
5. At a high level (governance level), align e-commerce activities, including any new activity, with the
overall strategy.
6. Be aware of the implications of outsourcing activities. For example, identify the risks associated
with any particular provider of services to the business or its customers.
7. Extend and expand existing policies to cover e-commerce, or develop new policies where
appropriate. Particular emphasis needs to be given to security infrastructure and related controls,
particularly in the areas of identity verification, ensuring the integrity of transactions, and policies
relating to privacy and information protection, payment, shipping, and returns and refunds. The
terms of trade must be agreed before an order is processed, including delivery and credit terms,
which usually will require payment before accepting the order.
8. Ensure legal and regulatory issues are understood.
9. Ensure effective use of firewalls and virus protection.
10. Use encryption to protect messages.
encryption
The coding of a message to make it unintelligible to any user not
authorised to read the message.
Finally, any internal control system must attempt to deal with cybersecurity. This is particularly difficult for
a variety of reasons. These include the fact that the issues raised are international, requiring global
solutions. Diverse laws, regulations and standards relating to financial technology, data protection and
cybersecurity make international consensus difficult. Threats, risks and technology move faster than the
regulations and standards. Current threats include independent criminals, nation-states or terrorist
groups, hacktivists (who work for political gain) and insiders (who typically abuse access by harvesting
customer information). These threats lead to an almost inevitable reactive response from regulators. This
will almost certainly mean that individual organisations will be exposed to significant threats in this area,
so constant vigilance is necessary. (Source: European Banking Federation, Global Financial Markets
Association, International Swaps and Derivatives Association, ‘International Cybersecurity, Data and
Technology Principles’, Washington, May 2016.)
A national campaign led by Financial Fraud Action UK Ltd has been introduced in the UK.
This campaign aims to help everyone protect themselves from preventable fraud. There are
lessons for us all from this campaign. The main points of the campaign are summarised below:
1. Many victims have felt rushed, hurried and pushed into making a quick decision, so slow
down and take time to reflect on what you are being told. Financial fraud isn’t confined to
the home.
2. There is a range of scams out there. Criminal activity is common and generally quite easy to
perpetrate. Care needs to be taken in a number of ways:
a. Scrutinise requests for bank details and check with your own databases and other
sources.
b. Make sure everyone in the organisation is made aware of issues generally and in
relation to specific known scams.
c. Be conscious of scams such as invoice fraud; CEO spoofing (i.e. where emails come
from people pretending to be the CEO); phone calls, texts or unsolicited emails from
someone claiming to be from your bank, a trusted organisation or computer
business; and online fraud.
In addition to the specific internal control policies and processes referred to above, there are some
general organisation-wide factors to think about, which include:
ensuring staff are appropriately qualified and trained in their specialist areas
ensuring there is a clear system of responsibility, authority, delegation of duties and separation of
duties
maintaining procedures manuals
ensuring there is a budget which is well understood and committed to
being aware that all are subject to internal and external audit.
Table AT2.1 should give you some ideas as to document flows in a function such as purchasing.
Clearly, this table reflects the assumptions made. Each business has its own model, and hence its own
best way of doing things. Table AT2.1 is based on a reasonable sized company. A smaller business
would not be able to do things in the same way as the organisation assumed in the table. It would almost
certainly have to compress the range of activities across a smaller number of staff, with consequent
implications for the systems that are to be used, if internal control is to be maintained. It is important that
you recognise that the accounting part of the system will reflect the needs of each particular business, so
documentation and ways of recording are likely to differ from one business to another. The use of ledger
accounts is pretty much universal, though in many businesses the accounts are largely completed on the
computer, rather than by hand. Hence, a full understanding of ledger accounts is essential if you wish to
go on to a career in accounting, and will be useful if you wish to make your career in business. When it
comes to the journal, or a more complete system of subsidiary records, you must anticipate many
different approaches, though they are generally based on the same principles as the manual system. For
this reason, the next five sections are based on a traditional manual system. When working through these
sections, you should focus on the principles that underlay these systems as, almost inevitably, the
systems you use when you are at work will have some practical differences.
Stores/warehouse Responsibility for stock availability and control Detailed records of stock availability and use
Appropriate record-keeping
Carry out spot checks to ensure that records and actual stock
are the same
Purchases via purchase requisition sent to Clear policy about how purchase requisitions are to be
purchases department controlled
Write-offs of obsolete or spoiled stock Policy regarding how write-offs can happen and who can sign
them off
Receive new stock Policy about checking receipts and signing for them
Check delivery note and sign that goods were Ensure that staff signing as having received goods are not part
received of the purchasing routine
Identify any shortfalls on the order Notify purchasing department of shortfalls or damage
Prepare and send order Order must be signed by an authorised individual and be within
the limits of the particular delegation
Receive invoice Check goods received
Receive credit note Credit notes could act as a subsidiary record—a purchases
returns journal
Check code or creditor number to ensure correct Have a file of approved or expected suppliers with appropriate
creditor identified code number, identified bank account numbers and a range of
other details
Update accounting records: Use a purchases ledger control account (see later in this topic)
Debit stock records in as much detail as required Ensure this control account is completed by someone other
than the person completing the individual accounts
Credit individual creditor (supplier) accounts Have stock records prepared by the accounting department to
enable comparison with the records kept by stores
Check invoice not paid previously Must be signed for by person checking
Probably as part of a regular payments routine Make sure that payments above a certain amount require a
second signature
If necessary, use an urgent payment routine—for Set of rules developed for such payments
suppliers who cannot wait until the next payment run
Concept check 1
Which of the following statements is false?
A. Segregation of duties is an important part of internal control.
B. Standardised unnumbered documents enable better control to be achieved.
C. Physical audits can reveal discrepancies between what is shown in the records and
what is actually there.
D. Trial balances, while not guaranteeing that there are no errors in the accounts, do
provide some added reliability.
E. Reconciliations and control accounts enable sections of the accounts to be verified.
Concept check 2
Which of the following statements is true in the context of internal control?
A. It is sound business practice to develop people’s skills by keeping them on the same
job for a long time.
B. Organisations should all keep track of their assets by ensuring that everyone enters
details of assets owned and disposed of in an assets register.
C. It is good practice to make notes of passwords used and put them in your office
drawer for safe-keeping.
D. It is important that authorisation of expenditure is closely controlled.
E. It is sensible for the person making an order to be able to follow it through to final
payment.
The ledger and subsidiary records
LO 2 Explain why in a typical manual system the ledger needs to be split up, identify common ways of
doing this, and outline the purpose and structure of a traditional manual system of subsidiary records
We have already seen that the system of ledger accounts described in Additional Topic 1 is not the
complete picture. Points to consider in devising an accounting system include the following:
The high volume of transactions involved in certain accounts (e.g. cash, sales, wages, etc.) means
that ledger accounts will be quite clumsy. Methods of substituting totals rather than lots of individual
figures are necessary if the accounting process is to be handled relatively easily.
The system clearly needs to be able to cope with large amounts of data.
A clear ‘audit trail’ needs to be maintained—it should be possible to track back through a transaction
from its inception to its place in the final accounts.
A sound system of internal check and internal control is needed, such that the action of one person
acts as a check on another, and the system is designed so that responsibilities are clear and
separated. For example, only a poor system would give one person responsibility for recording
debtors, bad debts and cash. The splitting of responsibilities is an important part of fraud prevention.
The system should be sufficiently flexible to be able to produce useful reports in the detail needed by
managers.
There was an implication in Additional Topic 1 that all the accounts are kept in a single book, known
as the ledger. In practice, this is unrealistic for the following reasons:
The volume of transactions undertaken by many, if not most, businesses would make this extremely
difficult, if not impossible.
As the volume of transactions grows, more staff would be needed to record them, so more than one
person would need to use the ledger at the same time.
Some staff will specialise in, or be responsible for, particular areas of work (e.g. keeping control of the
individual accounts relating to receivables), so there are inherent difficulties in sharing access to a
single ledger.
Information from the ledger or the supporting source documents may need to be accessed quickly.
Balancing off the ledger accounts would become a lengthy process, prone to error, if every transaction
were recorded in detail.
Clearly, a single ledger is unlikely to be sufficient (or practical) for all but the smallest of businesses, so
there is a need to break down the ledger into sub-ledgers. In Additional Topic 1 we used the general
journal as a single book of original entry (also known as a subsidiary record) as a means of ensuring that
every transaction was recorded. In fact, there is a host of different ways in which this information can be
collected. Remember that such books provide the information to be recorded in the ledger accounts.
However, this information can be entered in detail, or as a total, thus reducing the amount of detail
needed in the ledger accounts. Also, it should be noted that the two entries do not have to be recorded at
the same time, or by the same person. Already you should be able to see ways in which the ideas about
internal control, covered in the last section, can be applied.
In practice, a variety of subsidiary records are kept, either in a completely manual system or a
computerised system. Many small businesses use accounting packages, which often use the same terms
for the various files as those found in a manual system.
A well-developed system of ledger accounts based on a well thought through chart of accounts.
A number of subsidiary records to hold the day-to-day transactions until they can be recorded in the
accounts. For a business of any size, the records are unlikely to be recorded manually, rather they are
likely to be captured electronically. For example, the use of barcodes in a retailing business enables
the point of data capture to be when the item is scanned at the point of sale.
A method of cross-referencing or tracing information through the system from the subsidiary books (or
original point of capture) to the ledger.
Subsidiary records are not part of the double-entry system. They are essentially books of original entry—
the primary source of detailed information about the transactions of the business. They are a device for
ensuring that all of the transactions are recorded prior to entry into the accounts. It is important that all this
information is collected. What is not important is just when (within reason) it is recorded in the accounts.
Sales ledger (also known as the debtors ledger)—which contains the detailed accounts relating to
individual customers (debtors). These are effectively personal customer accounts.
Purchases ledger (also known as the creditors ledger)—which contains the detailed accounts of
suppliers (creditors). These are effectively personal supplier accounts.
Cash book/ledger—which contains the accounts relating to cash and bank.
Nominal ledger—which contains revenue and expense accounts from which the trading and profit
and loss account can be prepared.
General ledger—which contains the remaining accounts.
The general and nominal ledgers are often combined for convenience. The first two ledgers are typically
referred to as subsidiary ledgers. These subsidiary ledgers are where the detailed accounts of individual
debtors and creditors are kept. Typically, sets of total or control accounts are kept in the general ledger.
These will be discussed in more detail later in the topic.
You should note that in many computerised systems there will be no actual ledger or hard copy. In these
circumstances, most ‘debtors ledgers’ are kept in computer files, as are ‘creditors ledgers’ and ‘cash
books’. It is quite possible that there will be few, even no, hard-copy ledgers anywhere. It is not
uncommon for the hard-copy ledger to be confined to the closing down process each year. It is, however,
important to note that the general principles of a manual system still apply to a computerised system.
sales and sales returns journals (books), in which the credit sales and returns are recorded in detail
purchases and purchase returns journals (books), in which the credit purchases and returns are
recorded in detail
cash receipts and payments journals, in which detailed receipts and payments are recorded
a general journal, in which anything not recorded initially in the earlier books is recorded.
Clear responsibilities will be allocated for these journals, bearing in mind the basic principles of internal
control. The journals will be subsequently posted to the ledgers. The advantage of a system of subsidiary
records is that the postings can be carried out by different people at different times. Also, totals can be
posted as appropriate. For example, a sales journal will include a list of sales and debtors. The individual
debtor accounts will need to be debited, but only one total posting is needed for the credit to sales. A final
advantage is that the subsidiary records should provide a record of every transaction prior to entry in the
ledger.
We shall examine each of these subsidiary records in more detail in the next few sections.
Concept check 3
Which of the following statements is not true?
A. The sales ledger contains the sales accounts.
B. The purchases ledger contains the detailed accounts of individual suppliers.
C. The cash book contains the accounts relating to cash and bank.
D. The nominal ledger contains the accounts which are closed off to the profit and loss
account.
E. The general ledger contains the accounts likely to appear in the balance sheet.
Concept check 4
Using the breakdown of the ledger suggested in the topic, which of the following is not a
general ledger account?
A. Discount received
B. Plant and machinery
C. Capital
D. Loan
E. Drawings.
Activity AT2.2
a. Consider the accounts of your local supermarket. What are the limitations of reliance on a simple
double-entry system to record the transactions of the business? Identify ways of dealing with a
business of this sort.
b. Assuming that a business maintains the subdivision of the ledgers identified above, identify in
which ledgers the following accounts would be found:
i. an account for David Anth, a customer
ii. administration expenses
iii. interest received
iv. premises
v. an account for B. Fennell, a supplier.
c. Explain how a computerised accounting system might use computer files as part of a subsidiary
record system and ledger system.
d. How important are barcodes in data capture?
e. Identify ways in which the use of subsidiary records can help internal control.
The sales and purchases journals
LO 3 Explain the nature and role of sales and purchases journals and show how they are used in
posting figures to the accounts in a traditional manual system
Credit transactions are typically first recorded in a subsidiary record, known as a day book, book of
original (or prime) entry, or journal. The usual books are:
The basic idea is very simple. When a sale is made on credit, the detail is entered in the sales book,
which is simply a list of sales on credit, showing date, customer, invoice number and amount. This
ensures that a record exists of the transaction, from which appropriate entries can be made in the ledger
accounts, and also provides a reference to supporting documents detailing the transaction. The actual
entering into the relevant accounts (which, as we saw in Additional Topic 1 , is known as posting) can
occur at a convenient time, and using totals if appropriate. The two aspects of the posting process do not
have to happen at the same time, nor do they have to be done by the same person. They must be posted
before the account can be balanced off, but there is a reasonable degree of flexibility. Separation of these
two roles has advantages in terms of internal control. Use of a system of this sort can make it easier to
give one person the overall responsibility for managing the individual debtors accounts.
EXAMPLE
AT2.1
Sales book
Date Detail Invoice number Folio/account number Amount $
2020
The seller sends the invoice to the customer, while retaining a copy.
The document (copy invoice) acts as the prime (also known as source) document or voucher,
which acts as the documentary evidence that a transaction has occurred.
The document initiates the recording of the transaction.
The information on the document is entered into the sales book.
At the end of each day (week or appropriate period) the total of the sales book is posted to the
sales account in the nominal or general ledger.
Individual debits are made to the individual accounts in the sales ledger.
There are no time savings in postings to the individual accounts, but these can be made at a
convenient time. There are considerable savings of posting time by making the total posting to
sales.
The format and procedure for the other books is very similar. The postings of the sales returns book are:
a single debit entry of the total to the sales returns account, and a series of individual credit entries to the
individual debtor accounts in the sales ledger. The prime document is typically the credit note that is
issued.
The postings of the purchases book will be a single debit to the purchases account for the total of the
purchases book, while a series of individual credit entries will be made in the creditor accounts in the
purchases (creditors) ledger. The prime document will be each invoice received.
The postings of the purchases returns book will be a single credit to the purchases returns account, and a
series of individual debits to the purchases (creditors) ledger. The prime document is typically the credit
note given by the supplier.
Subsidiary books can be prepared using analysis columns. Suppose sales are of different products, or
covering stores in different geographical locations. The sales book can be modified to facilitate a
breakdown of the sales along the following lines, where columns headed 1–4 reflect the breakdown
Transactions will be entered into both the total column and the appropriate analysis column, permitting a
breakdown of the type of sales, or sales relating to the range of stores within the business.
It may be convenient to modify the form of the purchases book to include all inward invoices. All that is
needed to do this is to adapt the analysis columns accordingly, along the lines shown below.
Date Detail Invoice Folio Total Purchases Rates and insurance General expenses Fuel Ledger
The ledger column is for items which do not fit under any of the main headings used, and will require
detailed posting, whereas the totals can be used to post the other columns.
It is important to note that we are concerned in this topic with the principles of data capture and recording.
We may well find that no formal book is kept, but that invoices are filed (or even just thrown) in a box, and
are then posted, say, weekly or monthly. Detailed postings to creditors can be made from each invoice,
and the total from a checklist can be debited to the purchases account. Many manual systems (and
probably most personal systems of accounting) may well have elements that operate this way. For many
computerised systems, invoices are bundled up and processed in batches.
Sales and purchases books imply a trading business. Many small businesses that use manual systems
are service providers, for example plumbers, electricians real estate agents. Essentially, the aim of the
sales and purchases books is to provide a record, prior to entering in the accounts, of transactions that
relate to revenue and expenses. This is as necessary for service and manufacturing businesses as for
trading businesses. The principles of the day book remain valid; the title needs changing.
It is important to note that the use of analysis columns and computer coding systems is based on the
chart of accounts. The move from a simple day book, to one which uses a set of analysis columns, to a
computerised system which uses a coding system derived from the chart of accounts should be seen as a
logical extension of the same principle.
Concept check 5
Which of the following statements is false?
A. The sales and sales returns journals record credit sales and customers in detail.
B. Purchases and purchases returns journals record credit purchases and returns in
detail.
C. The general journal records anything not recorded in the other subsidiary records.
D. The advantage of journals is that postings can be made by different people at
different times.
E. In a system of subsidiary records there is no time saving in terms of the number of
entries to be posted.
Concept check 6
Which of the following postings is correct?
A. The sales book is posted as a debit to sales in total, and a series of detailed credits
to the individual creditor accounts.
B. The purchases book is posted as a debit to purchases or inventory in total, and as a
series of detailed credits to individual supplier accounts.
C. When an analysis purchases book is used, the totals of the analysis columns are
debited to purchases or inventory and credited to the accounts which reflect the title
of each analysis column.
D. The sales returns book is posted in total to the sales account and credited to the
detailed customer accounts.
Activity AT2.3
A. What kind of day book might an audiologist or a real estate agent keep?
B. You are required to complete a purchases book and a purchases returns book from the following
details, and then post the contents to the appropriate accounts in the appropriate ledger.
i. January 1 Credit purchases from L. Howard $500
ii. January 1 Credit purchases from R. Sage $350
iii. January 2 Credit purchases from C. Johnson $750
iv. January 2 Credit purchases from M. Dewar $600
v. January 3 Goods returned to C. Johnson $200
vi. January 3 Credit purchases from R. Sage $400
vii. January 3 Goods returned to R. Sage $100
C. Suppose that you misread the figure from the 1 January purchases from R. Sage as $530, and
also made the same mistake when totalling the purchases book. Would these errors have shown
up when the trial balance was drawn up?
The cash book and cash journals
LO 4 Explain the nature and role of the cash book and cash journals and show how they are used in
posting figures to the accounts in a traditional manual system
There are a number of ways of dealing with cash transactions. At the simplest level, maintaining a single
cash account in a separate ledger is possible but highly unlikely. Other options include:
The two-column cash book is simply a ledger account which contains both cash columns and bank
columns. The cash book doubles both as ledger accounts, namely a cash account and a bank account,
and as a day or subsidiary book. Postings to complete the double entry from cash to the other side of the
transaction need to be made from the cash book. There are no particular time savings that can be
achieved by use of this book.
The three-column cash book includes a third column, a discount column, as illustrated in Example
AT2.2 .
EXAMPLE
AT2.2
Cash book
Date Detail Discount Cash Bank Date Detail Discount Cash Bank
It facilitates the posting together of both the cash and discount figures to the individual debtor or
creditor accounts.
It enables the posting of totals to the discount allowed and discount received accounts.
Neither of the cash books referred to have the advantages that cash journals have, especially when used
with analysis columns.
Cash journals are subsidiary records, so they bring with them the advantage of avoiding some detailed
postings. An example of the typical headings used in a simple cash receipts journal is given below.
The totals of the cash and bank columns can be debited to the cash and bank accounts, and the total of
the discount column can be posted to the discount allowed account.
A similar approach could be used for a separate cash payments journal. However, the reality is that most
payments will be made by cheque, direct credit transfer or by use of internet banking, so a cash column is
unlikely to be used. Using actual cash to pay for things is normally kept to an absolute minimum, and this
is normally handled by a Petty Cash account which is dealt with later.
Use of analysis cash journals provides a further means of reducing the detailed postings needed into the
accounts. Possible headings for the two journals are given below.
Date Detail Receipt number Total Sales region 1 Sales region 2 Interest Sales ledger Discount Folio
Date Detail Cheque number Total Purchases Wages Rent and rates Purchases ledger Discount Folio
Clearly these are illustrative. In reality, many more columns will be needed to analyse the necessary
detail. Prime documents for the cash receipts journal or the cash books typically include receipts issued,
credit card receipt summaries and bank statements. Prime documents for the cash payments journal
include invoices, receipts given to the organisation, credit card statements, and bank statements or
records from online banking.
1. The total of the total column would be debited to the cash account.
2. The totals of the analysis columns—other than the sales ledger column—would be credited to the
appropriate account, namely sales of region 1, sales of region 2, and interest.
3. The sales ledger column contains receipts from debtors, which, together with individual amounts of
discount, need to be credited to each of these individual accounts.
4. The total of the discount column would be debited to the discount allowed account.
The folio column enables cross-referencing to the individual debtor accounts.
As already pointed out, very few payments occur in cash (as distinct from cheque or credit transfer) for
reasons relating to internal control. Physical cash is very easy to lose, for one reason or another.
Typically, most organisations have clear and restrictive rules on the use of cash. It is very difficult to
prevent all cash expenditure, but generally cash expenditure is controlled by a small number of petty cash
holders and there are strict rules about just what the cash can be spent on. Generally, petty cash systems
operate on what is known as an imprest system . Typically, the petty cash system operates along the
following lines.
1. There is usually a maximum amount that can be held, known as an imprest or float.
2. A detailed record, known as a petty cash book, is maintained.
3. When set up, a cheque is drawn on the main bank account for the amount of the imprest, which is
entered on the receipts side of the petty cash book. The cheque is cashed and the cash is held in a
safe place.
4. Expenditure, which must be in line with the agreed policy on what can be spent in this way, is
made, and the person spending the money completes a voucher, which sets out details of what the
money was spent on, and attaches a receipt. These details are then recorded on the payments
side of the petty cash book, and cash spent is refunded to the person who has spent the money.
5. At the end of an appropriate period (often a month), the total amount spent (as shown in the petty
cash book) is reclaimed and a cheque is drawn and cashed, at which point the float is back to the
maximum allowed, so the process can start again.
6. Postings can be made of the totals if an analysis petty cash book is used (which it usually is). This
completes the double entry, matching the cheque drawn.
imprest system
A system (usually associated with petty cash) in which an allowance is given for a
period, from which expenditure, of an approved nature, can be made.
At any point, the sum of the cash held plus the total of the vouchers held should equal the maximum
balance allowed. Regular checks on this should be carried out by senior staff or audit staff as
unauthorised ‘borrowings’ can be a feature of systems of this sort.
Large organisations may have a significant number of petty cash accounts going at any one time.
AT2.3
Petty cash book
Voucher
Receipts Folio Date Detail number Total Travel Stationery Postage Office sundries
July
125.000 1 Balance
b/d
375.00 1 Cash
500.00 500.00
114.70 8 Balance
b/d
385.30
500.00
The detailed postings (i.e. the total figures in the last four columns) are debit entries. The corresponding
credit is $385.30 to cash.
You should remember that the essence of journals is to ensure that all transactions are remembered and
recorded. Another key related element is the setting up of an audit trail, which should enable the
transaction to be followed up from initial transaction to final recording through a ‘document’ trail.
Increasingly, with today’s modern technology, documents are not part of the normal process, but
equivalent trails will be present. For example, many business executives now have credit cards from their
business and have authority to use them in an approved manner. The monthly statements could be used
as a kind of journal, but these statements indicate what has been spent and who has been paid, but
seldom provide any detail as to what the expenditure actually covered. In general, it would be a
reasonable expectation that receipts and credit card slips could be provided on request, though many
people do not even take, or keep, their slips. This expectation could well be waived when a credit card is
to be used only for a specific purpose (e.g. fuel) where actual expenditure could be assessed on the
mileage driven.
Concept check 7
Which of the following subsidiary records would be seen as part of the ledger accounting
system?
A. Journal
B. Sales returns book
C. Cash book
D. Purchases book.
Concept check 8
How should the total of the discount column in a cash receipts journal be posted?
A. Credit discount allowed
B. Credit discount received
C. Debit discount allowed
D. Debit discount received.
Concept check 9
Which of the following is not an advantage of an analysis cash payments journal?
A. It reduces the detailed postings needed in the accounts.
B. It enables purchases to be easily analysed under appropriate headings.
C. As long as a discount column is used, it can facilitate posting to creditors for both
cash and discount at the same time.
D. The purchases ledger column means that the double entry can be limited to a single
debit to purchases.
Activity AT2.4
a. Explain how use of analysis columns in cash journals can save posting time.
b. Identify any key points relating to internal control that you have noted in relation to cash journals.
c. If you were put in charge of petty cash for a company, and were shown the petty cash book
provided earlier in this section as an example, would you feel it necessary to discuss any particular
expenditure included in that petty cash book?
d. Which of the following statements relating to petty cash is true?
i. The imprest is the amount of cash left at the end of the period.
ii. The imprest is the sum of the balance plus the sum of the vouchers issued for the period to
date.
iii. The imprest is the total payments for the month.
iv. The imprest system provides an audit trail.
The journal
LO 5 Explain the nature and role of the journal and show how they are used in posting figures to the
accounts
While the subsidiary records dealt with to date cover the high-volume transactions, there remains a
number of other transactions not covered. In order to ensure that every transaction goes through a
subsidiary record, these ‘other transactions’ are recorded in what is known generically as ‘the journal’.
Given that the term ‘journal’ has been used as part of the titles of other subsidiary records, it is common
to refer to this journal as the ‘general journal’. You need to understand that in Additional Topic 1 we
assumed that only the general journal would be used, and that every transaction would go through this
journal and would subsequently be posted in detail. However, we have seen in the current topic that there
are ways of grouping transactions by type, which is more efficient than simply using the general journal.
This means that the journal, in practice, has a more limited role than was implied in Additional Topic
1 , but the items that are recorded in the journal are usually very important.
The transactions entered in this journal require posting in detail. There are no time savings through the
use of the journal. Its main advantage is that it completes the system of original entry. Other advantages
are:
1. The narrative section means that a considerable amount of information can be included explaining
the transaction.
2. The risk of omission of entries is reduced.
3. Because more information can be provided, more complicated entries can be more easily
understood.
4. Fraud, irregularities and errors are easier to find because full reasons are given for each particular
transaction.
5. Because the journal provides an explanation of the more recent transactions, it ensures better
continuity if there are staff changes.
In fact, many accountants use journal papers, rather than a formal journal, which are then filed in order.
These journal papers can include a tremendous amount of detail and workings when explaining complex
transactions. Example AT2.4 illustrates a complex journal entry to open a set of books.
EXAMPLE
AT2.4
An individual has been running a business for some time without a formal system of record-
keeping. He has now decided to use a proper accounting system. The journal entry to initiate this
might look something like this.
Receivables
Payables
500,000 500,000
errors of omission—where the entries have been completely omitted from the books
errors of commission—where the wrong account has been debited or credited
errors of principle—where an account of completely the wrong type has been debited or credited
compensating errors—where an error on one side of the accounts is matched by an error equal in size
on the opposite side
complete reversal of entries—where the debit side entry has been made on the credit side and vice
versa
an error in the subsidiary record which has been posted to both sides of the accounts for an incorrect
amount.
The situation where the trial balance does not agree requires a different approach, typically will require
the opening of a suspense account to make the trial balance agree. Once the errors are found, the
correction needs to be made with a double entry to the suspense account. Typically, certain errors in the
subsidiary records, for example an incorrect totalling, or an error in the detailed debtor posting from a
sales book, will result in the trial balance not agreeing.
Of the other entries in the journal, probably the most important relate to the period-end adjustments. As
we saw in Additional Topic 1 , there is a range of adjustments for things such as prepayments and
accruals, bad and doubtful debts, and depreciation. Many of these adjustments (e.g. depreciation) are the
result of accounting standards, accounting policies and/or judgements made by management. The journal
(or a set of journal papers) provides a clear indication as to the basis of the adjustments and a clear audit
trail. The entries transferring the revenues and expenses to the profit and loss account are also normally
journalised.
Concept check 10
For the system of subsidiary records used in this topic, which of the following is not true?
A. Credit purchases are entered in a purchases book.
B. Cash transactions are entered in the cash journals.
C. Credit sales are recorded in the sales book.
D. If an analysis purchase book is used, all other expenses will be entered in this book.
E. The journal has a far more restricted role than was implied in Additional Topic 1 .
Concept check 11
Which of the following statements is incorrect as far as the journal is concerned?
A. Only transactions not recorded elsewhere in the subsidiary records are entered in the
journal.
B. The journal is substantially used for end-of-accounting-period adjustments.
C. The journal is not used for closing off the accounts.
D. The journal is used to enter corrections of errors.
Concept check 12
Which of the following statements is not true?
A. An error of omission (where the entries have been completely omitted) will not
prevent the trial balance agreeing.
B. An error in a subsidiary book, which has been posted to both sides of the accounts,
will stop the trial balance agreeing.
C. A complete reversal of entries will not stop the trial balance agreeing.
D. An error of principle will not prevent the trial balance agreeing.
E. An error of commission will not prevent the trial balance agreeing.
Activity AT2.5
a. Journalise this transaction: the purchase on credit on 19 October of a new BMW for $70,000.
b. Which of the two errors below is an error of commission and which is an error of principle?
i. Sales of $350 to J. Harvey were debited to J. Hardy.
ii. Wages of $2,000 relating to improvements was debited to wages.
c. Identify the nature of the following errors and journalise the necessary corrections:
i. The purchases book was incorrectly totalled, being too high by $1,000. Discount received
amounting to $5,900 was incorrectly posted as $6,900.
ii. Sales to F. Woody amounting to $555 were recorded in the sales book as $585.
iii. A payment of $450 to K. Waterhouse was entered as a debit to the cash account and a
credit to his account.
d. How likely are the kind of errors discussed in this section to be found in a manual system? In which
areas do you think that the use of computer-based systems reduces the likelihood of errors?
Control accounts and reconciliations
LO 6 Explain the importance of control accounts and reconciliations, and prepare control accounts for
debtors and creditors and a bank reconciliation
There are a number of ways in which checks and balances can be introduced. This section covers two
such ways, control accounts and reconciliation statements.
Control accounts
We talked earlier about the subdivision of the ledger. Unless we can find some way of isolating errors to a
particular division of the ledger, all ledgers will need to be checked in order to find the errors. Control
accounts provide such a way. They can be used as part of the double-entry system and appear in both
the appropriate subsidiary ledger and the general ledger—effectively meaning that the subsidiary ledger
should ‘self-balance’. Or the main ledger account becomes the total account in the general ledger and the
detailed entries in the subsidiary ledger form a third memorandum set of entries.
Basically, a control account summarises all of the transactions that have been recorded in a particular
ledger. If the balance on the control account for a particular ledger agrees with the sum of the individual
balances of the individual accounts in the ledger, there may be an implication that the accounts are
correct. We have already seen that this is not necessarily the case. However, control accounts do provide
another check on the accounts. Control accounts, being essentially summaries of the transactions of a
ledger, are sometimes known as total accounts.
Probably the most important of the control accounts are those relating to the sales ledger (debtors) and
purchases ledger (creditors). These two ledgers are possibly going to be the biggest in terms of number
of accounts, so the possibility of errors may be greater. A wages control account would also be common
for other than small businesses.
A typical format for a sales ledger (debtors) control account is shown in Example AT2.5 .
EXAMPLE
AT2.5
Sales ledger control account
July 1 Balance b/d 100,000 July 31 Sales returns 50,000
1,350,000 1,350,000
Most of these entries are self-explanatory as they mirror the transactions in the individual debtor
accounts. The only one that is new is the purchases ledger control. This transaction is likely to be a contra
to an account in the sales ledger, where one person is both a debtor and a creditor and wishes to offset
one account against the other.
Typically, the control accounts are maintained in the general ledger and are used for trial balance
purposes, with the accounts in the sales and purchases ledgers being seen as a secondary detailed
record.
When entering amounts in a control account, it is usual to use totals wherever possible. The following
advantages result:
1. The control account provides an effective check on the accuracy of the postings from the
subsidiary records and on the addition of those records.
2. Because the control account has a limited number of postings, it is possible to extract balances
extremely quickly.
3. The control account can be easily and quickly kept by someone other than the person making the
detailed posting, a factor which improves internal control and makes fraud more difficult, since
collusion would be necessary for fraud to be successful.
Control accounts can also be used to self-balance the various ledgers. For example, a sales ledger
control account can be kept and used in the sales ledger, and at the same time kept in the general ledger
by a different person. This approach has the advantage of providing an opportunity for the sales ledger
administrator to self-check, while at the same time a separate check can be provided by the general
ledger administrator. Any differences will probably be found more easily and reconciled than if only one
such account is kept.
Reconciliation statements
Historically, a bank reconciliation statement has been an important and necessary document for almost all
organisations. It is usual to check the balance in the cash account in the books with the figure shown on
each bank statement when it arrives. (Of course, if internet banking is used, it is easy to choose a
particular date for reconciliation that suits the particular organisation.) It is unusual for these two figures to
be the same, though in principle we would expect them to be. Clearly it is necessary to identify and
explain any differences and make any corrections required. You should note that the aim of the
reconciliation statement is confirmation of the actual cash balance at a particular date.
The main reasons why the figure in the cash account in the ledger may be different from the balance
shown on the bank statement are as follows:
1. Some amounts received and recorded in the accounts may not have been paid in, or they may
have been paid into a different bank and not yet been credited to the customer’s branch or bank
account.
2. Money banked on the day of the issue of the bank statement may not appear on the statement.
3. Cheques paid out by the business, which have been recorded in the cash account of the business,
may not have been paid in by the recipient or cleared by the bank. These appear on the bank
reconciliation statement as unpresented cheques.
4. Some payments shown on the bank statement will not have been recorded in the accounts. Bank
charges and interest are the most likely. Amounts paid relating to standing orders and direct debits
are also sometimes omitted from the accounts.
5. Certain receipts on the bank statements using direct debit or credit transfer may also be omitted
from the accounts.
6. Returned or dishonoured cheques will be reflected on the bank statement but not in the accounts.
1. Start with the bank statement and identify any items that are not in the accounts.
2. These items can then be recorded in the accounts and a revised cash account balance (in the
ledger) calculated.
3. Add unpresented cheques paid.
4. Subtract payments made into the bank but not shown on the bank statement.
5. The result should match the balance on the bank statement.
It seems likely that preparation of a bank reconciliation statement, which is not hard, has become even
easier in recent years with the decline in use of cheques and a corresponding increase in use of direct
credit transfer and EFTPOS. The probable demise of cheques in the next few years will contribute further
to this, but it is unlikely that we shall see the demise of bank reconciliation statements any time soon.
Checking of credit and debit card statements is effectively another type of process akin to a reconciliation.
Concept check 13
In explaining the difference between the balance on the cash account in the ledger and the
bank statement balance, which of the following is a genuine reconciliation statement item,
as distinct from an item which requires an entry in the cash account?
A. An unpresented cheque
B. Bank charges
C. A standing order
D. A credit transfer
E. A direct debit.
Concept check 14
Which of the following transactions relating to the debtors ledger control account is
incorrect?
A. The total of the sales book is debited to the control account.
B. The total of the sales returns book is credited to the control account.
C. The total of the sales ledger column in the cash receipts journal is credited to the
control account.
D. The total of the discount column in the cash receipts journal is debited to the control
account.
E. A journal entry is posted crediting an amount for bad debts to the control account.
Concept check 15
It is important to understand how various items appear on a bank statement. Which of the
following is incorrect?
A. A standing order for a monthly bill would appear as a debit.
B. Payment of your monthly salary would be a credit.
C. Dividends paid to you via direct bank credit would be a debit.
D. Bank charges would appear as a debit.
E. A cheque paid in and shown as a credit, which was subsequently dishonoured,
would then appear as a debit.
Activity AT2.6
a. The following information relates to sales and purchases for a business.
Balances as at 1 June 2020
2,000 credit
1,200 debit
Transactions in June 2020
Prepare the two control accounts and derive the balances as at 30 June.
b. The accounts of a business include a cash account with a balance of $35,000 as at 30 June. The
bank statement has a closing balance of $35,356. After comparing the entries in the cash account
with the bank statement, you find that:
i. Cheques received amounting to $1,500 have not yet been presented for payment to the
bank.
ii. An amount received of $180 has been incorrectly credited to the cash account.
iii. A cheque from a customer for $551 has been recorded in the cash account as $515.
iv. Bank charges shown on the bank statement of $100 have not been included in the cash
account.
v. Interest on the bank statement of $10 has not been credited to the cash account.
vi. An amount of $250 received has been entered into the cash account but has not been
banked.
vii. Several cheques paid out remain unpresented. These total $1,800.
Show the additional entries that need to be made to the cash account and bring down the
corrected balance. Then prepare a statement reconciling the cash account with the bank statement
balance.
SELF-ASSESSMENT QUESTION
AT2.1
Assume that you are working in an organisation that keeps a system of subsidiary records which
includes the following:
Sales book
Sales returns book
Purchases book
Purchases returns book
Cash receipts journal
Cash payments journal
Journal.
The cash receipts journal has columns for the overall total, cash sales, other revenue, cash
from debtors and discount allowed.
The cash payments journal has columns for the overall total, cash purchases, administration,
rent and rates, marketing, cash paid to creditors and discount received.
The organisation also maintains a sales (debtors) ledger control account and a purchases
(creditors) ledger control account. The detailed personal accounts relating to debtors and creditors
are kept in two subsidiary ledgers, and the two control accounts are kept in the general ledger.
You need to identify the basic principles of the manual system and then apply these. Many businesses do
this via computerised accounting packages, but many simply adapt the manual system to suit their
particular business model and their particular areas of expertise. Real World AT2.1 provides an
example. This business is run by a well-organised couple with considerable business acumen and flair,
and a father-in-law with an accounting background (the ‘bookkeeper’) who keeps the books. The system
described satisfies the needs of the business and its owners, is easy to maintain, is well controlled, and is
effective.
This business, owned by a couple, operates in a small country town and has an annual turnover of
around $1 million. It has two arms to the business, homewares and an upmarket cafe. It employs
six to eight staff. These two arms of the business are run and recorded separately. While the
business is seen as a single business, with synergies between the two arms, the owners want to
be able to keep track of each part of the business.
The nature of a business is important in devising systems. Interestingly, the homewares part of this
business is seen by the owners as part of the fashion industry rather than one that supplies the
same kind of inventory on a regular basis. This means that the type of inventory is continually
changing, though, obviously, there will be a part of the carrying stock which will be held and
replaced continuously. The end result is that there is no set pattern either for ordering inventory or
for a particular type and level of stock. Orders can occur based on specific customer needs, gaps
on the shelves, visits and recommendations by suppliers’ reps, and ‘gut feel’ as to what might go
well. There appears to be a general feeling among customers that this ‘gut feel’ works very well.
All products are barcoded, which means that inventory and sales can be analysed in detail. This
enables product profitability to be identified by product lines, which also enables purchasing
decisions to reflect past sales.
Sales are for cash or card. Occasionally, there are orders from local public bodies, such as the
local TAFE, which are via an official order with subsequent payment by credit transfer. These,
including the issuing of receipts, are dealt with by the owners, and details are then passed to the
person who keeps the books, typically in batches every couple of weeks. For the homewares
section the barcodes enable detailed analysis to be made of the sales by product. For the cafe, the
till enables sales to be categorised under four headings. Details of receipts are passed to the
bookkeeper.
Cash from card receipts is usually transferred into the business bank account by the end of the
day. The bookkeeper regularly reconciles the credit card listings with the cash received from the
credit card company. Some goods are sold on lay-by. Detailed records of these are maintained.
Regarding cash receipts, cash from each arm of the business is separately banked intact (i.e.
without any deductions being taken out) after reconciling with the till. Occasionally, the two do not
reconcile, though this usually relates to the cafe takings, where errors or wrong key strokes are
more likely.
Suppliers’ invoices and any other bills are paid by the owner from the business bank account,
using internet banking. Copies of the invoices are sent to the bookkeeper, again typically in
batches, every couple of weeks.
Wages are contracted out. Time sheets are maintained and sent to the agent fortnightly. The pay
calculation is externally processed and pay slips are emailed to the employee. Superannuation is
arranged through a single fund, and this fund liaises with the individual employees as appropriate.
Fortnightly payments are made to employees by the owner using internet banking through the
business bank account. Payments are also made by the owner into the super fund once a quarter,
and to the ATO once a month, again using internet banking through the business bank account.
GST is based on revenue (1/11) less GST inputs, which are derived from the invoices paid, the
calculation being made by the bookkeeper. Payment is made by the owner from the business bank
account, again using internet banking.
The annual reports are compiled by the bookkeeper from the information collected and recorded,
most of which is journalised and put into a spreadsheet. The spreadsheet is prepared in such a
way as to provide a detailed split between the two arms of the business, as well as facilitating
detailed analysis of the profitability.
The details of the income for the year are then sent to the tax agent used by the owners.
Many businesses use computerised accounting systems for part or all of their accounting. Computerised
accounting systems can range from straightforward off-the-shelf accounting packages to part of large-
scale management information systems. Large organisations usually have dedicated accounting systems,
and these are likely to be part of a sophisticated management information system. A typical small to
medium-sized business is more likely to use a smaller computerised accounting system, but many still
use manual systems in part. Some businesses start with an off-the-shelf package, which is then
developed or customised in-house. It is important that when information technology is used it is used
appropriately and value adds. The records kept, and the output produced, must be meaningful. In
general, computerised accounting systems follow the same principles as manual systems. In fact, many
accounting packages use a modular system, which mirrors much of the manual system. For example, at
the time of writing, MYOB Essentials includes banking transactions and reconciliation, sales, expense,
contacts, payroll and reports. MYOB has arguably been the leader in small business accounting software
for the last 20 years. Also, the internal control principles introduced at the beginning of the topic apply as
much to computerised systems as to manual systems, but there are some different and difficult issues
associated with the former
The main elements of a computerised accounting system are set out below:
The computerised interface is comprised of a number of sub-systems (termed ‘modules’), for example
debtors, creditors, payroll, banking, inventory, etc. A business may not use all sub-systems (e.g.
service businesses will not generally use the inventory module). Each sub-system is further divided so
as to provide a set of individual records as required. This is generally known as a database, and is
created automatically by the accounting system once the user enters information. Information is
usually required to be set up in this database, before transactions can be entered, through ‘records’.
Each record entered is usually termed a ‘card file’. Card files can be created for employees, suppliers,
customers, etc. These card files are then used as part of transaction recording and greatly simplify the
recording process. For example, consider the payroll needs of a reasonable sized business employing
100 staff doing a range of jobs under different employment conditions, and possibly using different
superannuation funds. Such detailed records would be kept in each electronic card file for each
employee, and then distributed by the system automatically when the regular payroll is processed.
Details such as pay rate, superannuation fund and leave entitlements are all automatically pulled from
the individual card files and then automatically posted back to each card file after payroll is ‘recorded’.
This means that the card files are constantly being updated, so at any time current information can be
obtained for any individual employee by simply opening that employee’s card file. The advantages of
computerising this area is obvious. Further, the monthly wages and PAYG can be automatically
completed and reported to the ATO through the online BAS lodgement linkage with the ATO system.
The annual payroll PAYG Payment Summary reporting can also be automatically exported to the
ATO, thus providing considerable efficiencies.
A sound system of coding is required, and the system must be devised in such a way as to be able to
provide information at a variety of levels, including a detailed level. The codes used will be linked to
the chart of accounts, which, you will recall from Additional Topic 1 , requires careful planning and
consideration of information needs relating to the entire business (and possibly future areas of the
business). The coding system is, in effect, an extension of the idea of analysis books. Rather than be
limited by the size of the page, detailed coding systems can be used to replace and extend the
analysis columns to as many headings as are needed. The results will be either printed out or
accessible online, or, most likely, a mixture of the two. In most computerised accounting systems, the
coding system has already been created for the user, so that the user can simply use it as is, or tailor
it to better suit their business. Usually, there will be multiple coding systems as part of one accounting
system, and each sub-system will have its own unique coding system. For example, MYOB provides
separate coding systems for the general ledger, inventory items and jobs. One transaction, using the
relevant card file, can be coded to the general ledger, the relevant job and the relevant inventory item
—automatically updating each sub-system as soon as the user ‘records’ that single transaction.
Properly coded information can be input into the system using a variety of ways (e.g. barcodes,
keyboard, mark sensing, scanning, etc.).
The accounting system records are automatically updated. Reports can be generated for aspects of
each sub-system (e.g. sales, purchases, inventory, payroll, banking) or for the accounts in general
(such as general ledger, financial statements). Such reports can be analysed, exported to systems
such as Excel or PDF and printed out where required, with information being targeted to a specific
user. Typical output includes the standard accounting reports, with as much supporting detail as is
needed, whatever documents are needed to carry on the business of the organisation (e.g. invoices,
credit notes, pay slips, cheques, end-of-year tax documents etc.) and other reports generated for
specific purposes (e.g. inventory reports, age profile of debts, etc.).
The files/databases collected provide the business with a carefully designed information set, which
enables production of a range of reports, including costing and management accounting reports and
historic and forecast analyses, which could not be done easily or quickly using a manual system. A
rigorous system of historical recording provides a sound underpinning for forecasting. This can be
done manually, but sensitivity analysis done manually can be quite tortuous, whereas when
computerised a wide range of sensitivities and scenario analyses can be produced quickly.
A typical accounting package uses a menu-driven screen. This gives the user a choice of a range of
accounting tasks (modules) that can be worked on (e.g. raising invoices, processing sales orders,
inventory control, payroll, paying creditors, purchases order processing and job costing). The routines
usually lead the user through the transactions. These routines generally relate to one particular part of the
data collection and recording process, and often cover similar areas to those covered in a manual system.
In a well-designed and integrated package, however, the information will be entered only once and
automatically drawn on as appropriate. The double entry, posting and updating therefore takes place
automatically, thus saving time and avoiding duplication. Control accounts for debtors, creditors and
wages are common, and form part of the formal ledger accounts. In general, computerised systems can
be expected to eliminate some errors relating to manual data entry. They are also associated with greater
speed and ease of analysis than manual systems. Certain additional security and internal control
procedures may need to be added or modified.
In general, computerised accounting systems follow the same broad principles as the manual system.
They are likely to be used where:
Cloud computing
Cloud computing has been around for several years now. Essentially, it is the ability to use and store a
data file on an online server instead of a physical computer. Users purchase only the accounting system
or modules that they require, which are operated ‘in the cloud’. This means that internet access is
required and all software and files remain online. So as long as the internet is operating efficiently, the
accounting system remains reliable and current. Furthermore, by accessing and paying for use of the
services provided, there are no version updating costs since updates are performed by the service
provider—a significant advantage if you have ever been on the treadmill of constant version updates!
The cloud also offers a number of advantages for accounting systems, predominantly by minimising the
redundant bookkeeping work of most businesses. Cloud accounting systems provide real-time data,
which means that any authorised user can access the same up-to-date file, at any time, using any device
with an internet connection. Such mobility provides real-time accounting: a sales invoice can be entered
at the airport; reports can be accessed whilst overseas. This also means that multiple versions of data
files are eliminated, and that a backup is automatic—a significant advantage for data security which those
who have been involved in frequent data backup and storage will appreciate! Similarly to offline computer
accounting system users, cloud users can be designated particular access for data security (e.g. all users
excepting the payroll administrator can be denied access to payroll records).
One of the main advantages of cloud accounting systems is that a business can link its accounting
system to external parties, such as banks, to eliminate much of their mundane data entry. For example,
users can download real-time data from their bank accounts, termed ‘live feeds’, which automatically
enter bank account and credit card transaction data into the business accounting system. Further, most
cloud accounting systems offer the option of automated bank reconciliations, with smart features like
autocoding of repetitive transactions into the general ledger (see Real World AT2.3 ).
Automatic linking with other organisations, such as the ATO, suppliers and customers, is also increasingly
commonplace. This often eliminates further data entry! Many small business owners are now sending
invoices via their mobile devices (once created and emailed, the invoices are automatically entered into
their accounting system); being paid by direct credit transfer (which is automatically entered into their
accounting system upon linking with the bank system); and getting reconciliations completed
automatically (through the same bank system linkage). This means that the traditional paper trail of
documents is being replaced by an electronic audit trail of transactions, which most cloud computing
packages offer as a security function in their system settings.
Of course, there are a number of issues relating to the cloud, generally pertaining to data security. Such
issues include:
concerns about internet reliability, both in terms of access and unauthorised user access (e.g.
hacking)
concerns relating to the reliability of the cloud accounting system provider (e.g. temporary system
outages, company reputability and longevity)
concerns regarding privacy and legal issues (there are regulations that some types of information
should not leave the country of origin, for example certain medical data is prohibited from leaving
Australia).
The cloud accounting system providers are well aware of the security concerns and processes such as
encryption and tokenisation provide protection against, for example unauthorised access, but some risk
does remain. Any business considering using a cloud accounting system provider should carry out due
diligence regarding their financial position and the location and capacity of their data centres. The
question as to what happens if the provider fails should also be considered, but for many small
businesses it probably won’t be.
Overall, cloud accounting programs are having a considerable impact on the way businesses, including
small businesses, are keeping track of data and how they are using it. While in some ways business
activity continues along the same track (a plumber or electrician is still doing the same job), the process of
dealing with things such as ordering, invoicing, payroll, payment of bills and banking has changed. The
end result is a system which looks quite different from the manual system described earlier. However, the
basic ingredients of the mix remain the same, but the newer systems are far more streamlined and
integrated and eliminate virtually all chances of arithmetical error. Effectively, what is happening is that,
with computerised systems, we can safely presume that the postings that follow from the point of original
entry will be accurately followed through. The systems also provide scope for greater awareness of the
key elements of a business because there is less emphasis on data collection and more on how the
business is travelling. Once data collection becomes easier, it is to be hoped (and expected) that the
resulting information can and will be used more efficiently and effectively.
Concept check 16
Which of the following do you see as being incorrect regarding potential advantages of
computerised accounting systems?
A. Ability to deal with large volumes of transactions
B. Greater accuracy through automatic postings
C. Elimination of certain types of errors
D. Ability to extend the range of reports, including more detailed management
accounting reports
E. Reduced security risks.
Concept check 17
Which of the following do you think is incorrect?
A. Many computerised systems facilitate the desirable end result of minimising actual
cash transactions.
B. With a fully computerised accounting system, the importance of the chart of accounts
and the system of coding is reduced.
C. Many accounting packages use a modular system, which is based on similar
principles to those of a manual system.
D. It is common for small businesses to use a mix of parts of the manual system with
modules from an accounting package.
E. Batching of invoices in a computerised system is similar to a purchases book.
Activity AT2.7
a. What kind of information needs to be part of a computerised wages record or database for each
individual staff member?
b. Assume that a company has a sound historical accounting system and wishes to use this as a
base for planning over the next five years. For what areas do you think sensitivity analysis would
be appropriate in determining the future financial performance of the business?
c. Do you consider information overload an outcome of using computerised accounting systems.
d. Does the use of a computerised accounting system reduce the required accounting knowledge of
its users?
e. Explain the importance of the chart of accounts and the coding system in a computerised
accounting system.
Activity AT2.8
Did you know that you can try before you buy? Most computerised accounting systems provide the option
to trial a version of their software or cloud for free (usually for a period up to 30 days). For this activity you
will trial MYOB software, since it is the leader in small business software in Australia. Go to the MYOB
website (https://www.myob.com/au/accounting-software/compare#compare-products) and choose
the version you would be most interested in using (for your business or for your personal records). Click
on the ‘Try now’ or ‘Try for free’ links to learn how to use this software for free! MYOB offers tutorials for
operating all of their products at http://help.myob.com/teachme/. Simply choose which product you
have downloaded for the trial version, click on the ‘Start learning’ button and simply follow through the
prompts. Allow about 1.5 hours for the initial training on setup and a further 3 hours for learning how to
use the software.
Activity AT2.9
This activity aims to consolidate your understanding of all concepts in Additional Topics 1 and 2 by
considering your own personal finances. If you have understood the recording process, then you will be
able to produce a basic set of financial statements for yourself by simply using your bank/loan account
and credit/debit card account transactions.
First, obtain the bank statements for all of your personal accounts (savings, cheque, loan, credit and debit
cards) for the same period (choose a reasonable period (e.g. one month) so that the volume of
transactions will not overwhelm you.
Decide on which chart of accounts you wish to use. This is a very important step, as you know from
completing Additional Topic 1. You might like to begin by going through each of your statements, line by
line, and ‘classifying’ each transaction—in this way creating your own chart of accounts. Assume this was
your bank statement for the month of January 2020 (first three columns). You might go through and
classify each transaction as follows (last column):
3/01/2020 −$120.10 PAYMENT TO GMHBA LTD 2-1 Private Health Insurance Expense
3/01/2020 −$17.73 PAYMENT TO INSURANCE LINE 2-2 Income Protection Insurance Expense
3/01/2020 −$32.00 DIRECT DEBIT—DEBIT TO VIRGIN MOBILE 2-3 Telephone Expense (mobile)
4/01/2020 $981.50 DEPOSIT FROM XYZ—PAY FOR 4/01/2020 1-2 Income—Salary and Wages
5/01/2020 −$695.35 INTERNET BANKING BILLPAY—TMR REG RENEW 2-4 Vehicle Expense (registration)
11/01/2020 $981.50 DEPOSIT FROM XYZ—PAY FOR 11/01/2020 1-2 Income—Salary and Wages
17/01/2020 $692.75 DEPOSIT FROM ABC—PAY FORTNIGHT 17/01/2020 1-2 Income—Salary and Wages
18/01/2020 $981.50 DEPOSIT FROM XYZ—PAY FOR 18/01/2020 1-2 Income—Salary and Wages
18/01/2020 −$500.00 INTERNET BANKING BILLPAY VISA CARD 2-6 General Living Expenses (food, fuel)
23/01/2020 −$35.00 DIRECT DEBIT—DEBIT TO VIRGIN MOBILE 2-3 Telephone Expense (mobile)
25/01/2020 $981.50 DEPOSIT FROM XYZ—PAY FOR 25/01/2020 1-2 Income—Salary and Wages
27/01/2020 −$363.48 PAYMENT TO COLES MASTERCARD 2-6 General Living Expenses (food, fuel)
27/01/2020 −$197.19 PAYMENT TO 28 DEGREES CREDIT CARD 2-6 General Living Expenses (food, fuel)
If you have online banking, you can do the above very simply by choosing a date range and simply
exporting this to a CSV file, which can be opened in Microsoft Excel. You can then simply classify your
chart of accounts in the next column. The benefits of using Excel will flow through to the next step, where
you can use linking and simple formulae.
Now you have enough information to prepare a simple profit and loss statement, as follows:
Your Name
INCOME
Income—interest $ 197.29
EXPENSES
Note that the items listed as income and expenses are directly from your chart of accounts. You are
simply grouping each transaction by your classification! To use Excel’s linking features, simply type ‘=’ to
start a formula in the cell that you wish (for example, you can link the interest figure of $197.29 directly to
the bank statement figure for this interest). This makes more sense when grouping more than one figure,
for example grouping the figures for Income—Salary and Wages. You would begin with ‘=’ and then click
on each bank statement figure for the pays, pressing ‘+’ in between each, and hitting ‘Enter’ to complete
the linking. Excel then automatically sums all of these pays as $4,618.75. You can also enter formulae for
the Profit/Loss—simply type ‘=’, then click on the TOTAL INCOME figure, and ‘1’ the TOTAL EXPENSES
figure.
a. What is the chart of accounts so far, as illustrated in the above example? What is your own chart of
accounts? Is it similar to the one shown here? Remember, you can add to your chart of accounts
as you classify more of your own transactions.
b. What level of detail could you change in the chart of accounts shown in this activity? Why might
you want to do this?
c. How might you analyse the profit and loss statement shown in this activity? Has this recording
process (transaction through to financial statement) exercise been useful for you?
We have seen how a system of subsidiary records provides a kind of ‘first response’, which tries to
ensure that all data is collected and can then be incorporated into the accounts. We have described a
very basic set of subsidiary records which can be completed manually. The various ways in which the
manual approach can be computerised were then explored. It should be clear that there is no one system
that fits all. Accounting systems range from simple manual systems to fully computerised systems, and
the most common among small-to-medium organisations are probably hybrid systems that use a mix of
the two. It is easy for those who are used to large corporate systems to think that no-one actually still
uses a manual system. Anyone who believes this need only look in their local stationery store to realise
that books for entering transaction data by hand are still best-sellers. Particular favourites seem to be
receipt books, which act as a subsidiary record, cash books, journals and analysis books.
Most businesses that use these kinds of subsidiary records have built in some aspects of internal control.
While for many businesses these may fall a long way short of the kind of ideas set out in the COSO
document discussed at the beginning of the topic, they are important and probably appropriate for small-
to-medium businesses.
Below are three Real World examples which illustrate just how the general principles can be applied. Real
World AT2.2 summarises the accounting system used by a very successful independent real estate
agent. This illustrates how some modules of a computerised accounting package can be used alongside
what is basically a manual system. Real World AT2.3 provides an illustration of cloud accounting,
while Real World AT2.4 illustrates how a fully computerised system operates. Both of the last two
examples illustrate the advantages of computerisation for the businesses discussed.
The real estate agent concerned is a highly experienced real estate agent who has worked in real
estate groups/franchises in the past, but who is now independent. He has one fellow agent and
two staff, primarily engaged in administration. Annual commissions are well in excess of half a
million dollars.
Given the nature of the business, the record-keeping is divided into a separate set of trust
accounts and a set of accounts for the business. All transactions relating to sales and rentals are
recorded in the trust accounts. The trust accounts are done completely manually. A sale note is
drawn up for every transaction. This note covers both sale transactions and rental transactions. It
provides details of the purchaser or tenant, the vendor or landlord, details of the property and, if
rented, the amount of the bond and rental. Details of any amounts received or spent are recorded
on the sale note in the form of a journal entry. The sale note is started on signing of the contract.
Until the contract is completed, this sale note is ‘alive’. Once any sale contract is complete, the
amount of commission is calculated, together with any fees or expenses, and the net revenue is
transferred to the business account. The sale note then becomes ‘dead’. Revenue from rentals are
transferred to the business accounts on a regular basis, after the event.
A detailed receipt book is kept for the trust accounts. These are classified as income relating to
deposits, rental, bonds or advertising. All transactions relating to the trust accounts are kept
completely separate from the other business accounts. In a sense, the sale note can be seen as a
personal account relating to a particular customer, so it has similar characteristics to a sales book
and personal debtor account all in one.
The business accounts are kept completely separate to the trust accounts. Incoming invoices are
held and filed, effectively acting as the source document and day book. These are paid weekly.
They are entered into a cash payments journal. A cash receipts journal is also maintained.
Transactions are analysed under a number of headings. Postings are made to a double-entry
accounting system on a monthly basis.
MYOB is used to deal with tax and GST. It can be used to prepare financial statements and further
analyses, but these are not seen as being particularly important. This is simply because the owner
of the business is completely on top of the business at all times.
Both sets of books are audited annually. Audits are quickly and efficiently completed.
The records are generally kept by one staff member, but are reviewed by two others, with the
principal taking an oversight role.
The view taken by the principal is that the system works well, is clear, easy to track, keeps track of
all individual contracts, and has a clear document and audit trail.
A small community health organisation in Central Queensland provides quality primary healthcare
services to the local community. Patient numbers fluctuate around 3,000 annually, serviced by a
staff of around 60, including both full-time and part-time. Their annual operating budget is in
excess of $5 million. As the organisation is partly government-funded, it is subjected to an annual
external financial statement audit covering all of its operations.
The accounting system is fully computerised using MYOB AccountRight in the cloud. The system
uses a number of modules including Accounts, Banking, Sales, Purchases and Payroll, which
follow most of the basic principles identified in this topic. The chart of accounts is based on the
MYOB generic coding, which has been tailored to better suit the organisation’s activities. The
general ledger is coded using the MYOB numbering system: 1-XXXX numbers for assets, 2-XXXX
numbers for liabilities, 3-XXXX numbers for equity, 4-XXXX for income and 6-XXX for expenses. It
does not use the 5-XXXX numbers for cost of sales, as it is predominantly a service entity.
The organisation operates a number of programs under the primary health banner, including a
quit-smoking program, dental unit, a maternal unit, a playgroup unit and a chronic disease team, in
addition to the general clinic. Each of these programs is a separate cost centre. They are coded in
the MYOB system as ‘jobs’ using numerical four-digit coding. Currently there are around 10
identified ‘jobs’. It is easy to add new codes as appropriate or required.
Every transaction entered into the MYOB cloud system requires both a general ledger code and a
job code. The system will not allow a user to save a transaction otherwise. The payments module
uses a system that is built on a purchase order. Almost everything paid needs to start with an
order, with ordering capability being restricted to a small number of staff who have financial
delegation approved by the Board of Directors. This is followed by receipt of an invoice, at which
stage a process of authorisation and sign-off takes place by the Finance Manager and the
Executive Manager. Anything that is not supported by an official order needs to be signed off by
the Finance Manager and Executive Manager. Invoices are batched up and processed every two
days. Payment of bills is normally by electronic credit transfer or BPAY (90%). Occasionally
cheques will be drawn, but these are kept to a minimum.
Income comes from a variety of sources, but mostly from government grants and self-generated
Medicare billings. A dedicated Medicare Officer enters all doctor and dental billings from the
medical information systems (Medical Director, PracSoft and Exact) and bills Medicare daily.
Medicare pays these invoices by directly crediting one of the organisation’s bank accounts.
Payroll is performed weekly and employees must use the electronic time clock to prove their
working hours. The payroll administrator collects each employee’s time card once it has been
signed off by the supervisors and approved by the Executive Manager. In the MYOB payroll
module, detailed records are kept of the permanent information relating to every staff member in
each employee’s card file. Staff are able to engage in salary sacrifice due to the organisation being
a Public Benevolent Institution, which means it can access certain Fringe Benefits Tax
concessions, which assists it in attracting quality employees. Payroll is processed in MYOB and
automatically exported to the organisation’s bank account, which automatically distributes it by
direct credit transfer to each employee’s nominated bank account (set up in their individual card
file). Pay slips are sent by email directly from the MYOB linking to the Microsoft Outlook email
program. The organisation pays PAYGW tax monthly through its IAS/BAS, which is lodged through
the ATO online portal, and the employees’ annual PAYG Payment Summaries are also lodged
electronically through this portal. Both IAS/BAS and PAYG Payment Summaries are prepared
directly from and within MYOB.
This organisation has minimised the amount of actual cash flowing through the system. Cash
outgoings are confined to three cash floats (clinic reception, dental and petty cash) totalling less
than $500, using the petty cash imprest system outlined in this topic. Cash receipts are backed up
by the issue of official receipts, copies of which are kept as a source document and audited by the
external auditors annually. Cash receipts are typically summarised and banked daily, with details
going to the finance department.
The journal is also used, as full accrual accounting statements are prepared every month.
Adjusting entries include those for prepaid insurance (asset) and government grants received in
advance (liability). Year-end audit journal entries are also used, being only input by the external
auditors as required. The system will not permit a journal entry where the debits do not equal the
credits. This does not completely eliminate the possibility of errors, but does prevent a number of
common types of error.
Bank reconciliations are performed weekly, using the live bank feed from the cloud and automated
entries from the organisation’s multiple bank accounts. Bank accounts are kept for each separate
source of income. Reports are prepared for the Finance Manager monthly in regard to Medicare
commissions, banking and purchases. The Finance Manager reports to the Board of Directors
monthly on the financial statements directly exported from MYOB, as well as program profits and
losses, using the ‘Job Profit and Loss Statement’ in MYOB.
The number of users of the MYOB cloud system is limited to six. However, each authorised user
can access the file at any time, anywhere—at the time of writing, one finance staff member was
based in Western Australia and another was working from home. Backups can be made manually
and stored; however, the system remains in the cloud. The external auditors also have access to
the MYOB file at any time, providing a third-party check.
This organisation uses separation of duties as a large part of its internal control. It has a stringent
payment authorisation system as per the Financial Delegations Instrument decided by the Board of
Directors. This, in addition to the external audit, provide further controls over transactions. It has
also largely eliminated cash transactions, reducing the potential for cash fraud.
This is a middle-range organisation involved in health, with a staff of around 450, both full-time and
part-time, and an annual operating budget in excess of $30 million.
It uses a chart of accounts, which acts as a means of effectively coding figures in as much detail
as needed. In terms of cost-centre allocations, the code is alpha-numeric, consisting of one alpha
character and four numbers. This enables a large number of cost centres to be identified and
grouped as needed and useful. Currently there are around 100 identified cost centres. It is easy to
add new codes as appropriate or required. On top of this, there are code numbers allocated by
income and expenditure types. This enables figures to be analysed in many different ways, either
on a regular basis or on an as-needs basis.
The accounting system is fully computerised. The system uses a number of modules, which follow
most of the basic principles identified in the topic.
The payments module uses a system that is built on an ordering routine. Almost everything paid
needs to start with an order, with ordering capability being restricted to a relatively small number of
senior people. This is followed by receipt of an invoice, at which stage a process of authorisation
and sign-off takes place. Anything that is not supported by an official order needs to be signed off
by the cost-centre head. Invoices are batched up and processed twice a month. Payment of bills is
normally by credit transfer (90%). There is a facility for urgent payments, which can be made
separately, and occasionally cheques can be drawn, but these are kept to a minimum.
Income comes from a variety of sources, but mostly from government agencies. Other income
(fees and charges) is built up from detailed records, which enable monthly bills to be prepared and
issued. In many cases (e.g. residential aged care) income is collected via direct bank credit, rather
than direct debit, as bills are fairly standard. In other cases, notification of detailed time spent and
work done is collected by the staff doing the work and then details are sent to the finance section.
Wages can be quite complex in reality, although quickly glossed over in texts. In this organisation,
there is a variety of modules which integrate to cover what is generally known as payroll. In the
basic module, detailed records are kept of the permanent information relating to every staff
member. On top of this there is a variety of detailed linking modules that cover things such as
leave and pay history, allowances, long-service leave, award conditions, etc. Staff are required to
check in and out every shift. A range of managers are assigned responsibility for specified staff
and have to sign off on the figures that result. A pay run occurs every fortnight. Pay is by direct
credit transfer. Pay slips are sent by email.
This organisation has minimised the amount of actual cash flowing through the system. Cash
outgoings are confined to several petty cash floats, totalling less than $1,000, using the kind of
approach outlined in this topic. Cash receipts are backed up by the issue of official receipts, copies
of which are kept as source documents. Cash receipts are typically summarised and banked daily,
with details going to the finance department.
The journal is used regularly as full accrual accounting statements are prepared every month. This
requires all closing adjustments (e.g. prepayments and accruals) to be journalised. Some journal
entries can be very long and complex. In inputting a journal entry, the system will not permit an
entry where the debits do not equal the credits. This does not completely eliminate the possibility
of errors, but does prevent a number of common types of error.
The organisation uses the control account and reconciliation concepts, although in a slightly
different way from that discussed in this topic. Because the system is computerised, it is easy to
produce a range of reports (often
Overall, this organisation displays good internal control in a variety of ways. It has largely
eliminated cash transactions, thus reducing the potential for cash fraud. It has developed systems
which enable a variety of reports to be produced on either a regular basis or an as-needed basis.
The system facilitates reconciliation of every item in the balance sheet. The possibility of arithmetic
errors is just about zero.
LO1: Identify the main elements of internal control and explain the need Defined internal control
for sound internal control in accounting systems Identified the main features of internal control in practice
Identified issues with internal control and e-commerce
Explained why internal control sometimes doesn’t work
Used an Accounting and You to identify ways of avoiding
being defrauded
Illustrated how internal control might operate in a
functional area of business (i.e. purchasing)
LO2: Explain why in a typical manual system the ledger needs to be split Identified practical problems with ledger accounts
up, identify common ways of doing this, and outline the purpose and Identified possible ways of subdividing the ledger
structure of a traditional manual system of subsidiary records Outlined a typical manual system of subsidiary records
LO3: Explain the nature and role of sales and purchases journals and Outlined the principles behind sales and purchases
show how they are used in posting figures to the accounts in a traditional journals
manual system Illustrated how simple sales and purchases books work
Explained the advantages of use of analysis columns
Showed how information is posted to the accounts
LO4: Explain the nature and role of the cash book and cash journals and Described the cash book, including two- and three-
show how they are used in posting figures to the accounts in a traditional column formats
manual system Explained the role of cash journals, including analysis
journals
Explained and illustrated the use of the imprest system
for petty cash
Showed how information is posted to the accounts
LO5: Explain the nature and role of the journal and show how they are Explained and illustrated the use and form of the journal
used in posting figures to the accounts Showed how postings are made to the accounts
Identified typical errors and ways of correcting them
LO6: Explain the importance of control accounts and reconciliations, and Explained and illustrated the role of control accounts
prepare control accounts for debtors and creditors and a bank Explained the need to reconcile various figures in the
reconciliation business
Explained and illustrated the preparation of a bank
reconciliation statement
LO7: Explain the major elements of computerised accounting systems Outlined the main elements of a computerised
and explain how these systems still use the same basic principles of accounting system
accounting and internal control used by a manual system, but that they Discussed the implications of cloud computing on
deal with large volumes of transactions more effectively, and can be accounting
linked with appropriate documentation or file production and maintenance Illustrated by way of Real World examples how
accounting systems in practice can vary from basic
manual systems through to sophisticated computer
systems which facilitate detailed reporting and analysis
Reinforced throughout that the underlying basic
principles are the same for manual and computerised
systems, though computerised systems are better able
to deal with higher volumes, provide better
documentation, and are flexible enough to do much
more than the basic manual system
Discussion questions
Easy
AT2.1 LO1 Identify the components of internal control, as defined by the Treadway Commission. Compare these components with the
definition of internal control given in businessdictionary.com.
AT2.2 LO1 Discuss the role of the trial balance in internal control.
AT2.3 LO1 List as many approaches as you can that contribute to internal control.
AT2.4 LO2 Why does the ledger need to be split up, and what are the main ways of doing this?
AT2.5 LO3 Explain the basic idea behind a purchases book or journal.
Intermediate
AT2.6 LO1 Discuss segregation of duties as an internal control device.
AT2.7 LO1 What do you think are the critical elements of good records maintenance?
AT2.8 LO1 Identify some physical safeguards commonly found in internal control systems.
AT2.9 LO1 How might the use of standardised documents help internal control?
AT2.10 LO1 Discuss the importance of a good staff profile to internal control.
AT2.11 LO1 Identify and discuss the main internal control issues that arise with e-commerce.
AT2.13 LO4 What are the main reasons for the development of analysis books?
AT2.14 LO4 Explain the reasons for use of an imprest system of petty cash.
AT2.15 LO5 Provide examples of transactions that might appear in a general journal.
AT2.17 LO1 Why is pre-numbering of receipts an important part of internal control relating to cash receipts?
AT2.18 LO1 What do you understand by the term ‘asset register’? What is its purpose? How often might it be checked?
Challenging
AT2.19 LO6 Discuss the notion that, as more and more transactions are carried out by direct bank transfer, the bank reconciliation is
dead.
AT2.20 LO1/6 Are you one of the many people who never require a receipt in relation to purchases using a credit card? If so, how are
you able to keep track of your financial positon?
AT2.21 LO7 Discuss what might be the critical components in broad terms of a system for purchasing goods, and then paying
creditors, using a computerised accounting system.
AT2.22 LO7 Discuss the link between the recording process and the production of documents used in the business process when
using a computerised accounting system.
AT2.23 LO1/3 Why is it important that the responsibility for ordering goods is held by someone other than the person who is responsible
for paying bills?
AT2.24 LO1/3 Why is it important that those people making the sale are not also responsible for despatch of the goods sold and receipt
of cash?
AT2.25 LO1/3 In devising a purchasing system, how might you prevent payment of fictitious invoices?
AT2.26 LO7 What do you understand by cloud accounting? What are the implications for accounting systems?
AT2.27 LO1/7 What kind of physical, mechanical or electronic controls have you experienced in dealing with businesses to date?
Application exercises
Easy
AT2.1 LO2 Using the ledger division suggested in the topic, identify the ledger in which each of the following accounts would be kept.
a. Premises
b. Accumulated depreciation—vehicles
c. Sales
d. Purchases
e. Bad debts
f. Doubtful debts provision
g. Wages
h. G. Austin (a creditor)
i. M. Holmes (a debtor)
j. Drawings
k. Capital
l. Loans
m. Discount received
AT2.2 LO3 Draw up a sales book and a sales returns book for the following transactions, and show where the figures contained therein
would be posted.
February 3 Receives a cheque for $350 from A. Veck in settlement of a debt of $365
AT2.5 LO5 B. Quick opens his business with the following assets and liabilities: Premises $500,000; Equipment $150,000; Fixtures
$50,000; Inventory $100,000; Cash $45,000; Receivables—J. McCool $10,000, P. Gover $8,000; Payables—A. Hardy
$20,000.
Intermediate
AT2.6 LO4 A business operates a petty cash system using the imprest system with an allocation of $1,000. The opening balance is
$1,000. During October the following transactions were completed through the petty cash account.
October 11 Newspapers $7
Are there payments made that ought not to have occurred in normal circumstances?
AT2.7 LO3/4 David is responsible for entries in the nominal ledger of a business. Jonathan is responsible for the sales (debtors) ledger.
A sales book is kept in which the total for each sales invoice is recorded, along with the name of the customer. Jonathan
and David complete their records on Monday and Tuesday respectively, on which days they have access to the sales
book of the previous week.
James is the cashier of the business. He receives cash and cheques, and records these in the cash receipts journal.
AT2.8 LO1 Identify ways in which the recording process can use principles of internal control, relating to:
a. recording of transactions
b. separation of roles and responsibilities within the accounting function
c. separation of custody of assets and accounting for assets
d. authorisation of transactions.
AT2.9 LO3– Assume that a business uses the subsidiary records described in this topic. It also keeps a sales (debtors) ledger control
5 account. At the start of a period it has a debit balance on this account of $250,000. During the next month, the totals on
the various subsidiary records are as shown below:
Also, a journal entry writing off bad debts for the month was made, totalling $8,000.
AT2.10 LO6 The bookkeeper responsible for maintaining the individual records of creditors relating to purchases prepared a schedule
of the balances of individual supplier’s accounts at the end of April. This was drawn up from information in the creditors
ledger. The balance was $883,660.
He then passed this over to the accountant who was responsible for keeping the creditors ledger control account, for
checking and reconciliation.
1,790,000 1,790,000
In examining the discrepancy, a number of errors were found in both the control account and the individual accounts. You
may assume that the totals posted to the control account are correct, other than when listed below:
1. One supplier had been paid $30 from Petty Cash. This had been correctly posted to his personal account, but had
been left out of the control account.
2. Goods which had cost $400 had been returned, but this transaction had been omitted from the purchases returns
book.
3. Discounts received amounting to $50 and $30 had been posted to the wrong side of the individual creditor
accounts.
4. One balance, amounting to $1,000, had been completely omitted from the schedule.
5. A credit balance on one account amounting to $969 had been transposed in the schedule to $699.
6. The credit side of one account had been under calculated by $100.
a. Prepare a statement starting with the original closing balance on the control account, identifying and
correcting the errors in the account, and concluding with an amended closing balance.
b. Prepare a statement starting with the original total of the schedule of individual creditors, then identify and
correct errors in the schedule, concluding with an amended total.
AT2.11 LO6 You are a fairly careful person who likes to keep tabs on the balance in your bank account. You try to keep a diary, which
acts as your equivalent of a ledger account. This shows the following for the month of August:
Less
Direct debits
Mortgage (1,000)
Cheques
5,996
You are pleasantly surprised by the size of the balance at the bank.
Identify all of the differences between your diary record and the bank statement.
AT2.12 LO4 Your business gives senior staff credit cards for use on specified purposes. Expenditure can be made on the card for fuel,
accommodation, meals and entertaining up to a limit of $500 on any one transaction. You are expected to provide credit
card slips and/or receipts where necessary and appropriate.
Your credit card statement for February shows the following detail:
a. Identify the advantages of using credit cards for purchases of this type, with particular emphasis on internal control
aspects.
b. Identify the disadvantages and dangers of their use.
c. Use the information from the statement to prepare a four-column analysis for the month that could be used for
posting to the accounts. (This could be perceived as being an analysis cash payments journal of a particular type.)
d. How important is it that credit card slips and associated receipts are kept?
Challenging
AT2.13 LO6 The trial balance of Gippsland Trading Co. includes the following items:
AT2.14 LO6 The bank account for November of Mahendra Ltd, prepared by the bookkeeper, was as shown below:
Bank account
November November
20 Gas rebate (direct credit transfer) 200 12 Office agencies 1011 280
16,690 16,690
November
28 Interest 20 3,200 Cr
You will need to cross-check the entries carefully in order to reconcile the bank account.
AT2.15 LO6 The subsidiary records of your business consist of the following:
Sales book
Purchases book
Journal.
Postings are made monthly, using totals wherever possible. Control accounts are kept for the sales ledger and the
purchases ledger. At the end of each month the balances on the individual debtor and creditor accounts are add listed
and compared with the relevant control account balance. The lists below show the balance on the control account and
the total of the add list. They do not agree.
a. A purchase of goods from J. Smith amounting to $450 had been correctly recorded in the purchases book, but
had been debited to his account.
b. A payment to P. Brown of $500 had been debited to P. Bron.
c. In entering the sales book, a credit note for $150 had been included (as an invoice) with a batch of invoices. It
related to goods returned by D. Lowe. The credit note will be processed in the next month.
d. $400 paid to B. Giddings for purchases had been debited to his account.
e. The purchases book had been overcast by $1,000.
f. The sale of goods to G. Templeton had been correctly recorded in the sales book at $750, but had been debited
to his account as $570.
g. Discount allowed of $50 to G. Dean had been debited to his account.
h. The add list for debtors was found to be $900 short.
i. Sales of $950 to T. Dance had been correctly recorded in the sales book, but posted as $590 to his account.
j. The total of the purchases returns book ($1,500) had been debited to the sales returns account, and credited to
the debtors control account. The detailed postings to the creditors accounts had been made correctly.
Complete the statements below, where appropriate, showing the appropriate adjustments to the control accounts
or the add lists of personal accounts to ensure that agreement is reached.
Debtors
Control account Add list of personal accounts
$ $
a)
b)
c)
d)
e)
f)
g)
h)
i)
j)
Adjusted balance
Creditors
Control account Add list of personal accounts
$ $
a)
b)
c)
d)
e)
f)
g)
h)
i)
j)
Adjusted balance
AT2.16 LO1 Identify ways in which physical controls can be used to ensure security and safety of staff and assets.
AT2.17 LO1 List any potential security issues that you can see with e-commerce and identify possible ways of dealing with them.
AT2.18 LO1/3/4 How might you devise a sales system and related cash receipts so as to minimise scope for abuse? Using Table
AT2.1 as a guide, indicate what kind of documents might be needed and identify as many internal control features
as you can.
AT2.19 LO1/4/5 Using Table AT2.1 as a guide, identify the main features of a payroll system and the kind of internal controls you
think would be useful.
Additional topic 2 case study
Find a friend or relative (or the relative of a friend) who is involved in a managerial or ownership role in a
business. Try to ascertain the following relating to the business:
Activity AT2.1
a. To ensure clarity regarding who does what. Separation of duties is likely to mean that collusion
would be necessary to commit fraud.
b. Uncontrolled authorisation of expenditure is likely to facilitate waste, extravagance and cheating.
c. A cashier with access to both cash and the records would mean that cheating and fraud would be
easy.
d. If staff are involved in anything wrong, this is likely to be identified when they are on leave. The
requirement that staff take leave should be applied across the organisation.
e. Staff may have interests in both the organisation in which they work, and in outside organisations
(e.g. suppliers). Sometimes these conflict, and clear policies regarding conflict of interest are
needed to deal with this.
f. An inventory of assets owned is effectively a listing of these assets. Such an inventory is needed to
ensure that the organisation knows what it owns and whether the assets are still held. It is quite
common for assets of a certain type to ‘disappear’, and it is important that there is both a record of
ownership and some means of identification when an investigation occurs.
g. Without good staff training, the probability of error and staff disengagement is high.
h. An audit is a check on a system, with an aim of checking that the system works and, if failures are
found, identifying the errors occurring and possible ways of improving the system.
i. Backup copies, physical security, limited access.
Activity AT2.2
a. The sheer volume of transactions will mean that a simple double-entry system will not be able to
cope, so ways of dealing with large volumes of transactions need to be found. The main way in
which this is done is by use of barcodes, which are put on everything in the supermarket, including
the things that are not prepacked, such as purchases from the deli. At the checkout the barcodes
are scanned. The codes typically enable detailed records to be kept. The checkout process usually
takes a relatively short time. Problems usually occur when the barcode is not clear or has been
lost. The barcodes enable detailed inventory/stock records to be maintained, together with
production of sales and profit reports.
b.
i. Sales (debtors) ledger
ii. Nominal ledger
iii. Nominal ledger
iv. General ledger
v. Purchases (creditors) ledger
c. Individual debtor or creditor accounts are typically kept in a computer file. The cash book is often
computerised, with very few transactions occurring in actual cash.
d. Barcodes are very important, as indicated above in section (a). Most retail businesses use
barcodes extensively.
e. By separating roles, by summarising and using totals as doublechecks, by formalising the system
of original entry so that the systems are clear and easy to follow, and by dealing (by use of the
journal) with complex adjustments.
Activity AT2.3
a. To record the ‘sales’ (i.e. patients seen by an audiologist) clients relating to sales or letting for a
real estate agent. For an audiologist, this might be in the form of a day book, but with considerable
supporting detail, enabling invoices to be prepared based on the detail contained in this preliminary
record. For a real estate agent, it is more likely that the day book would have a particular form,
reflecting the ongoing needs related to a contract for sale. Different records would probably be
developed to deal with contracts relating to lettings.
b.
Purchases book (1)
NL5 2,600
NL6 300
M. Dewar
L. Howard
C. Johnson
750 750
R. Sage
350 350
Nominal ledger
Purchases
Purchases returns
c. No.
Activity AT2.4
a. All we need to do is post the totals of any analysis columns, rather than all of the items in each
column.
b. The use of cash journals enables us to post totals rather than individual figures, which acts as a
check on the individual amounts.
Cash books and cash journals would be prepared by someone who is responsible for the cash
receipting and recording.
The cashier would not have any responsibility for authorising any expenditure.
c. It would be unusual for a large amount ($150 for copy repair) to be paid for out of petty cash. This
would normally be paid as part of a normal creditors payments run.
d. ii
Activity AT2.5
October 19 Vehicles GL 45 70,000
Purchases 1,000
Sales 30
F. Woody 30
Being correction of total of sales book by $30 (see sales book 31/3)
K. Waterhouse 900
Cash 900
d. All of these kinds of errors are possible in a manual system, though probably errors of commission,
errors of principle and errors in the subsidiary record are more likely than the others.
In all of these types of error the likelihood of occurrence is much lower (and sometimes impossible) with a
computerised system.
Activity AT2.6
a.
Sales ledger control account
4,488,800 4,488,800
2,554,500 2,554,500
b.
Bank reconciliation statement
Interest 10
Correction of misposting c. 36
33,556
Activity AT2.7
a. Information will need to be of two main types—permanent (relatively) and temporary.
Permanent information will relate to personal information such as name, address, grade, whether
full-time or casual, tax code, rates of pay, award conditions, holidays entitled to, cumulative pay to
date, superannuation and such like. The temporary information is likely to relate to hours worked,
special conditions, one-off payments, leave taken, etc. The temporary information, when linked
with the permanent information, should enable the regular pay to be made and also ensure that
this is added to the permanent information.
b. Sales and sales growth, costs and cost growth, profitability trends, wages and wages growth,
energy costs, expense trends, non-current asset needs and growth, inventory costs and trends and
such like.
c. A well-developed computerised system should facilitate an array of reports, as evidenced in Real
World AT2.4 .
However, just because something can be produced does not mean that it is sensible to produce it.
Information overload is a well-acknowledged potential problem. The key is to know your business
well enough to be able to establish just what information is of most use to you, and produce this
information. Needs may change, but if you are on top of your business you will probably be able to
identify gaps and fill them.
d. This is an interesting point. It may reduce the need to be on top of the technical recording side of
the business, but other than that there is no reason to suppose that it reduces the required
accounting knowledge of users.
e. The chart of accounts should be prepared in a way that facilitates production of information and
reports in ways that have been identified by the user. The chart of accounts and the coding system
in a computerised accounting system are two sides of the same coin and are fully integrated.
Activity AT2.8
No solution is necessary for this activity as it involves trialling a real-life MYOB product. All relevant
training is provided free by MYOB.
Activity AT2.9
a. The chart of accounts so far, as illustrated in this example, is as follows:
INCOME
1-1 Interest income
EXPENSES
2-1 Private health insurance expense
b. You could change the level of detail for 1-2 Income—salary and wages by having two sub-
accounts, one for the pays from ABC and the other for the pays from XYZ. You would do this so
that you could see how much you earn from each employer. You could also change the level of
detail for 2-1 Private health insurance expense and 2-2 Income protection insurance expense, by
consolidating both into one account called 2-1 Insurance expenses. You might do this so that you
can see the overall amount spent on insurances in general. You could also change the level of
detail for 2-6 General living expenses by splitting each category (e.g. food, fuel, etc.). You might
want to do this so that you can see exactly how much you are spending on each item.
c. The profit and loss statement shows that you should have savings for the month of January! The
‘profit’ amount should be showing as a cash saving in your bank account at the end of the month of
January. You could use this amount towards asset purchases, or simply save your cash in the
bank.
Contents
1. Preface
2. Chapter 1 Introduction to accounting
A. Learning objectives
B. Nature and role of accounting
1. Accounting as a service function
a. Further qualities
3. Not-for-profit organisations
N. Solutions to activities
1. Activity 1.1
2. Activity 1.2
3. Activity 1.3
4. Activity 1.4
5. Activity 1.5
6. Activity 1.6
7. Activity 1.7
8. Activity 1.8
2. Valuing assets
a. Non-current assets
a. Non-current assets with finite lives
b. Non-current assets with indefinite lives
b. Fair values
c. The impairment of assets
K. Application exercises
1. Easy
2. Intermediate
3. Challenging
M. Solutions to activities
1. Activity 2.1
2. Activity 2.2
3. Activity 2.3
4. Activity 2.4
5. Activity 2.5
6. Activity 2.6
7. Activity 2.7
2. Classifying expenses
3. The reporting period
4. Recognition of expenses
Recognising expenses where the expense for the period is more than the cash paid
a. during the period
Recognising expenses where the amount paid during the year is more than the full
b. expense for the period
L. Application exercises
1. Easy
2. Intermediate
3. Challenging
N. Solutions to activities
1. Activity 3.1
2. Activity 3.2
3. Activity 3.3
4. Activity 3.4
5. Activity 3.5
6. Activity 3.6
7. Activity 3.7
8. Activity 3.8
3. Dividends
F. Summary
G. Discussion questions
1. Easy
2. Intermediate
3. Challenging
H. Application exercises
1. Easy
2. Intermediate
3. Challenging
J. Solutions to activities
1. Activity 4.1
2. Activity 4.2
3. Activity 4.3
4. Activity 4.4
5. Activity 4.5
3. Corporate governance
J. Solutions to activities
1. Activity 5.1
2. Activity 5.2
3. Activity 5.3
4. Activity 5.4
5. Activity 5.5
6. Activity 5.6
7. Activity 5.7
8. Activity 5.8
9. Activity 5.9
E. Indirect method
F. Some complexities in statement preparation
1. The investing section
2. The financing section
J. Application exercises
1. Easy
2. Intermediate
3. Challenging
L. Solutions to activities
1. Activity 6.1
2. Activity 6.2
3. Activity 6.3
4. Activity 6.4
5. Activity 6.5
6. Activity 6.6
7. Activity 6.7
8. Activity 6.8
G. Integrated reporting
1. Integrated reporting guiding principles
2. Integrated reporting and value creation over time
L. Application exercises
1. Easy
2. Intermediate
3. Challenging
N. Solutions to activities
1. Activity 7.1
2. Activity 7.2
3. Activity 7.3
4. Activity 7.4
5. Activity 7.5
a. Reporting principles
b. Report quality
c. Other factors
6. Activity 7.6
7. Activity 7.7
C. Profitability ratios
1. Return on ordinary shareholders’ funds (ROSF) (also known as ‘return on equity (ROE)’)
2. Return on capital employed (ROCE)
3. Operating profit margin
4. Gross profit margin
D. Efficiency ratios
1. Average inventories turnover period
2. Average settlement period for accounts receivable (debtors)
3. Average settlement period for accounts payable (creditors)
4. Sales revenue to capital employed
5. Sales revenue per employee
6. Alternative formats
7. The relationship between profitability and efficiency
E. Liquidity
1. Current ratio
2. Acid test ratio
G. Investment ratios
1. Dividend payout ratio
2. Dividend yield ratio
3. Earnings per share ratio
4. Price/earnings ratio
I. Summary
J. Discussion questions
1. Easy
2. Intermediate
3. Challenging
K. Application exercises
1. Easy
2. Intermediate
3. Challenging
L. Questions
M. Solutions to activities
1. Activity 8.1
2. Activity 8.2–8.5
3. Activity 8.6–8.10
4. Activity 8.11–8.12
5. Activity 8.13–8.14
6. Activity 8.15–18
7. Activity 8.19
C. Break-even analysis
D. Contribution
1. Profit–volume (PV) charts
2. Margin of safety and operating gearing
3. Weaknesses of break-even analysis
4. Expected costs rather than historic costs
5. Use of spreadsheets
G. Summary
H. Discussion questions
1. Easy
2. Intermediate
3. Challenging
I. Application exercises
1. Easy
2. Intermediate
3. Challenging
K. Solutions to activities
1. Activity 9.1
2. Activity 9.2
3. Activity 9.3
4. Activity 9.4
5. Activity 9.5
G. Summary
H. Discussion questions
1. Easy
2. Intermediate
3. Challenging
I. Application exercises
1. Easy
2. Intermediate
3. Challenging
K. Solutions to activities
1. Activity 10.1
2. Activity 10.2
3. Activity 10.3
4. Activity 10.4
5. Activity 10.5
6. Activity 10.6 Overhead rate for each activity
7. Activity 10.7
H. Summary
I. Discussion questions
1. Easy
2. Intermediate
3. Challenging
J. Application exercises
1. Easy
2. Intermediate
3. Challenging
L. Solutions to activities
1. Activity 11.1
2. Activity 11.2
3. Activity 11.3
4. Activity 11.4
5. Activity 11.5
6. Activity 11.6
7. Activity 11.7
8. Activity 11.8
9. Activity 11.9
10. Activity 11.10
11. Activity 11.11
12. Activity 11.12
I. Summary
J. Discussion questions
1. Easy
2. Intermediate
3. Challenging
K. Application exercises
1. Easy
2. Intermediate
3. Challenging
N. Appendix 12.1
1. Present value table
G. Summary
H. Discussion questions
1. Easy
2. Intermediate
3. Challenging
I. Application exercises
1. Easy
2. Intermediate
3. Challenging
2. Hire purchase
a. Securitisation
a. Securitisation and the financial crisis
3. Private placing
4. Venture capital and long-term financing
a. Business angels
F. Summary
G. Discussion questions
1. Easy
2. Intermediate
3. Challenging
H. Application exercises
1. Easy
2. Intermediate
3. Challenging
F. Period-end adjustments
1. Prepayments and accruals
2. Revenues due and prepaid
3. Depreciation
4. Bad and doubtful debts
5. Inventory
L. Application exercises
1. Easy
2. Intermediate
3. Challenging
I. Summary
J. Discussion questions
1. Easy
2. Intermediate
3. Challenging
K. Application exercises
1. Easy
2. Intermediate
3. Challenging
Landmarks
1. Brief contents
2. Frontmatter
3. Start of Content
4. backmatter
5. Glossary
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