UNIVERSITY OF LUSAKA
SCHOOL OF BUSINESS
DEPARTMENT OF POSTGRADUATE STUDIES
GBS 520 FINANCIAL AND MANAGEMENT ACCOUNTING
Table of contents
1.0
Financial Information for Management-------------------------------------------------------------
2.0
Introduction to Accounting----------------------------------------------------------------------------
Page
3
9
3.0 The Accounting Process--------------------------------------------------------------------------------- 21
4.0
Financial Statements------------------------------------------------------------------------------------ 37
5.0 Analysis and interpretation of Financial Statements---------------------------------------------- 51
6.0
Costs--------------------------------------------------------------------------------------------------------- 64
7.0
Budgeting-------------------------------------------------------------------------------------------------- 81
8.0
Budgetary Control---------------------------------------------------------------------------------------- 86
9.0
Working Capital management ------------------------------------------------------------------------ 91
10.0 Decision Making------------------------------------------------------------------------------------------ 104
2
UNIT 1: FINANCIAL INFORMATION FOR MANAGEMENT
1.0
INTRODUCTION TO ACCOUNTING
1.1
What is accounting
Accounting is defined as the process of collecting, recording, summarizing, and communicating financial information
to owners and other interested parties. Alternatively it can be defined as a method of accumulating financial
information using an organized/ systematic approach involving recording transactions in the books of account (journals
and ledgers), analyzing these transactions, summarizing them and reporting them to various users including owners by
way of financial statements. Financial information is an output of the accounting system.
Recording transactions in the books of account constitutes BOOKKEEPING. Keeping accounts and generating
financial reports and information from these accounts for various purposes is ACCOUNTING. In other words
accounting is broader than bookkeeping.
Accounting takes place in an organizational context. It is carried out in all sorts of organizations. They can be
businesses or non-businesses. Although the growth of accounting information is closely associated with economic
progress it is not exclusively found in business contexts.
1.2
Purpose of accounting
The purpose of the accounting is to provide information to users to enable them to make decisions. That is the
information provided enables the users to answer a number of questions such the following:
 What does the entity own at a particular time?
 What does the entity owe other parties ?
 How is the entity financed?
 How has the entity performed over a specified/given period?
 What is owed to the entity by other parties?
3
Accounting information is required for a variety of reasons such to fulfill legal requirements and to assist managers to
plan, control and make decisions.
Accounting information is of interest not only to the entity but also to other users such those specified below.
1.3
Organisational Context of accounting
The accounting system and processes take place within the organization. For instance, if you consider a company such
the Zambian Breweries Plc the accounting system exists to provide information to enable the Company to make beer
and sell it at a profit to customers. The Company has an accounting system to assist it record the transactions relating to
making beer and selling it. It cannot do without the accounting system.
Next consider a Sports Club such as Nchanga Rangers Football Club. There must be an accounting system to to provide
information to support the operations of the Club.
You can also think of a Church organization such as the Victory Ministries or Bread of Life Ministries. There must be
an accounting system to provide accounting information to support them.
The accounting system must exist in some context. This context can be a company, partnership, sole trader or a nonbusiness organization (club, association, non-governmental organization, government ministry, parastatal organization,
church or church-related organization or any other entity. Whatever entity it is within which the accounting system
exists in it provides financial information that is of interest to internal and external users.
4
1.4
Users of Accounting Information and their Information Requirements
Financial information is of interest to different parties. Below are some of the accounting information and what they
require.
User
Shareholders
Information they require
Participate in distribution of profits, additional share issues,
assets on winding up, voting rights of shares, election of
directors, inspection of company books, transfer of shares.
Directors and
Managers
Manage the entities (business enterprises, non-business
organizations and others).
They plan, control and make decisions as part of managing
the entities.
They are accountable to owners.
They perform a stewardship function.
Employees
Share in the fortunes of entities in which they work.
They seek economic, social and psychological satisfaction in
the places of work.
They need freedom from arbitrary and capricious behaviour of
company officials, freedom to join trade unions, and
participation in offering up their services through an
employment contract, favour conducive working conditions.
Lenders
Participate in legal proportion of interest on loans and
repayment of principal, security of pledged assets, relative
priority in the event of liquidation. Participate in certain
management and owner prerogatives if defaults of payments
of interest occur.
5
Customers
Product quality, technical data to use the product, suitable
warranties, spare parts to support the product, facilitation of
consumer credit, safety in use of product.
Suppliers
Continuing source of business, timely payment of trade credit
obligations, professional relationship in contracting for,
purchasing and receiving goods and services.
Governments
Fair and free competition, legal obligations for businessmen
and business organizations to obey antitrust, pollution control
and other laws. Public policy, health, safety, employment
law.
Tax authorities
Taxes (income, property, VAT & Customs & Excise)
Unions
Recognition as the negotiating agent of employees,
opportunity to continue representing workers in the business.
Competitors
Norms established by the industry and society for a
competitive product/service. Business statesmanship on the
part of companies
Local
Communities

Safety of company products


Healthy working conditions and fair pay
Participation of company officials in community
affairs.
Local purchase of reasonable portion of the products

6



Analysts and
Advisors
Regulatory
Agencies
The general
public
of the local community.
Interest in and support of local Government
Support of cultural and charity projects
Favourable impact on environment

Information for their clients about investment
opportunities.
 Information to assess the credit worthiness of
companies issuing securities.
 Information for the readers.
For companies listed on the stock exchange information is
required to fulfill their listing requirements.
Other regulatory agencies are interested to ensure that
companies or other organizations are operating within
prescribed rules.
 Participation in and contribution to the Government
process of society as a whole.
 Creative communication between Government and
business units designed for reciprocal understanding.
 Fair proportion of the burden of Government and
society.
 Fair price for products and advancement of the stateof-the art in the technology, which the product line
offers.
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1.5
Regulatory Framework
The maintenance of accounts and production of financial reports from those accounts has to be done according to
accounting rules (also called accounting principles) and financial reporting standards established by the Accountancy
Profession.
The standards are enforced by Professional bodies such as the Zambia Institute of Chartered Accountants (ZICA) in
Zambia, the Association of Certified Chartered Accountants (ACCA), Chartered Institute of Management Accountants
(CIMA), Institute of Chartered Accountants in England and Wales (ICAEW) AND OTHERS in the United Kingdom
(UK). With effect from 01/01/2005 the International Accounting Standards Board is responsible for the issuance of the
International Financial Reporting Standards (IFRS’s). Accountants are required to observe these standards in the
preparation and presentation of the financial reports.
In Zambia accounts produced by companies and /or corporate bodies are required by the Company Law or by Statutes
establishing those corporations. Such companies or corporations have to observe the legal requirements and the
requirements of the Accountancy profession when preparing the accounts and the financial reports.
Financial Information for Managers
Managers are one of the users of accounting information. They are responsible for managing organizations. They plan,
organize, direct, coordinate, communicate, staff and control. In short managers plan, control and make decisions. They
are responsible for achieving organizational objectives. Managers need information to do their job. The information
needed for planning, control and decision making is financial and non financial. Financial information is derived from
the accounting or financial system of the organization. It comes from accounts that are maintained in the organization
or the accounts provide the data which when analysed will be financial information. The accounting information is
about assets, liabilities, capital, reserves, revenues and expenses. It is about cash flows of the organization.
Questions
1. State 10 users of accounting information. and indicate the type of information they need.
2.
Explain what measures have been instituted to ensure that accounting information is truthful or valid.
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UNIT 2: ACCOUNTING PRINCIPLES
2.1
Accounting Principles
2.1.1
Introduction
The preparation of financial reports is based on accounting principles or conventions. There are accounting
standards as well which must be observed in the preparation, presentation and disclosure of financial
information in the financial reports. The financial information reported to the various parties must be objective
relevant, understandable, reliable and comparable.
Some of the attributes of the accounting / financial information are explained below.
2.1.2
Relevance
Accounts must be up to date and current and actually used by the reader.
2.1.3
Reliability
The reader must have faith in the information in the accounts and the information must be free from material
error.
It must represent faithfully what it is supposed to represent.
2.1.4
Comparability
Consistency is really the consistency concept, comparable from period to period and within like items in the
same period.
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2.1.5
Understandability
Financial reports must be understandable to the user.
Users of accounting information include the following:
 Owners (i.e. shareholders)
 Creditors
 Lenders
 Managers
 Government including Tax Authorities
 Financial Analysts
 Investors
 Employees
 The public
2.2
Generally Accepted Accounting Principles (GAAP’s)
Accounting principles constitute “ground rules” for financial reporting. They are also called Generally
Accepted Accounting Principles (GAAP’s).
They are also referred to as standards, assumptions, postulates and concepts. Accounting rules are not rooted in
laws of nature, as the laws of the physical sciences. They are developed in relation to what we consider to be
the most important objectives of financial reporting.
10
These principles are explained below:
2.2.1
Accounting Entity Concept
Accounting information is compiled for a clearly defined accounting entity. Accounts are prepared for a
separate entity.
Distinction must be made between accounting and legal entities.
2.2.2
Going Concern Assumption (Continuity)
An accounting entity will continue in operation for a period of time sufficient to carry out its existing
commitments – indefinite life. An entity will continue in existence for the foreseeable future.
So ignore immediate liquidating values or break up value in presenting assets and liabilities in the
balance sheet.
The going concern assumption should be dropped if the entity will be liquidated or wound up in the near
future.
When an entity will be wound up, statement of affairs will be prepared. Report assets at their break up
or liquidating values and liabilities at the amount required to settled the debts immediately.
The entity for which accounts are prepared will continue in existence for the foreseeable future.
Accounts are prepared on the basis that the entity is a going concern. If this is not the case, the accounts
have to be prepared on the basis of a gone concern.
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2.2.3
Time Period (or Periodicity)
Since the lifespan of entities is indefinite measure performance or operating progress and changes in
economic/financial position (income and expenses) at relatively short time intervals during this
indefinite life. For this reason, a year or a 12month period is selected.
Periodic measurement of profit/loss, reporting financial position and cash flow are mere estimates
during the 12month period.
Therefore, the life span of entity/enterprise is divided into the time segments periods such as a year, half
a year, quarter of a year and measure the profit/loss and financial position for these short periods are
reported.
2.2.4
Monetary Principle
Money is the basic yardstick or measuring unit for financial reporting.
denominator in which accounting measures are made and reported.
Money is the common
The Kwacha represents a unit of value i.e. it reflects ability to command goods and services.
The Kwacha is a stable unit of value just as a kilometer is a stable unit of measure of distance.
Accountants combine dollar measures of economic transactions occurring at various times during the
life of a firm. They combine K10, 000 cost of furniture purchased in 1968 and the K21, 000 cost of
furniture purchased in 1978 and report the total K21, 000 investment in furniture.
BUT the Kwacha is not a stable unit of value. The prices of goods and services in our economy change
over time.
When the general price level increases the value of money decreases.
general price level rises.
Money loses value when the
12
Despite the steady erosion in the purchasing power of the Kwacha, Accountants continue to prepare
financial statements in which the value of the Kwacha is assumed to be stable.
Hence financial statements are misleading to the extent that the Kwacha is assumed to be stable when it
is unstable. That is why there are calls for change to replacement costs or current costs as bases for
valuation instead of historical costs.
2.2.5
Objectivity
To attain reliability, there must be objectivity. Measurements that are unbiased and subject to
verification by independent experts e.g. a price established in an arm’s length transaction are an
objective measure of an exchange value at the time of the transaction.
Not surprising, exchange prices established in business transactions contribute much of the raw material
from which accounting information is generated.
Despite the goal of objectivity, opinions and personal judgment are quite common, e.g. in computing
depreciation expense.
2.2.6
The Cost Principle (derived from Objectivity)
Cost is the most objective amount that should be recorded in the books of account. The cost incurred in
acquiring an asset should be used to value that asset. Cost incurred constitutes objective evidence of a
transaction. Hence record assets at what it cost the entity to acquire them. Cost at time of acquisition
represents the “fair market value” of the goods/services exchanged in an arm’s length transaction.
However, with passage of time the fair market value of assets such as land and buildings may vary
greatly from their historical cost. These changes are ignored in the accounts. Hence the values of a lot
of fixed assets are understated.
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2.2.7
Realization Principle
(when to consider that revenue is earned and expenses incurred)
When should an entity recognize that revenue has been earned? Under the accrual concept, revenue is
recognized when it is earned. The earning of revenue is an economic process. It does not actually take
place at a single point in time.
The earning process relates to economic activity. In such a case, accountants do not recognize revenue
until the revenue has been realized. Revenue is realized as follows:
(i)
When the earning process is essentially complete.
(ii)
When objective evidence exists as to the amount of revenue earned.
In most cases, the realization principle indicates that revenue should be recognized at the time of
sale of goods or rendering of services. At this point the firm will have essentially completed the
earning process and the realized value of goods/services sold can be objectively measured in
terms of the price billed/invoiced to customers.
Interest earned – is directly related to time periods.
(iii)
When cash is received – cash basis of accounting (realized revenue is cash that is received). But
to wait until cash is received to recognize that revenue is earned may be too late.
(iv)
Recognizing revenue when production is completed.
This is the basis used for previous minerals.
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Long-Term Contracts
For companies that carry out long term projects revenue is the contract priceThe revenue (contract price) is
known when the construction job is begun. As the job/contact progresses the revenue earned is estimated by
reference to the contract and the portion of the project completed during the financial year. Revenue earned is
determined on the basis of work that is completed in the financial.
Percentage of completion method of accounting for long term contracts
Year
Actual Cost
Incomes
1
2
3
600 000
2 000 000
1 452 000
4 052 000
Actual costs as
a % of
estimated total
cost
15
50
*
Portion of
contract price
realized
75 000
2 500 000
1 750 000 bal
5 000 000
Profit
considered
realized
150 000
500 000
298 000
948 000
* Balance required to complete the contract
2.2.8
The Matching Principle (or Accrual)
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Revenue (the gross increase in net assets resulting from the production or sale of goods and services) is
offset by expenses incurred in bringing the firm’s output to the point of sale or in earning the revenue.
Therefore, match
 Cost of goods sold
 The expiration of asset services and
 Out of pocket expenditures for operating costs
to the revenue earned in the year or period.
The measurement of expenses occurs in two stages:
i)
Measuring the cost of goods and services that are consumed or expire in generating the revenue.
ii)
Determining when the goods and services acquired have contributed to revenue and their cost
thus becomes an expense.
Matching costs and revenue
This is fundamental to the accrual basis of accounting.
Costs are associated with revenue (and thus become expenses) in 2 major ways:
i)
In Relation to the Product sold or service rendered
If a good or service can be related to the product or service, which constitutes the output of the
enterprise, its cost becomes an expense when the product is sold or service rendered to
customers, e.g.

cost of goods sold in a merchandizing firm
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
ii)
cost paid to a real estate salesperson by a real estate brokerage office is an expense directly
related to the revenue generated by the salesperson.
In relation to the time period during which revenue is earned
Period costs – incurred in a period and not related to specific transactions. They contribute to
revenue generation e.g.
* Property taxes
* Depreciation of a building
* Salary of CEO of a company
Cannot be related to a
specific transaction. They
are overheads for the
period (they are period
costs)
Recognition of gains and losses
An increase in the value of a productive asset such as a machine or a building is not recognized until the asset in
question is sold. In such a case, the amount of the gain is objectively determinable.
If a productive asset increases in value while it is in service, the accountant ordinarily does not record this gain
because it has not been realized. “Not realized” means that the gain in value has not taken place or has not been
substantiated by an arm’s length transaction in which an exchange price has been established independently.
But in relation to anticipated losses – record losses when inventories/stocks appear to be worthless than their
cost, (when using the lower of cost or market valuation of inventories results in the recognition of losses in
inventory investment prior to sale of the goods in question. This is justified by conservation.
17
2.2.9
Consistency Principle
A particular accounting method once adopted should not be changed from period to period.
It enables users of financial statements to interpret intelligently the changes in financial position and the amount
of net income/loss.
But management can change an accounting method if a different method would better serve the needs of users
of the financial statements.
The auditor will have to report the changes and the Kwacha effect of the change.
Consistency applies to a single accounting entity and increases the comparability of financial statements from
period to period.
2.2.10 Disclosure Principle
Adequate disclosure means that all material and relevant facts concerning financial position and the results of
operations are communicated to users.
Disclose financial information in the financial statements or in the notes accompanying the statements.
Adequate disclosure requires that NO IMPORTANT facts are WITHHELD.
2.2.11 Materiality
An item is material if there is reasonable expectation that knowledge of it would influence the decision by
prudent users of financial statements.
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Relative Importance of an item or event

What is material is likely to be relevant.

Accountants are concerned with significant information.

Materiality of an item is a relative matter.

What is material for one business unit may not be material for another.

Materiality of an item may depend on its amount and its nature.
2.2.12 Conservatism/Prudence
In reporting financial information, an accountant should refrain from overstatement
of net income and net assets. Conservatism is a powerful influence upon asset
valuation and income determination (i.e. income measurement).
Conservatism is most useful when matters of judgment or estimates are involved.
Base estimates on sound logic and select those accounting methods, which neither overstate nor understate the
facts.
When in doubt about the valuation of an asset or the realization of a gain, however, the accountant should use
caution or be CAUTIOUS and select the accounting option, which produces a lower net income for the current
period and a less favorable financial position.
When in doubt choose the solution that is least likely to overstate assets and income of the entity. When in
doubt, it is better to understate than to overstate.
But an understatement in one year may be followed by an overstatement in the next period.
A judicious application of conservation to the accounting process should produce more useful information.
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The excessive use of conservatism or failure to apply conservatism may produce misleading information and
result in losses to creditors and stockholders (bondholders/debenture holders).
Examples
Lower cost or market in the valuation of inventories.
Another way of knowing accounting principles is to consider:
Basic concepts
Accounting Conventions
Accounting Procedures
Assets
Liabilities
Capital
Revenue
Expenses
Profit
Transactions
Entity
Recording transactions
Money Measurement
Classifying transactions
Going Concern
Summarizing transactions
Cost
Reporting transactions
Realization
Interpreting reports
Accrual
Matching
Periodically
The Accounting Model Consistency
Consists of traditions, conventions Prudence
and laws that must be followed in accounting. See the diagram beow.
Judgment
Judgment
Conventions
1. Separate entity
2. Money terms
3. Double entry
4. Historic Cost
Traditions
5. Realization
1. Terminology 6. Matching Laws
2. Presentation
1. Disclosure
3. Conservation
2. Security
4. Accounting
3. Consistency
Progression
Judgment
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UNIT 3: ACCOUNTING PROCESS – RECORDING TRANSACTIONS IN THE ACCOUNTS
Accounting processes involve recording transactions in the accounts as shown in the diagram below:Transactions
(must be
authorized and
approved)
Are captured on
business
documents e.g.
receipts,
invoices, credit
notes,
debit
notes, bank, pay
in slips etc.
Record transactions in accounts
Journals, books
of prime entry
e.g. cash book
journal proper, or
general journal,
sales day book,
purchases day
book, returns
inwards book,
returns outwards
book.
Ledger
(Collection of
accounts)
accounts of
assets, liabilities,
capital income
expenses
Prepare Financial Reports
Internal
Financial reports
For use by
management e.g.
budgets, variance
analysis and
operating
statements (see
costing below).
External
Financial
reports
To fulfill the
stewardship
function of
management
Income
Statements
Balance Sheet
21
Records in accounts are made using the double entry bookkeeping system. Very
simply the double entry bookkeeping system involves debiting and crediting
accounts for every transaction.
3.1 ACCOUNTING PROCESS
The accounting process consists of a number of tasks including recording
transactions in accounts as can be seen from the diagram below.
SUBSIDIARY BOOKS
Posting
LEDGER
ORIGINAL
INFORMATION
(TRANSACTIONS)
(Journalizing)
CASH BOOK
Collection of
accounts
FINAL ACCOUNTS OR
FINANCIAL
STATEMENTS
(Financial Reports)
LEDGERS
CASH BOOK
SALES LEDGER
BALANCE
SHEET
PURCHASES LEDGER
EQUITY ACCOUNT
REAL LEDGER STOCKS
PROFIT AND LOSS
ACCOUNT
NOMINAL LEDGER
(INCOME STATEMENT)
22
Accounting processes involve recording transactions in the books of
account (that is recording in journals and ledger(s)), balancing the
accounts ,making corrections and adjustments.
The following transactions illustrate recording the transactions in the
accounts:
3.2
Recording Transactions in Accounts using the Double Entry
Bookkeeping System
MAJALIWA COMPANY LIMITED
Date
Transaction
1/1/2003
2/1/2003
3/1/2003
8/1/2003
17/1/2003
18/1/2003
28/1/2003
31/1/2003
Shareholders contributed capital by cheque
Withdrew Cash from the Bank
Rented office building – rent is payable by cheque on
28/1/2003
Purchased office furniture by cheque
Purchased computer for office use
Purchased office supplies by cheque
Purchased goods for resale by cheque
Sold goods in cash
Paid insurance of office equipment for the year by
cheque
Obtained loan from standard chartered. Interest is
payable monthly on last day of the month
Sold goods on cash
Sold goods on credit to John
Purchased goods on credit from Apollo market
Banked cash
Sold goods on credit to Peter
Paid rent by cheque
Purchased on credit from Mukuni wholesalers
Paid electricity by cheque
Paid salaries and wages in cash
Accrued Interest
Paid Interest by cheque
Paid water in cash
Amount in
K’Million
100
5
0.5
4.5
7.8
1.7
10
6.3
3.1
100
5
2.6
14
11.3
3.5
.05
13
0.8
2.3
0.625
0.625
0.4
Solution
Taking each transaction at a time we must identify what account is debited
and what account is credited. This is because the double entry
23
bookkeeping system requires that for every transaction there must be a
debit or debits and a credit or credits.
In bookkeeping transactions give rise to debits and credits which are
received and given by some accounts. An account which receives value is
debited and the on giving the value is credited. The most important rule
when recording in the accounts is that for every transaction the total
amount debited must equal the total amount credited.
3.4
Recording Transactions in Accounts
Majaliwa Company Limited
Date
2003
1/1
2/1
3/1
8/1
17/1
18/1
28/1
31/1
Account Debited
Account Credited
Bank
Cash
Furniture and Fittings
Office equipment
Office supplies
Motor vehicles
Purchases
Cash
Insurance
Bank
Cash
John
Purchases
Bank
Peter
Rent
Purchases
Electricity
Salaries and wages
Salaries and wages
Interest
Loan
Water
Share capital
Bank
Bank
Bank
Bank
Bank
Bank
Sales
Bank
Loan
Sales
Sales
Apollo Mart
Cash
Sales
Bank
Mukuni Wholesalers
Bank
Cash
Wages payable
Loan
Bank
Cash
Amount K’m
100
5
4.5
7.8
1.7
35
10
6.3
3.1
100
5
2.6
14.0
11.3
3.5
0.5
13
0.8
2.3
0.7
0.625
0.625
0.4
Having identified the accounts to be debited and credited the transactions
have to be entered in the books of prime entry or journals.
24
3.5
Recording in Accounts – Ledger Accounts
Open ledger accounts in which to record the transactions. In practice
companies have chart of accounts which indicate the possible accounts for
Assets, Liabilities, Capital, Income/Revenue, Expenses etc:
Capital
1/1
Bank
100
Bank
1/1
17/1
18/1
Capital
Loan
Cash
100
100
11.3
2/1
3/1
8/1
28/1
31/1
Cash
F&F
OE
OS
MV
Purchases
Insurance
Rent
Bank
Electricity
Balance c/d
211.3
142.275
31/1 Bal b/d
5
4.5
7.8
1.7
35
10
3.1
0.5
0.625
0.8
142.275
211.3
Cash
2/1
8/1
Bank
Sales
5.0
6.3
18/1
Sales
5.0
16.3
Balance b/d
18/1
31/1
Bank
S&W
Water
Balance c/d
2.3
11.3
2.3
0.4
2.3
16.3
211.3
95.0
Furniture and Fittings
3/1
Bank
4.5
25
Office equipment
3/1
Bank
7.8
Motor vehicles
3/1
Bank
35
Office supplies
3/1
Bank
1.7
Purchases
3/1
18/1
28/1
Bank
Apollo Mart
Mukuni
10
14
13
37
Insurance
8/1
Bank
3.1
Loan
3/1
Bank
Balance c/d
0.1625
100
100.625
17/1
31/1
Bank
Interest
100
0.625
100.625
Balance b/d
100
John
18/1
Sales
2.6
Sales
8/1
18/1
“
28/1
Cash
Cash
John
Peter
6.3
5
2.6
3.5
17.4
26
Rent
28/1
Bank
0.5
Apollo Mart
18/1
Purchases
14
Electricity
31/1
Bank
0.8
Salaries & Wages
31/1
Cash
2.3
Mukuni Wholesalers
28/1
Purchases
13
Interest
31/1
Loan
0.625
Peter
28/1
Sales
3.5
Water
31/1
Cash
0.4
27
3.6
Balancing an account
To balance an account involves adding debit entries for that account and
also adding credit entries for the same account. The difference between the
bigger sum and the smaller sum is found. and added to the smaller side so
that the smaller side equals the bigger sum. If the debit is bigger than the
credit the difference is added to the credit and vice versa. The totals are
written and underlined. The account balance is described by the side
which is larger. Eg If the debit side of an account is larger than the credit
side of the same account then such an account has a debit balance. The
list of account balances as at a particular time is called a trial balance as at
that date.
MAJALIWA COMPANY LIMITED
Trial Balance as at 31/1/2003
Dr
Km
Capital
Bank
Cash
F&F
OE
Motor Vehicles
OS
Purchases
Insurance
John
Loan
Sales
Rent
Apollo Mart
Electricity
Salaries & Wages
Mukuni Wholesalers
Interest
Peter
Water
Cr
Km
100
142.275
2.3
4.5
7.8
35
1.7
37
3.1
2.6
100
17.4
0.5
14
0.8
3
0.625
3.5
0.4
245.1
0.7
13
245.1
28
3.4
Periodic Adjustments
3.4.1 Introduction
The accounting process consists of a series of activities/tasks the
performance of which ensures that transactions are recorded in the
accounts using the double entry bookkeeping system. These transactions
consist of cash and credit transactions as well as correction of errors and
periodic adjustments.
3.4.2
Why adjust some accounts
The accounts written up reflect transactions previously authorized by
project/organizational/company managers.
In view of certain
circumstances, there may be need to adjust certain accounts in order to
ensure that the accounts are correct, i.e. true and fair. When that is done,
then the financial statements prepared using data from the accounts will
give true and fair information to the users of the financial statements.
3.4.3
The Adjustments
Various adjustments have to be made to assets, liabilities, income and
expenses in order to provide true and fair information based on the
accounts. The commonest adjustments are:
(i)
(ii)
(iii)
(iv)
(v)
(vi)
(vii)
(viii)
Closing stock
Prepaid expenses
Provision for doubtful debts
Unearned income
Depreciation of fixed assets
Accrued expenses
Accrued income
Correction of errors
A brief description and discussion of each adjustment follows:
Closing Stock
In a project/organization/company involved in buying goods and reselling
them, i.e. a merchandising entity, goods are purchased at cost from
suppliers. When selling the goods to customers a profit margin is added to
cost to arrive at the selling price.
29
PURCHASES AT COST
ENTITY
SALES AT COST + %
Purchases are goods recorded in the purchases account at the cost incurred
to acquire those goods. Similarly sales are recorded in the sales account at
the selling price.
Recording purchases at cost:


DEBIT Purchases Account
CREDIT Cash/Bank (If goods bought in cash)
OR Supplier Account (If on credit)
Recording sales at Selling Price (i.e. at cost + %):
 DEBIT Cash/Bank (If sales are in cash)
OR Customer Account (If on credit)
 CREDIT Sales Account (At selling price)
If by the time of preparing financial statements all goods available for sale
or purchased are sold no problems arise to determine the cost of goods
sold. In such a case, the cost of goods sold is what the goods cost at the
time of purchasing them. Accordingly, when the cost of goods sold is
deducted from the sales, the gross profit if obtained.
Sales – Cost of goods sold (i.e. What it cost to acquire the goods)
However, it may happen that some of the goods purchased or available for
sale remain unsold. Then there is need to calculate the cost of the stock of
goods which are unsold. This will facilitate the determination of the COST
OF GOODS SOLD. Closing stock can be calculated by either keeping a
perpetual inventory system or physically counting the unsold goods and
calculating their cost.
A perpetual inventory system can be used to determine the cost of goods
unsold. However, it is quite expensive to keep a perpetual inventory
system. That is why it should be done only for very expensive goods.
Alternatively, a physical count of the unsold goods can be carried out.
This is the most common method in our environments.
Some
organizations do stock taking at the end of every month. It is quite
common to come across notices on doors to the effect that a
shop/store/organization is closed for stock taking.
The closing stock is important in the determination of the profit/surplus.
30
Opening stock + Purchases = Cost of goods available for sale
Cost of goods available for sale – Closing stock = Cost of goods sold
Sales – Cost of goods sold = Gross profit
The adjustment is effected by:
Debiting the stock account and crediting the Trading Account.
The stock/inventory figure in the balance sheet is the closing stock figure.
It is a current asset.
Prepaid Expenses
It is quite common to pay certain expenses in advance, e.g. insurance is
normally paid in advance for a year. It is also possible to pay expenses
such as rent and fuel in advance.
If financial reports are for shorter periods than the period paid for, the
prepaid expenses have to be adjusted so as to correctly reflect expenses
and hence the profit/surplus and the financial position.
The adjustment is to:


Debit the expense, e.g. insurance/rent/fuel.
Credit the asset called prepaid insurance/rent/fuel with the amount,
which has become an expense.
Provision for Doubtful Debts
Debtors are current assets. These are people or entities, which have to pay
money to the project/organization/company for goods/services bought on
credit.
While it is difficult to pinpoint a debtor or debtors who will fail to pay
their accounts, it is possible to use past data to arrive at a percentage of
debtors, e.g. 2% or 2.5% or any other figure who will fail to pay their
accounts. The percentage is applied/multiplied with the debtors to arrive
at the amount of provision. The provision is the amount to be shown in
the account called PROVISION FOR DOUBTFUL DEBTS.
To provide for a loss means that the loss will occur, however, the amount
is not known. It is prudent to provide for all losses. It is certain that some
debtors will never pay for their accounts. Therefore a provision
recognizes this loss before it actually happens. This correctly states
31
debtors. When some debtors actually fail to pay then they are written off
as bad debts.
The adjustment is to:


Debit the Profit and Loss Account (or Income and Expenditure
Account)
Credit the Provision for Doubtful Debts (with the amount of
provision)
Note that the amount of provision in the first period is quite
straightforward. However, in subsequent periods, it will be a matter of
finding out whether the new provision is higher or lower than the amount
already provided for. If the new figure is higher that the previous one, the
difference will be debited in the Profit and Loss Accounts and credited in
the Provision for Doubtful Debts Account. In case the new level of
provision is lower than the previous provision, this shows that had been an
over-provision in the past. So the adjustment is to lower the level of
provision by debiting the Provision for Doubtful Debts Account and
crediting the Profit and Loss Account (or Income and Expenditure
Account).
A quick method of finding the under or over-provision is to calculate the
new level of provision and from it deduct the old level of provision. See
under:
New level of provision (Balance c/f) = % x debtors = XXX
Old level of provision (Balance at the beginning) (XXX)
Amount by which to adjust the provision
XXX
If the difference is positive (i.e. Balance c/f is higher than the Balance b/f),
then debit the Profit and Loss Account with the difference and credit
provision for doubtful debts account.
If the difference is negative (i.e. the balance c/f to the following period is
less than the previous balance) then debit Provision for Doubtful Debts
Account, credit the Profit and Loss Account.
It is worth noting that the provision for doubtful debts is always deducted
from debtors in order to arrive at net debtors. The latter are conceived as
the correct figure for debtors to be shown in the balance sheet.
32
Unearned Income (Income Received in Advance)
In a situation whereby customers have paid for goods or services to be
supplied or provided later, the money received has not yet been earned as
income by the project/organization/company. It represents a liability. By
the time the financial reports are being prepared part of the income
received in advance may have been earned. Therefore, an adjustment is
necessary.
The required adjustment is to separate the income, which has been earned
from the liability represented by money received in advance. The actual
entry is to:
Debit the unearned income account and credit the income account by the
amount of earned income.
Depreciation of Fixed Assets
Another adjustment to fixed assets relates to the depreciation of fixed
assets. When fixed assets are used in project/business operations there is
an expense represented by a part of the original cost of the fixed asset.
This cost is a loss in the value of the fixed asset. It is wear and tear of the
fixed asset as a result of using it in project operations.
There are various methods of calculating the depreciation expense. These
are not discussed here. However, to record the depreciation charge in the
accounts:


Debit Depreciation Account
Credit Provision for Depreciation Account
Depreciation is an expense like any other expense as it represents the cost
of the fixed asset that has been used in generating the income/revenue.
However, unlike other expenses, depreciation is an expense, which does
not involve an outflow of cash, i.e. it is a NON-CASH EXPENSE. It is
merely an allocation of the depreciable amount to the years/periods, which
benefit from the services of the fixed asset.
The provision for depreciation is an account in which the depreciation
charges for each year are accumulated so as to be deducted from the fixed
asset being depreciated. Therefore, the older the asset, the more the
accumulated depreciation recorded in this provision for depreciation
account. On the balance sheet, the presentation is as follows:
33
Fixed Asset, e.g. Buildings at cost
Less provision for depreciation
Net book value
XXX
XXX
XXX
Accrued Expenses
Some expenses may accrue during an accounting period. Such expenses are
actually incurred but are not yet recorded in the accounts. The required
adjustment is to bring such expenses in the accounts by:


Debit Expenses Account concerned, e.g. Wages Account
Credit Liability Account
Examples of accrued expenses are interest on loan, wages that have been
incurred but not yet paid, etc.
Accrued Income
Just as expenses can be incurred but be unrecorded in the accounts it is
possible to earn income which is not yet reflected in the accounts. The
adjustment is to record the income in the accounts by the following entry:


Debit Accrued Income Account (An asset)
Credit Income Account
Interest on a loan to customers by a financial institution is an example of
this.
Correction of Errors
Various errors may be made in the accounts during the financial year or
period. Such errors may be unintentional or they may be due to fraud.
When they are discovered, they should be corrected by debiting/crediting
one account and crediting/debiting another account.
Conclusion
Adjustments and correction of errors are done in order to have correct accounts.
The latter constitute the basis for of financial statements. When the latter are
supplied to users, they will provide information, which can be relied upon by
them.
34
For Majaliwa the adjustments are as shown below.
1.
Adjust for insurance part of which is prepaid for the next period:
1
Calculate
of the expense appearing in the accounts. K3.1 million *
12
1/12=
K0.26 million.
The journal entry is as follows.
Dr Prepaid Insurance 2.84 million
Cr Insurance
2.84 million
2.
Depreciation of fixed assets as follows:
Furniture and fittings
Office equipment
Motor vehicles
10% of cost
25 % of cost
20% of cost
The depreciation charge is calculated using the method selected and is
then recorded by making the following journal entries.
Dr Depreciation – F & F For the year K0.45m for 1 month K0.0375
Cr Provision for depreciation – F & F K0.0375 million
Dr. Depreciation – O E (For year K1.95 for 1 month) K0.1625 million
Cr Provision for depreciation O. E.
K0.1625 million
Dr. Depreciation MV (For year K7m for 1month) K0.583 million
Cr. Provision for depreciation – motor vehicle
K0.583 million
3.
The physical count of stock revealed that closing stock is K25.7 million.
A journal entry has to be passed as follows.
Dr Stock
K25.7 million
Cr. Trading account K25.7 million
4.
Other income in January 2003 arose from the sale of sundry goods on
credit to various customers K5.8 million.
A journal entry is passed as follows.
Dr. Debtors
Cr. Other income
5.
K5.8 million
K5.8 million
Accrued expenses consisted of wages and these are recorded by a journal
entry as follows
Dr Wages account
K0.7 million
Cr Accrued wages account
K 0.7 million
35
The accounts affected by the above adjustments are adjusted as appropriate. See below.
Insurance
Balance
Balance b/d
3.1
31/1
Prepaid Insurance
Balance c/d
3.1
0.26
2.84
0.26
3.1
Prepaid Insurance
31/3
Insurance
2.84
Depreciation – F & F
31/1
Provision for depreciation
0.0375
Provision for depreciation – F & F
31/1
Depreciation – F & F
0.0375
Depreciation – OE
31/3
Provision for depreciation
0.1625
Provision for depreciation – OE
31/3
Depreciation
31/3 Provision for depreciation
Depreciation
0.1625
Motor Vehicles
0.583
36
Provision for depreciation – Motor Vehicle
31/3 Depreciation
0.583
Stock Account
31/1
Trading
5.7
Trading
31/1
Stock
5.7
Salaries and Wages Account
31/1 Cash
Accrued wages
Balance b/d
2.3
0.7
3.0
3.0
31/1 Balance c/d 3.0
3.0
Accrued Wages Account
31/1 Salaries and wages
0.7
Having adjusted the accounts and in readiness to prepare the
financial statements some schedules can be prepared for
debtors and creditors. See below.
Debtors schedule
John
Peter
Others
Shown in the balance sheet
Km
2.6
3.5
5.8
11.9
Creditors schedule
Apollo Mart
Mukuni Wholesalers
Shown in the balance Sheet
Km
14
13
27
37
ASSIGNMENT
Why are adjustments made in the accounts?
Give five examples of the adjustments made in the accounts of a company.
UNIT 4 FINANCIAL STATEMENTS
The maintenance of financial records or the keeping of accounts is not an end in
itself. Accounts are kept with a view to using information in them to prepare
financial statements.
Using the information in the accounts company financial statements are prepared
to fulfill the stewardship function or for accountability to shareholders, investors,
government, tax authorities and other external parties. Other reports can also be
prepared from the same accounts to provide information to company management
for internal use e.g. for planning, control or decision-making.
Nature, purpose and presentation of Financial Statements
The Financial Statements, which are usually prepared, are:



The Income Statement or the profit and loss account.
The Balance Sheet
The Cash Flow Statement
4.2.1
The Income Statement
Managing companies involves planning company operations in advance of
the period of implementation. For instance, Management has to prepare
the budget(s) for the forthcoming year. The budget once approved must
be implemented. During implementation, the company executes diverse
activities/operations using various resources. Human resources are
employed and carry out the planned company activities. Companies also
use various assets to carry out company activities/operations and in the
process resources are used. These resources are paid upfront or obtained
on credit to be paid for later i.e. liabilities/obligations are created in the
process.
Resources used up in carrying out activities/operations have a cost and
their costs become expenses as a result of using these resources. Thus
there are expenses related to human resources such as salaries and wages,
38
social security (provident fund and/or pension). Other expenses relate to
other resources e.g. rent for leased premises, fuel, oil and lubricants for
vehicles, water, electricity, telephones, insurance and others too numerous
to be itemized individually. We refer to these various expenses as
company overheads.
Thus there production costs, administration
overheads, marketing overheads, research and development overheads.
These overheads are usually classified under three headings, namely:

Production costs

Administrative and general expenses

Selling and distribution expenses (for companies)

Finance charges – expenses related to banking services including
charges on loans and advances to the company.

Research and development overheads
Expenses are incurred in carrying out company operations.
When company products and services are sold to customers, income or
revenue is earned. Therefore, income comes from selling products and/or
services. Income is earned when a company sells SOMETHING.
The Income Statement shows the profit or loss from, making something
and selling company products and/or services i.e. it shows the results of
operations for a period of time e.g. one month, one quarter of a year, half a
year or one year. In the Income Statement income is shown as a credit
(additions) and expenses are shown as deductions. The difference
between income and expenses is either a net profit if income exceeds
expenses or a loss, if expenses exceed income. The net profit increases
the money invested in a company, therefore it is added to the capital. The
loss on the other hand decreases the capital of the company because it
shows that the company did not fully meet the costs of resources used.
Using information from the accounts kept, the following can also be
prepared:
4.2.2
The Balance Sheet
Unlike the Income Statement, the Balance Sheet is NOT AN ACCOUNT.
The implication of this is that it is prepared without observing the double
entry rules.
39
The Balance Sheet is a statement of ASSETS and LIABILITIES of a
company or organization/enterprise as at a particular point of time and the
difference between them. That is, the Balance Sheet shows Assets and
Liabilities, it also shows the difference between these Assets and
Liabilities, which is capital or owners equity. The latter term simply
means the interest of the owners in a company.
The Balance Sheet is important because it shows the financial position of
the company as at a given point of time e.g. end of the month, end of the
quarter, end of half a year or end of the year.
Net profit or loss from the Income Statement is incorporated in the owners
equity appearing in the Balance Sheet. IT IS THE LINK BETWEEN the
opening Balance Sheet and the Closing Balance Sheet.
Thus if you look at three periods, SHOWN BELOW you will see that the
net profit or loss from the Income Statement links the previous Balance
Sheet to the next.
PERIOD
1
2
3
Income Statement
Income
Expenses
Surplus/ (deficit)
500
(570)
(10)
1980
(1700)
280
2590
3000
(410)
3240
2700
5600
4780
4370
3960
540
820
410
Balance Sheet
Assets
Liabilities
Owners Equity (or capital)
550 – 10 = 540
Loss for
The period
540 + 280 = 820
Net profit for
the period
820 – 410 = 410
Loss for the
period
The easiest way to comprehend this is to say the retained profit is equal to
the opening net profit or loss plus/(minus) the net profit or loss for the
40
current period in order to end up with the closing net profit or loss which
is added to or subtracted from capital.
Alternatively, liabilities and capital can be on the left hand side and assets
on the right hand side. Presenting it either way does not violate any
accounting principle because the Balance Sheet is not an Account.
However, the format in one period must be followed consistently in other
periods to facilitate comparison between periods. Balance Sheets are
prepared conventionally by categorizing assets and liabilities into current
(or short term) and long-term categories. Thus for assets, we have:
Current Assets and Fixed Assets. Current Assets are short-term
possessions of the company, which form part of working capital – i.e. pool
of resources used to meet short term obligations.
To emphasize an asset is a possession, which has value to the company.
When that possession is of a short term nature, it constitutes a current
asset. Thus our figures for assets, cash in hand and at bank, debtors, office
supplies, prepaid insurance are current assets. These assets will change
their present form within one year or less. For instance, cash/bank
balances will be used to purchase stocks/inventories, which in turn will be
used up and change their form. Thus motor vehicles, furniture and office
equipment will be used up in company operations. The debtors will pay
cash to the company and cash will increase. The bank balances will
ultimately be reduced as cash is drawn from the bank. Office supplies will
be consumed when writing letters. New assets will be purchased and
become current assets. Cash and bank balances also fluctuate as they are
used to pay for assets, expenses and liabilities.
Current Assets circulate in the course of the year. Hence they are also
called CIRCULATING ASSETS. As a group, current assets are part of
working capital – money which keeps the company operating.
NON –CURRENT OR FIXED ASSETS
Assets classified as fixed are retained for use in the company. They have
an economic life during which they are useful to the company. They are
used by the company for a number of years.
The distinguishing characteristic of fixed assets is that they wear out or are
subject to wear and tear as they are employed. Depreciation represents the
systematic spreading out of the cost of fixed assets over their useful lives.
It is important to note that depreciation is an expense (cost of resources)
like any other expense. The only difference with other expenses is that
depreciation does not involve an outflow of cash. It is a non-cash
expense.
41
From our balance sheet the following are fixed assets: motor vehicles,
furniture and office machinery. Depreciation already written off from a
fixed asset is reflected in a separate account called provision for
depreciation e.g. any depreciation written off from vehicles account will
be credited to the provision for depreciation for motor vehicles. Each time
depreciation is written off, the debit goes to a depreciation expense
account, which will then be shown in the Income Statement/Profit and
Loss Account.
So there will be a provision for depreciation account for each fixed asset.
When presenting fixed assets on the balance sheet the credit balances in
the provision for depreciation accounts for the fixed assets are deducted
from the (gross) figure of the asset to which they related to give the net
book value of each fixed asset. See the balance sheet above.
CURRENT LIABILITIES
Liabilities are obligations on the part of the company to pay other
entities/parties such as people, other companies, government, ZRA or any
other organization. When that obligation has to be settled in the short term
(i.e. within a period of up to one year) that obligation is called current
liability. To settle the obligation current assets in the form of cash or bank
balances are used. Thus the following obligations are current:
Apollo Mart
Mukuni Wholesalers
Accrued wages
K14 million
K13 million
K0.7 million
For a number of suppliers the credit period is 30 days. Accordingly,
settlement has to be done within 30 days or 1 month. Current liabilities
have to be settled within 12 months at most.
NET CURRENT ASSETS OR NET WORKING CAPITAL
Because current liabilities are paid out of current assets, it is conventional
to deduct current liabilities from current assets to arrive at the net current
assets or net working capital, which is then added to the net book value of,
fixed assets to arrive at total assets less current liabilities. It is not normal
accounting practice to present current liabilities without deducting them
from current assets.
LONG TERM LIABILITIES
42
Some liabilities are payable after more than one year e.g. 2 – 5 years or
more. Such liabilities are distinguished from current liabilities. They are
called long term liabilities. Such obligations usually carry interest charges
to compensate the lenders for parting with their money for an extended
period of time.
OWNER’S EQUITY
The difference between assets and liabilities is called owner’s equity or
capital. This quantity represents what the owners put in the company
originally or what the owners have left in the company after offsetting
liabilities from assets. The capital originally contributed as well as
additional investments plus any profit not distributed to shareholders as
dividends or less any loss will be shown as capital or owner’s equity.
Assets = Capital + Liabilities or Assets – Liabilities = Capital.
This is the accounting equation.
4.2.3
CASH FLOW STATEMENTS
Objective
The objectives of the Cash Flow Statement are:

To report an entity’s cash generation (cash inflows), and cash
absorption (cash outflows) for a period in a form that highlights the
significant components of cash flows and facilitates comparison of the
cash flows performance of different businesses.

To provide information that assists in the assessment of the entities
liquidity, solvency and financial adaptability.

The Cash Flow Statement should include all reporting entity’s inflows
and outflows of cash and exclude any other transactions from the cash
flows.
Format of the Cash Flow Statement
43
An entity’s cash flows should incorporate a list of cash flows for the
period classified under the following standard headings:

Operating activities (using either the direct or indirect method)

Returns on investments and servicing of finance

Taxation

Capital expenditure and financial investment

Acquisitions and disposals

Equity dividends paid

Management of liquid resources

Financing
(See below for further details)
Definitions
i.
Cash
Includes:
Cash in hand and deposits repayable on demand with any
qualifying financial institution eg a commercial bank, less
overdrafts from any qualifying financial institution eg a
commercial bank repayable on demand. Deposits are repayable
on demand if they can be withdrawn at any time without notice to
the bank and without penalty or if a maturity or period of not more
than 24 hours or one working day has been agreed.
Cash includes cash in hand and deposits denominated in foreign
currency.
ii.
Cash Flow
An increase or decrease in an amount of cash.
iii.
Equity Dividend
Dividends relating to equity shares (i.e. shares other than nonequity shares.
iv.
Liquid Resources
44
Current Assets investments held as readily disposable stores of
value. A readily disposable investment is one that:
(a)
Is disposable by the reporting entity without curtailing or
disrupting its business and is either;
(b)
(i)
(ii)
v.
readily convertible into known amounts of cash at
or close to its carrying amount, or
trade in an active market
Net Debt
The borrowings of the reporting entity together with related
derivatives and obligations under finance leases less cash and
liquid resources.
Where cash and liquid resources exceed the borrowings of the
entity reference should be to ‘net funds’ rather than ‘net debt’.
vi.
Overdraft
A borrowing facility repayable on demand that is used by drawing
on a current account with a qualifying financial institution.
vii.
Qualifying Financial Institution
An entity that as part of its business receives deposits or other
repayable funds and grants credits for its own use.
viii.
Operating Activities
The principal revenue – producing activities of the entity /
enterprise and other activities that are not investing or financing
activities.
ix.
Financing Activities
Activities that result in changes in the size and composition of the
equity capital and borrowings of the entity/enterprise.
x.
Investing Activities
45
The acquisition and disposal of lt assets and other investments not
included in cash equivalents (i.e. s.t. highly liquid investments that
are readily convertible to known amounts of cash and which are
subject to an insignificant risk of changes in value).
Classification of Cash Flows by Standard Heading
Operating Activities
Cash Flows from Operating Activities
Generally the cash effects of transactions and other events relating to operating/trading
activities normally shown in the Profit and Loss Account (or the income statement) in
arriving at operating activities.
They include cash flows in respect of operating items relating to provisions whether
included in operating activities or not.
Dividends received from equity a …. Entities should be included as operating cash flows
where the results are included in operating activities.
A reconciliation between the operating activities (per profit and loss account) and the net
cash flow from operating activities should be given either
Adjoining the cash flow or as a note.
The reconciliation is not part of the cash flow. It should disclose separately the
movement in stock, debtors and creditors related to operating activities and other
differences between cash flows and profits.
The reconciliation should also show separately the difference between dividends received
and results taken into account for equity account received entities.
Returns on investments and servicing of finance are receipts resulting from the ownership
of an investment and payments to providers of finance, non-equity shareholders (e.g.
preference shareholders) and minority interests excluding those items required to be
classified under another heading.
Cash inflows include:





Interest received
Dividends received
Cash outflows include:
Interest paid
Cash flows treated as finance costs (e.g. issue costs)
46


Interest element of finance lease rental payments
Dividends paid on non-equity shares of the entity and dividends paid to minority
shareholders.
Taxation
Cash flows to/from taxation authorities in respect of the reporting entity’s revenue and
capital profits.
Other taxes exclude from here e.g. VAT, other sales taxes, property taxes and others.
Taxation cash inflows – rebates, claims or returns of overpayments.
Taxation cash outflows – cash payments to tax authorities of tax, including payments of
Advance Corporation Tax.
Capital Expenditure and Financial Investment
Cash flows related to the acquisition or disposal of any fa other than required to be
classified under acquisitions and disposals and any ca investment not included in liquid
resources (later).
Cash Inflows
Include receipts from sales/disposals of property, plant or equipment and receipts from
repayment of the reporting entity’s loans to other entities or sales of debt instruments of
other entities other than receipts from part of an acquisition/disposal or a movement in
liquid resources.
Cash outflows include:
Payments to acquire property, plant or equipment and loans made by reporting entity and
payments to acquire debt instruments of other entities other than payments forming part
of an acquisition or disposal or a movement in liquid resources.
Acquisitions and Disposals
Cash flows related to acquisition or disposal of trade or business or of an investment in an
entity that is or as a result of the to be either an associate, or joint venture, or a subsidiary
undertaking.
Cash Inflows include:

Receipts from sales of investments in subsidiary undertakings, showing separately
any balances of cash and overdrafts transferred as part of the sale.
47

Receipts from sales of investments in associates or joint ventures; and

Receipts from sales of trades or businesses.
Cash Outflows:

Payments to acquire investments in subsidiary undertakings, showing separately
any balances of cash and overdrafts acquired.

Payments to acquire investments in associate and joint ventures and payments to
acquire trades/businesses.
Equity Dividends Paid
Cash outflows are dividends paid on the reporting entity’s or in a group, the parent’s
equity shares, excluding any Advance Corporation Tax.
Management of Liquid Resources
This section should include cash flows in respect of liquid resources as defined above.
The cash flows in this section can be shown in a single section with those under
‘financing’ provided that separate sub totals for each case are given.
Cash flows include withdrawals from s.t. deposits not qualifying as cash so far as not
netted under financing.
Inflows from disposal or redemption of any other investments held liquid resources.
Cash Outflows include:
Payments into s.t. deposits not qualifying as cash in so far as not netted under financing
and outflows to acquire any other investments held as liquid resources.
Financing
Financing cash flows comprise receipts or payments of principal from or to external
providers of finance.
Cash flows in this section can be shown in a single section with those under ‘right of
liquid resources’ provided that separate subtotals for each are given.
48
Financing cash flows include:
(a)
Receipts from issuing shares or other equity instruments.
(b)
Receipts from issuing debentures, loan, notes and bonds and from other short
term borrowings (other than overdrafts).
Financing cash outflows include:
(a)
Repayments of amounts borrowed (other than overdrafts)
(b)
The capital element of lease rental payments.
(c)
Payments to acquire or redeem the entity’s shares; and
(d)
Payments of expenses or commissions on any issue of equity shares.
Reconciliation of operating activities to net cash inflow from operating activities
Operating profit
Depreciation charges
Increase in stocks
Increase in debtors
Increase in creditors
xxx
xxx
xxx
xxx
xxx
Cash flow from operations can be calculated by the direct method or the indirect
method.
49
Appendix
There are two methods of calculating cash flow from operations
Direct Method
Cash received from customers
Cash paid to suppliers and employers
Cash generated from operations
x
x
x
x
Indirect Method
Net profit before taxation and extra ordinary item (s)
Adjustments for
Depreciation
Foreign exchange loss
Investment income
Interest expense
Operating II before working capital changes
Increase in trade and other receivables
Decrease in inventories
Decrease in trade creditors
Cash generated from operations
x
x
x
(x)
x
x
x
x
(x)
x
The cash from operations can then be adjusted for other items to get cash flow from
operating activities.
Cash generated from operations
Interest paid
Income taxes paid
Net cash from operating activities
x
x
x
x
50
5.
ANALYSIS OF FINANCIAL STATEMENTS
5.1 INTRODUCTION
Projects as any other business organizations use resources in their
operations. These resources are made available to some projects or
organizations and not to others. It is very important for the projects or
organizations employing these resources to use them efficiently and
effectively.
Thus it is important to analyze financial statements so as to evaluate
performance and financial positions. The trading and profit and loss
account shows the results of operations by way of profit and loss. The
balance sheet shows the financial position of the project or organization.
More insight into the financial performance and financial position of
projects or organizations can be gained by analyzing the financial
statements by means of ratios.
The purpose of this handout is to describe, explain and discuss some ratios
used to evaluate a project’s/organization’s/company’s performance.
5.2 The Classification of Ratios
Financial ratios can be classified into five (5) categories.
(a)
(b)
(c)
(d)
(e)
Solvency or liquidity ratios
Profitability ratios
Efficiency or activity ratios
Leverage ratios
Investment ratios (or stock market ratio)
51
We shall explain and discuss all the ratios but compute those for which
data are available
Ratios
Liquidity ratios (solvency
ratios)
Profitability ratios
Efficiency ratios
Leverage ratios
Invesment Ratios
Purpose Served
Show project’s/organization’s ability to
meet short-term obligations.
Gauge project’s/organization’s profitability
based on sales (or turnover) and investment
in assets.
How efficient operations have been and
how well assets have been used to generate
sales.
Show the extent of debt in financing the
project/organization/company
Show the performance of investment in
shares
To compute the various ratios we are going to use figures from the
financial statements of GMK Limited, which are attached.
5.2.1 SOLVENCY OR LIQUIDITY RATIOS
To evaluate an organization’s or project’s ability to pay short term debts as
they fall due current assets are compared to current liabilities in order to
give the current ratio. It is meaningful to assets this ability because
current liabilities are settled out of current assets, utilizing cash/bank.
The standard ratio is: 1:1.
Using information from the balance sheet of GMK
(a)
Current Ratio
Current Ratio =
K 712 884
Current Assets
=
= 4.0
Current Liabilites K178 200
There are enough current assets to meet current liabilities. In fact,
current liabilities are covered 4 times by current assets. This is in
excess of the standard of 1:1. It is advisable for a project to be able
to meet its current liabilities because failure to do so will prompt
creditors to take legal action against the project which may include
winding up operations.
52
Using liquid assets or quick assets are defined as current assets less
stock the quick ratio or acid test can be calculated. This is a
further indicator of ability to pay it excludes stock which might
take long to sell and get cash.
Current assets less stock are called quick assets. The ratio of quick
assets to current liabilities is called the quick ratio. For GMK this
was:
(b)
Quick Ratio Acid Test Ratio
Quick Ratio Acid Test Ratio =
=
K 712 884  277 300
K178 200
=
K 435 584
K 178 200
Current Assets Less Stock
Current Liabilities
= 2.4
Quick assets exceed current liabilities more than 2 times. Once more it is
noticed that current liabilities are more than adequately covered.
Current assets differ in their liquidity, some current assets are more liquid
than others. Stock is excluded from other current assets in order to show
that it is the least liquid of the current assets. It requires time to convert it
into cash and may also lose value. The problem is that by excluding stock
it is implied that stock is worthless. This is not true.
It is a fact that stock takes time to convert into cash or to liquidate it. But
it can never be wholly worthless. Other current assets such as debtors and
cash are more liquid than stock. The ability to pay short-term obligations
is enhanced by how fast debtors pay their debts and the speed of payment
to suppliers.
Therefore, for GMK we can conclude that current assets are adequate to
pay current liabilities even when stock is excluded. However, GMK has
unnecessarily huge amounts of cash. Cash is not an earning asset. Cash
does not earn a return unless it is invested. Therefore, keeping huge
amounts of cash in hand and at bank is not productive. GMK should
consider investing excess cash in short-term investments to earn some
return.
53
(c)
Other ratios – Debtors, stock and creditors turnover are also helpful in
the evaluation of the liquidity of an entity.
Ratio
Debtor’s Turnover
Stock Turnover
Creditors Turnover
Meaning
How fast they pay
How fast stock is bought and sold
How fast they are paid
It is beneficial if debtors pay faster than the entity pays creditors. See
below for computation of these ratios.
5.2.2 PROFITABILITY RATIOS
In the long run liquidity and solvency are meaningless if the organization is not
profitable. Profitability is imperative for survival and prosperity. Profitability refers to
the ability to earn more income than expenses. A profitable entity covers its expenses
and earns extra income over and above its expenses.
The profitability ratios relate various measures of profit to sales and also sales and profit
to investment in assets.
(a)
Gross Profit
Gross Profit =
Gross Pr ofit M arg in
 100
( Net ) Sales
In GMK:
Gross Profit =
K 246 900
 100
K 597 800
= 41%
The company earns a gross profit of K41.3 on sales of K100. This means cost of
goods sold as a percentage of sales is 58.7%. It would appear that the level of
trading expenses is higher than gross profit. Since it is out of gross profit that
operating expenses are met and a profit is earned, the gross profit is not adequate.
Trading operations are not profitable.
Therefore, trading operations should be revamped so as to make them more
profitable by generating more gross profit.
54
(b)
Net profit before tax to Sales Ratio. This is obtained by finding the net profit
before tax divided by (net) sales.
Hence:
Net profit before tax to sales =
K115 144
 19 %
K 597 800
(Net) sales
= 100%
Cost of goods sold
Other expenses
(Gross Profit 41.3%)
=
=
58.7%
22.0%
100.0
It is also possible to relate Net profit after tax to sales.
This analysis confirms the fact that the cost of goods sold is too high compared to
other expenses which amount to only 22%.
GMK needs to reduce its expenses especially trading expenses to enhance its
profitability.
The other profitability measure is to compute total assets turnover or fixed assets
turnover.
Sales
The asset turnover
=
Total Assets
=
K 597 800
K 926 384
= 0.65
This shows that K1 of the assets is generating only K0.65 of sales. This is less
than satisfactory. However, if we consider fixed assets only and compute their
turnover, we see that the Fixed Assets turnover is 2.8 as follows:
(Gross) Fixed Assets Turnover
=
Sales
Fixed Assets
=
K 597 800
K 213 500
= 2.8
55
K1 of Fixed Assets is able to generate K2.8 of sales. This is much better than
total assets turnover. Since total assets are equal to current assets plus fixed
assets, it would appear that there is excessive investment in current assets in
relation to the level of sales, hence the dismal total assets turnover of K0.65 only.
It is important to look at the ratio of Net Profit before tax in relation to capital
employed which in this case is total assets. This ratio shows the profitability of
the investment in the entity i.e. GMK in this case. This is the PRIMARY RATIO
for an investor.
Earning Power or Return on Investment
=
Net Pr ofit before tax
Capital Employed
=
K115 144
 100
K 926 384
= 12.4%
A return of 12.4 is not satisfactory. Therefore, we can conclude that both the
operations of GMK and the profitability of the investment in it are low. This is a
weak area. Something should be done in future periods to improve this area. The
improvement needs to be planned so that when implemented in the future it will
improve the operation of GMK.
Further analysis can be done by relating the various expenses to sales. When such
relationships between expenses and sales are made over a period of time, a project will be
able to see the trends of expenses over time. Such an insight will be helpful in future
financial planning.
5.2.3 ACTIVITY OR EFFICIENCY RATIOS
Operations/activities of GMK consist of buying goods from suppliers and reselling them
to customers. Goods are purchased and sold over the year. These operations use
resources to purchase goods and generate sales. In this process, Stock, Debtors and
Creditors are created. When goods are sold on credit, the debtors arise. How fast goods
are being converted into sales and replaced by other goods constitutes stock turnover.
How fast stock is bought and sold is certainly one measure of efficiency and
effectiveness. How fast debtors are paying their accounts is also an important measure of
efficiency, especially in the management of working capital.
The calculation of the various ratios is as below:
56
(i)
Stock turnover ratio
Stock turnover ratio
Cost of Goods Sold
Clo sin g stock or average stock
K 350 900 .00
=
K 277 300 .00
=
=
1.3 times
Stock turnover indicates how fast goods are bought and sold. The higher the
turnover, the better because it is only when goods are sold that profit is generated.
It is not good for stocks to take a long time to be sold. The longer goods stay on
the shelf, the more likely they are to deteriorate an fail to be sold. Goods, which
are unsold, represent money tied in stocks. Thus the longer goods take to be sold,
the higher the cost of funds tied in those stocks.
A low stock turnover may be a sign of weakness in stock management.
Another way of looking at the stock turnover is to calculate how long it takes for
stocks to be bought and sold. This is done by the following:
K 277 300
 365 days
K 350 900
Average Stock
 365 days.
=
Cost of goods sold
Stock turnover (days) =
= K288 days
Stocks take 288 days or about 10 months to be converted into sales. This is an
extremely long time. Stocks need to move faster than suggested by these figures.
Please note that a very high turnover may also not be good.
(ii)
Debtors Turnover
The speed with which debtors pay their accounts is crucial for cash flow
management in the organization.
Credit Sales
Debtors turnover ratio
=
Debtors
=
K160 900
K 75 000
=
2.1 times
57
Debtors buy goods on credit and pay for them later. Using figures in the given
financial statements it is clear that debtors take time to pay their accounts.
When debtors pay fast, the debtors turnover is high. What is shown above is that
the debtors are taking a long time to pay because the turnover is low at 2 times.
This can best be understood by calculating how long (i.e. the number of days) the
debtors take to settle their accounts. This is calculated below:
Debtors
Time in days debtors take to pay (the collection period) =
Credit Sales
365 days
=
75 000
 365 days
160 900
=
160 900
365
= 170 days
The level of debtors in relation to credit sales suggests that debtors take as long as 6
months to pay their accounts. As the organization’s money is tied up in debtors it has to
borrow money for its operations. Therefore, the management of debtors is inefficient.
Trade creditors ratio =
Trade Creditors
178 200
 365 days =
 100
Credit Purchases
524 200
= 124 days
This ratio shows the number of days’ credit is taken from suppliers.
Debtors take 170 days to pay their account but creditors are paid in 124 days. The
desirable situation is to pay creditors later than debtors pay the company. Therefore, the
above situation shows weakness in the management of working capital.
Therefore, the operations of GMK Limited are not efficient. With the same resources,
GMK Limited could earn more revenue and increase the returns on investment.
Net Working Capital Turnover
This turnover measures the efficiency in the management of working capital. An
organization invests in both fixed and working capital. Fixed capital is represented by
fixed assets. On the other hand, working capital represents a short term investment.
Working capital turnover is calculated by:
58
Sales
Sales
=
Current Assets  Current Liabilities
Net Working Capital
For GMK the working capital turnover is:
=
K 597 800
K 534 684
= 1.1
The higher the Working Capital Turnover, the greater the efficiency in the management
of working capital and the larger the rate of profit generation. However, very high rates
may show a shortage of working capital i.e. there may be overtrading which is not
DESIRABLE to the entity. Too high or too low working capital turnover should be
avoided. Therefore, it is appropriate to establish the right turnover rate, not too low and
not too high.
In the above case, the turnover of 1 is very low which means there is an excessive
investment in working capital. The stocks, debtors and cash i.e. current assets less
current liabilities are excessive. This is not ultimately good for GMK because both stock
and debtors mean a lot of money is tied up in these items. Cash does not earn any return.
Hence very high levels of working capital is injurious to the financial health of the entity.
We have already seen the Fixed Assets turnover. We have seen that it is not satisfactory
either.
It can therefore be concluded that GMK is not efficiently managed. That is why
profitability is low although liquidity and solvency are good. There is need to plan for
the improvement of profitability and efficiency.
5.2.4 LEVERAGE RATIOS
The accounting equation states that:
ASSETS = LIABILITIES + OWNERS EQUITY
The equation represents two fundamental decisions, namely the financing and
investment decisions.
Assets represent how money is used in an entity. This is the investment decision. The
liabilities and owners equity constitute the way the organization is financed. It is normal
to deduct current liabilities from current assets to get net working capital. So the above
equation can be rewritten as follows:
FIXED ASSETS + CURRENT ASSETS – CURRENT LIABILITES = LONG-TERM LIABILITIES + OWNERS
EQUITY
59
FIXED ASSETS + NET WORKING CAPITAL = LONG TERM LIABILITIES + OWNERS EQUITY
(INVESTMENT)
(FINANCING)
Leverage ratios are concerned with the extent to which an entity is financed by debt.
Relevant ratios calculated are:
DEBT TO EQUITY RATIO
This shows long-term debt in relation to the funds from owners.
e.g. in GMK: 400 000 : 528 984 = 0.76
Alternatively, DEBT can be related to the TOTAL LONG TERM financing i.e.
DEBT/DEBT + EQUITY
In GMK:
400 000
 100 = 43%
928 984
Long-term lenders finance 43% of the long-term funds of GMK Limited. Interest has to
be paid on this debt. This interest is deductible from operating profit (or earnings) in
arriving at the income chargeable to tax. This is an advantage of debt finance compared
to equity. But debt must be used judiciously as excessive debt is risky or potentially
harmful. It (Debt) can lead to an entity winding up its operations as a result of failing to
pay interest or to service its debt.
The ability to pay debt is measured by the number of times profit before interest and tax
is available to pay interest charges. The profit before interest and tax for GMK is K131
800. The interest charges are K20 000. Therefore, the number of times profit before
K 131 800
interest and tax covers interest charges is
= 6.59 or 7 times.
K 20 000
This means that profit before interest and tax can fall 7 times before GMK Limited fails
to pay interest on the loan. GMK is therefore able to service its debt.
Debt in the long term financing of a project/organization/company shows the extent of
financial risk. Excessive debt shows high financial risk. That is interest charges become
burdensome and the company might fail to pay back the debt.
These figures are rough guides. The cover is based on earnings as reported in the profit
and loss account. However, it may be appropriate to assess the firm’s ability to repay
interest charges on the basis of the firm’s expected cash flows instead of on reported
operating profits.
There is a view that it is not only the payment of periodic interest but also the periodic
repayment of the principal is important. Hence it is important to calculate the cover
60
taking into account both interest and the annual repayment of the principal by the
following:
Interest and annual repayment ratio =
Earnings before int erest and taxes  1 
Interest  Annual Re payment Ch arg es  i  t 
 1 
where t = corporation tax rate. The 
 adjusts the annual repayment to the before tax
i  t 
basis. This adjustment is made because repayments are out of after tax profits. This
cover shows how many times interest charges and annual repayments of principal are
covered by current earnings before interest and taxes.
For GMK the above cover = 2.6 times assuming an annual repayment of K20 000 per
year for 20 years and a tax rate of 35%.
5.2.5INVESTMENT RATIOS (STOCK MARKET RATIOS)
Investors purchase shares in the hope that they will receive dividends and capital gains.
When profits are made, tax is paid on them leaving profits after tax. Capital gains arise
upon sale of shares at a price higher than the cost of the shares.
Using data from financial statement a number of investment ratios can be calculated:
(1)
Dividend yield =
Gross Dividend per share
 100
Market price per share
Gross dividends are related to the share price to obtain a yield.
This yield is important to an investor as one of the reasons for buying shares is to
receive a dividend on each of the shares bought. When dividends are declared
and we cannot calculate this yield and other investment ratios because we do not
have data.
(2)
Earnings yield =
Earnings per share after tax and pref . dividend
 100
Market price per share
Profit after tax is what is available to shareholders who are existing investors in
the company’s shares. Preference shareholders receive their dividends prior to the
ordinary shareholders. Hence the preference dividend is deducted and what is left
is what is available to ordinary shareholders. Even if not all profits made are paid
to the shareholders, profit after tax belongs to shareholders. This yield can be
61
compared with the return obtained by the company i.e. Net Profit after tax divided
by capital employed.
(3)
P/E ratio when the earnings yield is turned upside down (i.e. invested) it gives the
price/earnings (P/E) ratio.
A high P/E ratio indicates that the market expectation is that the company’s
profits will rise in the future, and a low P/E ratio shows the opposite. But a
company’s share price may fluctuate for reasons other than change in profit
expectations e.g. market expectations of a takeover bid may increase the market
price of shares of a company.
(4)
Earnings Per Share (EPS)
When profit after tax available to ordinary shareholders is divided by the number
of shares issued, the earnings per share (EPS) is obtained. This is a more useful
indicator of a Company’s progress than the simple annual trend of profits because
it shows whether a Company deploys the money profitably.
(5)
Dividend Cover
This is obtained by the following calculation:
Earnings after tax and preference dividend
 100
Ordinary dividend
It shows the number of times a dividend goes into the after tax earnings available
to ordinary shareholders.
Once again note that it is not possible to calculate these investment ratios based
on the GMK Limited data/figures. There are no data to use n the calculation of
these investment ratios. These ratios have been explained to make you aware that
investment ratios can also be calculated. In fact, there are newspapers and
magazines, which publish stock market ratios on a daily basis. Where such ratios
exist one should determine what they mean to learn how companies are doing.
62
5.3 CONCLUSION
The overall evaluation of the performance of GMK is that the company is not efficiently
managed although it is liquid and solvent (i.e. it is able to pay its short term debts). It is
not enough to only be able to pay debts.
Profitability requires to be improved. Primarily it would appear that the generation of
sales have to be revamped and the profitability of these sales need to be enhanced.
Management of GMK should focus on improving working capital management.
GMK has substantial debts, but debt is NOT EXCESSIVE. However, the company needs
to improve the use of resources at its disposal.
Finally, it is important to point out that the data we have used in the analysis is over a
very short period, a period of one year. Accordingly some of the conclusions may be
invalid on account of data not being typical of GMK. However, ratios point to something
to be looked into. There is need to consider other information to arrive at more valid
conclusions.
63
UNIT 6 COST S
6.1 Definition of cost
Costing is the application of costing principles, methods and techniques in the
ascertainment of costs. The role of costing in business management cannot be
overemphasized. Businesses incur costs in earning their revenue. Managing
costs is one critical aspect of business management. No business can succeed
without proper management of costs.
Cost is the amount of expenditure (actual or notional) incurred on or attributable
to a specified product service or activity. Cost is the product of a price multiplied
by a quantity.
Cost unit is the purpose for which costs are ascertained. A cost centre is defined
as a product or service, location, or item equipment (or group of these) whose
costs may be attributed to cost units. For costing purposes, a company may be
divided into a number of cost centers and each cost centre has costs units and
requires to be controlled.
The purpose of this unit is to offer an introduction to costs. With this knowledge
of costs , entrepreneurs will be able to manage and control costs and use them for
decisions such as pricing products or services.
6.2
Cost Elements
The expenditure making a cost of a product, or a service can be respect
of:
(a)
(b)
(c)
Materials
Labour
Expenses
Labour (human effort) is applied to materials with the assistance of expenses to
produce something (physical transformation) or to provide a service.
64
Direct and Indirect Costs
Direct Costs
Direct cost is a cost, which is directly identifiable or traceable to a finished
product or service. It is an expenditure, which is identified with a specific
cost unit. Accordingly, direct costs are classified as:
Direct Materials



Raw materials
Components
Consumables
Direct Labour
Wages and other remuneration to all employees who directly contribute to
the conversion of direct materials into saleable products/services. All
associated expenditure paid by the company in employing people
including NAPSA contributions and overtime premium constitute direct
labour costs.
Are expenses other than direct materials and direct labour, which is
directly, incurred in the conversion/transformation process e.g. hire
purchase charges for special equipment used in manufacturing a product.
65
CLASSIFICATION OF COSTS
Materials Used
Wages
Direct
Materials
General Administration
Marketing (Selling &
Distribution) and
Research and
Development
Indirect
Wages
Expenses
Costs related to
other functions
(Non-Production)
Expenses
Materials
Wages
Expenses
Production
Overhead
Prime Cost
Production
Cost
Total Cost
66
Indirect Costs
All those expenditures, which are not direct. They are incurred outside the
production function but enable production to take place e.g. general
administration.
BEHAVIOUR OF COSTS
This is defined as “the way in which costs of output are affected by fluctuations in the
level of activity.” Costs behave differently when there are changes in the level of
activity.
Variable Costs
These are costs, which vary (i.e. increase or decrease) in proportion with changes in the
level of activity. Variable costs increase when the level of activity increases and
decrease. Variable costs are fixed per unit of product or service. Variable costs are
always presumed to be linear. This may not be strictly true.
K
K
Variable Costs
Variable
cost per
unit
Units produced and sold
Units produced and sold
Fixed Costs
Fixed costs are fixed no matter what happens to level of activity within the relevant
range. Beyond such a range they vary. Fixed costs per unit decrease as output increases.
K
K
Fixed costs
Units produced and sold
Fixed costs
per unit
Units produced and sold
67
Semi-Variable Costs
These costs comprise both fixed and variable elements. Semi-variable costs increase as
activity increases but not in direct proportion to the increase in activity.
Importance of Classification
The classification of costs into variable and fixed is very useful in break-even analysis.
COST ASCERTAINMENT
Having looked at the elements, characteristics and behaviour of costs, we need to
examine cost ascertainment, that is, to look at some methods used to arrive at the costs of
jobs, products, processes and services.
There are various methods of cost ascertainment. The same method cannot be used to
determine the cost of a new hospital, a computer, a packet of biscuits or a flight between
Lusaka and Dar-es-salaam. The cost unit differs for each of the above products. The cost
unit is important in determining which method of ascertainment will produce desired
result. Due to diversity of production in organization, it may be necessary to have more
than one method of cost determination.
The Need for Cost Ascertainment
Cost ascertainment is known as historical costing because it is concerned with recording
actual costs.
Excessive time-lag between incurring the cost and ascertaining it is usually due to poor
organisation. A well-managed cost ascertainment system produces historical cost that is
very close to the event that effective action for the future can be taken. Cost is
ascertained for a number of reasons. First, cost control. For this to happen, there must
be accurate cost reporting.
Secondly, cost ascertainment is to determine selling price. Having known costs and
having used the cost to help to determine selling price, there is need to measure profit and
profitability. Profit is the difference between revenue and cost. Profitability is the
relationship between profit and sales or capital employed. Lastly, cost ascertainment will
enable an enterprise to decide whether what is happening (as shown by costs) is normal
(i.e. what is expected) and controllable (i.e. something can be done to about it).
Therefore, because of the above reasons, it is crucial to ascertain costs.
68
Costing Methods
INFORMATION
DATABASE
(COST DATA)
SERVICE/FUNCTION
COSTING
JOB ORDER
COSTING
CONTRACT
COSTING
JOB
COSTING
BATCH
COSTING
CONTINUOUS
OPERATION/
PROCESS COSTING
PRODUCT COSTING
Specific Order Costing (SOC)
Specific order costing is the application of the principles of cost
ascertainment/determination in situations where all the cost units are separately identified
and costed individually (or where the work consists of separate jobs, batch or contracts
each of which is authorized by a special order or contract).
Specific Order Cost = Direct Costs of Specific Order + Overheads
The direct costs are costs of direct materials, wages and expenses used on the order. The
overheads are absorbed under DL costs, DL hours or some other basis.
69
Job Costing
Job order costing is used where the cost units are relatively small e.g. plumbing jobs in
households by enterprise crew.
The method involves the following:
(a)
(b)
Each Job
(i)
Is given a job number (or works order number for identification)
(ii)
Has a job card used to capture/collect cost data of the job.
Direct Costs
(i)
(ii)
(c)
Are charged to the job
Share of overheads by using computed absorption rates
A share of selling overheads is charged as well as cost of delivery.
Job Costing – Example
Job No. T47
DM 200 tons @ K50, 000
=
D Wages 108 hrs @ 20, 000 =
Overhead
Absorption rate
K10, 000,000.00
K2, 160, 000.00
K1, 296, 000.00
K13, 456, 000.00
Budgeted overhead
12, 000, 000
1, 000
12, 000 per DLH
Allotment of overheads to job, product or unit i.e. the recovering of overheads by
the product.
If actual overheads came to K1, 500, 000, there is under absorption of:
-
K1, 500, 000
K1, 296, 000
K204, 000
70
BATCH COSTING
Batch costing is the application of the principles of cost ascertainment where a batch of
identical units is treated as singe identifiable job cost unit.
Cost per unit =
Total Batch Cost
No. of units in a batch
Costs for the batch are accumulated on a batch cost card.
CONTRACT COSTING
Is ordinary job costing applied to relatively large cost units, particularly units that take a
long time to complete and are taken away from the enterprises premises (e.g. Civil
Engineering works). Features of contract costing are:
(a)
Materials ordered are specifically for the contracts. They will be charged direct
from the supplier’s invoices.
(b)
All labour will be direct including night watchmen and site clerks.
(c)
Most expenses are direct e.g. electricity, insurance, telephone, postage,
subcontracts and architect’s fees.
(d)
Nearly all overheads are head office costs, e.g. tender preparation costs, material
procurement and labour administration. They will be a small proportion of the
total costs.
(e)
Plant and machinery costs – may be charged either on hourly rate or with the full
plant value and credited with depreciated value.
Architect’s certificates are prepared periodically after inspection of the work. The details
of the work completed show the value of the work completed at contract price (not at cost
price).
The contractor submits invoices to his customer/client claiming these amounts as
progress payments, enclosing the architect’s certificate as evidence of work done. The
customer withholds a proportion of the contract value (e.g. 10%) for a specified period
after the end of the contract. The retained money is held back to ensure that the
contractor remedies rectifies defects that are detected afterwards.
A separate contract account should be opened for each contract. Debit this account with
contact costs (materials, labour and overheads, plant and head office overheads). Credit
it with the contract price and many materials, plant and other items transferred from the
contract.
71
Example
CONTRACT 158 (CLIENT KITWE CITY COUNCIL)
K 000
Materials purchased
Materials ex-store
Site wages
Site direct expenses
Plant sent to site
Architects’ fees
Subcontract work
Head office overheads
Accruals c/d
4421
374
1440
195
480
200
680
180
37
8007
K 000
Materials returned
Plant returned
Prepayment c/d
Stock at site c/d
Plant at site c/d
Cost of work certified c/d
Work in progress c/d
86
130
11
124
205
7080
371
8007
72
PROCESS COSTING RESOURCES
E
L
E
Materials
M
Loss
(Normal)
E
N
T
Labour
S
O F C OST
Loss
Overhead
(Abnormal)
PROCESS
Work in Process
Scrap
By-product
Joint products
73
PROCESS COSTING
Process costing is where identical/homogeneous cost units are produced e.g. beer, juices, chemicals and fuel.
PROCESS ACCOUNT
Previous process
Materials:
A
B
Labour
Direct expenses
Overheads
Litres
30 000
K 000
15 000
Litres
Next Process 35, 000
K 000
34 500
20 000
10 000
10 000
10 000
20 000
600
3 000
586 000
Losses:
Normal
18 000
Abnormal
4 000
Closing stock 3 000
12 000
11 290
810
60 000
58 600
60 000
SERVICE/FUNCTION COSTING (OR OPERATING COSTING)
Service/functions costing or operation of costing is used where an enterprise wants to
find the cost of providing a service. The unit of cost will refer to the type of service
rendered.
The cost per unit is obtained by dividing the total number of units into the total costs of
providing the service e.g. litres of water supplied divided into the cost of supplying water
to a city or municipality or town.
Example: The Water Department in Municipal Council in the Copperbelt supplies
K7 billion litres of treated water in a month. It has been estimated that the cost of the
department is K6 billion per year.
What is the cost of supplying a litre of treated water?
Solution:
K6 000 000 000  12 months = K500 million per month.
Cost of supply a litre of treated water =
500 000 000
 100 = 50n
7 000 000 000
74
EXAMPLES OF COST UNITS
BUSINESS
Brewing
Brick making
Coal mining
Electricity
Engineering
Water
Gas
Paper
Petroleum
Sand and gravel
Steel
Timber
Transport (Railway)
Airline
Hotel and Catering
Professional Service (accountants,
architects, lawyers, surveyors)
Education
Healthcare (Hospitals)
Activity:
Building service
Credit control
Materials storage/handling
Personal Administration Selling
Telephone service
COST UNIT
Barrel/Hectolitre
1 000 bricks
Ton/tonne
KWH
Contract, job
Cubic metre
Therm
Ream
Barrel, tonne, litre
Tonne/ton/sheet (a) Rolled
(b) Cast
(c) Extracted
100ft/standard/store kilometer/ton
Available tonne km
Room/cover
Chargeable hour
(a) Enrolled student
(b) Successful student
(a) Bed-occupied
(b) Out-patient
Square metre account maintained
(a) Requisition
(b) Unit issued/received
(c) Value issued/received
Employee
(a) K of turnover
(b) Call made
75
6.3
ABSORPTION COSTING
The view is taken that a fair share of overhead costs should be added to
the cost of units produced. This fair share will include a portion of all
production overhead expenditure and possibly administration and
marketing overhead too.
SUMMARY OF ABSORPTION COSTING
1.
Include overheads in product cost using a pre-determined overhead
absorption rate.
2.
The pre-determined rate is set annually. Budgeted overheads are
allocated to cost centers and then apportioned so that all
production overhead is identified with the departments directly in
production.
3.
The departmental absorption rate is calculated by dividing the
budgeted overhead by the budgeted level of activity. (Normal
level of activity should really be used). Activity based costing
(ABC) is changing the absorption of overhead method.
4.
During actual production overheads are absorbed on the basis of
pre-determined rates.
5.
Actual overheads are recorded by cost allocation and
apportionment, so that each department has an actual overhead
figure. The actual figure is compared with absorbed overheads
giving a figure under or over absorbed overheads.
6.
This under or over absorbed overheads may be the result of both
expenditure and activity differences.
7.
Closing stocks will include absorbed overheads. Accounting
systems should distinguish between variable and fixed overheads
and have separate absorption rates.
76
Example
At the start of period 1, no stocks
Period 1
Sales
1200 units
Production
1500 units
V C of production
K4 per unit
Sales price per unit
K6 per unit
FC of which K1500 are fixed K2000
production cost
Period 2
1800 units
1500 units
K4 per unit
K6 per unit
K2000
ABSORPTION COSTING P & L
Sales
Opening stock
Production (F+V)
Less Closing
PERIOD 1
PERIOD 1
PERIOD 2
PERIOD 2
K
K
7200
K
K
10 800
-07 500
7 500
(1 500)
1 500
7 500
9 000
(6 000)
1 200
(500)
700
Gross Profit
Less FC
Net Profit
Pre-determined absorption rate : K
TOTAL
K
K
18 000
1 500
15 000
16 000
(1 500)
(9 000)
1 800
(500)
1 300
(15 000)
3 000
(1 000)
2 000
1 500
 K1 per unit
1 500 units
6.4 MARGINAL COSTING
1.
Definition
A marginal cost is the variable cost of one unit of a product or a service
i.e. a cost which would be avoided if the unit was not produced or
provided.
2.
Marginal costs of Production and Sales
Variable Cost of Production
(DM) – Direction Material
(DL)– Direct Labour
(VOH) – Variable Overhead
77
Variable Cost of:
3.
Administration
Sales
Distribution
Marginal Cost of Sales


4.
Marginal Costing



5.
Variable cost of production, variable cost of sales and variable
cost of distribution
Marginal cost of an operation/process/batch of output
Only variable costs are charged to cost of units (as product
costs).
Fixed costs are treated as period costs
Sales value – variable cost of goods sold = contribution.
When this is divided by the limiting factor, we get contribution
per limiting factor.
Principles of Marginal Costs
i)
Since period FC are the same,
- Revenue will increase by the sales value of the item sold
- Costs will increase only by the variable cost per unit
- The increase in profit will be the contribution per unit.
ii)
If volume falls by 1 unit, the profit will fall by the amount
of contribution from the unit.
iii)
FC are period costs. Units of sale should not be charged
with the share fixed costs.
Profit for the period = Total contribution – FC
If contribution > FC then profit is made
If contribution = FC then you have broken even, i.e there is
neither a profit nor a loss.
If contribution < FC then loss is made.
iv)
Closing stock should be valued at production variable cost
and variable production overhead.
v)
Contribution/Sales Ratio
78
Since contribution per unit is the same at all sales volumes, given
no change in the unit sales price, there n=must be a consistent
relationship between contribution and sales i.e. Profit per volume
or P/V ratio or contribution margin ratio.
MARGINAL COSTING P & L
Sales
Opening stock
Variable
Production Costs
Less Closing stock
Contribution
FC (Prod + Sales)
PERIOD 1
PERIOD 1
PERIOD 2
PERIOD 2
K
K
7200
K
K
10 800
-06 000
6 000
(1 200)
1 200
6 000
7 200
(4 800)
2 400
(2 000)
400
TOTAL
K
K
18 000
1 200
12 000
13 200
(1 200)
(7 200)
3 600
(2,000)
1 600
(12 000)
6 000
(4 000)
2 000
MARGINAL AND ABSORPTION COSTING COMPARED
Marginal Cost
Closing Stock
Valuation
At Marginal Production Cost
FC charged in full against
profit of the period
Identify VC
C
FC
VC
FPC
FC
C
MC
=
=
=
=
=
Absorption
Costing
At full production cost
including a share of
FPC
Cost of sales include
some FC incurred in
the previous period and
will exclude some FC
incurred in the current
period
No need to distinguish
MC from FC
VARIABLE cost
Fixed Production Cost
Fixed Cost
Contribution
Marginal Cost
79
THE BREAK EVEN CHART
K
TR
Profit
Income and costs
TC
FC
Q Produced and sold
What is shown on the diagram can be derived algebraically using the
formula:
Q
FC
P  VC
Where:
Q
FC
VC
P
=
=
=
=
Break-even point in units
Fixed costs
Variable costs per unit
Sales price
The break-even point can also be calculated in Kwacha using the
following formula:
Q (in Kwacha)
=
FC
Contribution Ratio
80
Where
Q = Break-even point in Kwacha
Contribution ratio =
Contribution M arg in
 100
Selling Pr ice
Break-even analysis is useful in decisions about the level at which to operate a
business. Having known such a level the actual operating level can be fixed
above it so as to earn some profit for the enterprise.
UNIT 7 BUDGETING
Definition of budget and budgeting
A budget is a financial plan for a future period. It is prepared taking into
account objectives to be achieved, and resources to be employed to
achieve those objectives.
A budget is useful in all organizations. The degree of sophisication of the
budget differs as between organizations. Its use is similar in all
organizations. It is a planning and control tool for managers.
Budgeting and Corporate Planning
Corporate planning is about long term planning. The environment in
which an organization operates is dynamic, multifaceted and complex. To
be able to survive and grow an enterprise needs to successfully adapt to its
environment. One way of doing this is to formulate a corporate/strategic
plan.
This is done by the enterprise having a vision that is an articulation of
what the enterprise wants to be. To achieve its vision an enterprise comes
up with a mission. For some enterprises, this is summarized in a mission
statement that is displayed in company premises and its documents. On
the basis of the vision and mission, the enterprise defines its goals and
objectives. Strategies are formulated after analyzing the external and
internal environment (i.e. carrying out environmental analysis to identify
opportunities and threats) and corporate appraisal or position audit to
identify strengths and weaknesses.
The strategies formulated for
implementation will have to be to exploit opportunities and counter threats
by using strengths and addressing weaknesses.
81
To implement the strategies in order to achieve the goals and objectives
the enterprise will require implementing the formulated strategies. The
annual budget will need to be prepared in the context/framework of the
corporate plan. The approved annual budget will be the basis of control.
While implementing the strategies monitoring and evaluation will be done
by providing feedback information. Actual results will be compared with
the budget and any corrective action will be based on an investigation of
significant variances.
Thus the strategic plan (i.e. formal and systematic plan which purposefully
directs and controls an organization’s future operations towards agreed
targets for periods more than one year) and the budget are intertwined.
Budgeting is part of long range and short term planning.
Purposes of Budgeting
Apart from the role of budgeting in long range planning, the purposes of
budgeting are:
Budgeting compels management to plan. That is management is forced to
define its objectives and also for it to decide the means of achieving the
objectives. Management plans what must be done and how to do it.
Controlling activities by comparing what is actually happening to what
was planned and taking any corrective action where necessary.
Communicating objectives, targets and policies to all employees for them
to be aware of what is expected of them.
Integration and coordination of the various parts of the organization. The
budget requires the participation of all parts of the organization. Through
the budget, the role of each employee is defined.
Performance evaluation – On the basis of the budget, the performance of
each responsibility center and manager are evaluated.
Motivation – The budget, where it is prepared with the participation of all
employees motivates workers and managers to work hard to achieve it.
Administration of Budgets
The commitment of top management is required for budgetary control to
succeed. There must be a clear organization charge showing authority and
responsibility allocations. Budget centers must be established in the
organization structure.
82
A budget committee must be in place in the organization. Along with the
budget committee there must be a budget manual. See below for more
details.
Budget Committee
The budget committee is responsible for all aspects of budgeting. It is
composed of:



The Chief Executive Officer (CEO)
Functional Heads and
The Management Accountant as Secretary or the Budget Officer.
The Budget Committee’s Secretary’s responsibilities are:


To ensure that the budget is adhered to.
He/she assists Function Heads to draw up the budget and to analyze
the results.
The functions of the Budget Committee are:





To agree on the policies with regard to budgets.
Coordinate budgets of the various parts of the organization.
Suggest amendments to budgets.
Approve budgets
Examine comparisons of budgeted and actual results.
Budget Manual
The budget manual sets formal procedures for the preparation of budgets
and use of budgets.
Stages in the Budgeting Process
The first stage in the budgeting process is to communicate policy guidelines for
the budget period and identify the limiting factor.
Sales Budget
Having communicated the policy guidelines including the limiting factor, the
sales budget will be prepared by specifying the products and quantities budgeted
to be sold and the respective selling prices. The sum of the budgeted sales
revenue for all products will sum up to the budgeted sales revenue for the whole
firm.
83
The Production Budget
The sales budget will be followed by the production budget. This will
incorporate the raw materials used, direct labour and production
overheads. Then there will be raw material usage budget based on the
production budget. The direct labour usage budget will follow and the
production overhead budgets.
These will also be followed by the cost of goods sold budget derived from
consideration of sales budget, the production budgets and finished goods
stock budget.
Budgets for sales and distribution expenses will be prepared as well as the
administration budget. These budgets will be taken into account in the
preparation of the budgeted profits.
The sales budget, the production and other budgets will together form part
of the operating budget. The diagram below illustrates this clearly.
The operating budget, which shows the budgeted profit, and the capital
budget will be used to prepare the Cash Budget. Budgeted receipts and
budgeted payments will be compared and when the opening cash balance
is incorporated, the closing cash balance will be calculated.
Using information about sales, production and other budgets including the
Cash Account will enable the preparation of the budgeted balance sheet.
84
OPERATING BUDGET
Sales Budget
Production Budget
RMB
LB
Fixed Overhead Budget
C G S Budget
General & Administration Expenses
Budget
S&DEB
MB
Budgeted Profit & Loss Account
Capital Budget
Cash Budget
Budgeted B S
85
METHODS OF BUDGETING
Budgets can be prepared using a number of methods.These are
INCREMENTAL BUDGETING
ZERO BASE BUDGETING and
ACTIVITY BASED BUDGETING
ACTIVITY BASED COSTING
Activity based costing provides for a means of associating resource consumption with
products, which is made more rigorous and sophisticated than the conventional approach
(i.e. the traditional budgeting system). It highlights not only the res inputs (costs) but
also the outputs in terms of the cost drivers. Usually the cost drivers are expressed in
non-financial terms, such as the volume of purchase. Order or the level of service
provided.
Activity Based Budgeting links the proposed res inputs and the expected outputs for the
forthcoming period. Activity Based Budgeting also recognizes that (non-volume-related)
some resources will be required for activity sustaining (non-volume related) as distinct
from activity variable resources (activity variable resources are driven directly by the
level of output of that particular activity).
An activity based approach means that resource inputs must be justified in relation
to each activity e.g. if an activity has been identified as non-value added, but it has
proved impossible to eliminate this activity in the short term, there would be no
question of increasing the resources.
UNIT 8 BUDGETARY CONTROL
Budgetary control sets the goals which it expects managers to achieve, and then evaluate
their performance by the use of variances [which seem to accentuate ‘adverse’ variance
as the fault of the manager]. Misuse of the system will harm the morale of managers and
this affect the performance of business.
Plan
Evaluate
Implement
Monitor
Budget
Actual Results
Corrective action
(where appropriate)
Variances
Reasons for
variances
86
Report significant variances periodically such as monthly.
Reporting after a year may be too long after the event.
Reporting weekly may be too often. Hence choose between the two extremes.
Reporting monthly is used by most organizations.
Aim of budgetary control to provide feedback (information gained from the explanation
of these variances).
So as to take corrective action where appropriate to improve performance (current and
future performance) and to improve budgets for the future periods.
BUDGET STANDARDS AND ACTUAL EXPENSES
The reporting of V’S to appropriate responsibility managers is achieved by exception
reporting. That is, reporting only exceptional V’S i.e. those significant variances rather
than reporting each and every V. By reporting only the important V’S requiring
management attention the responsible managers will hopefully speedily deal with the
those V’S deserving manager’s attention. Adverse variances are unfavourable variances.
Favourable variances are those that show that things are alright.
IDEAL STANDARDS
Too difficult targets result in adverse V when compared with actual. Managers and employees will not try to achieve too
difficult targets because they can never achieve them. Hence the difference between budget and actual expenditure will always
be adverse. Too difficult targets do demotivate.
LOW STANDARDS
These are standards that can be easily achieved so that comparing actual results with
budgeted will always result in favourable variances.Low standards do demotivate
employees.
ATTAINABLE STANDARDS
Attainable standards are difficult to achieve but they can be achieved.They motivate.
Easily achievable targets do not motivate either. They demotivate. Such targets do not
call for extra/additional effort to achieve them. They do not challenge. Therefore, when
interpreting /investigating Varinces, one should always bear in mind:
87
(i)
The level at which budget targets or standards were set.
Ideal standards can never be achieved. They always lead to adverse V’S, which
for control purposes are meaningless.
Too loose standards are equally useless because they always give favourable
variances.
(ii)
The level at which standards or targets are set affects motivation. Both too easily
attainable targets and too difficult to achieve targets demonstrate.
Budget costing is applicable to both the private and the public sector. It may/may
not be linked to standard costing. When linked to standard costing and attainable
standards, are used the budget will then tell you what the costs should be.
BUDGET REPORTING
In budget costing system feedback reports consists of provision of information with actual results or actual performance and
the computation of variances. Such information should be relevant to the recipients or the responsible managers. It should be
timely and be reliable, at appropriate level of detail and cost effective.




Relevant
Timely
Reliable
Cost effective
At appropriate level of detail – detailed at low level of management; summarized at higher levels.



Engineered costs
Discretionary costs
Committed costs
Efficiency
Effectiveness
Economy
88
RESPONSIBILITY ACCOUNTING AND FLEXIBLE BUDGETING
Divide the organization into different responsibility centres e.g. cost centres, investment
centres, II centres, budget centres. Each responsible centre (whatever it is) is headed by a
manager. Resources will be allocated to these responsible centres and it is the
responsible of the responsible centre managers to achieve the objectives of the
responsible centres under them. The managers are accountable for resources and
objectives of the responsible centres they need.
In terms of the budget each responsible centre will have a budget costs, revenue, assets
and liabilities and capital will be traced to the responsible manager. Performance reports
for each budget centre will be produced periodically e.g. monthly. Hence:

Managers are responsible for the activities over which they exercise control.

Managers should strive to achieve goals and objectives that have been established
for their responsible centres.

Managers participate in establishing the goals and objectives against which their
performance will be measured.

Goals and objectives are attainable with efficient and effective performance.

Performance reports and feedback are timely.

The role of responsible accounting in the company’s reward systems is clearly
stated:
89
Flexible Budgets
Production (units)
K
DM
DL
Maintenance
Depreciation
Rent & Rates
Other costs
Total
Budget
2000
K
6 000
4 000
1 000
2 000
1 500
3 600
18 100
Actual
3000
K
8 500
4 500
1 400
2 200
1 600
5 000
23 200
Variance
1000
K
2 500 U
500 U
400 U
200 U
200 U
1 400 U
5 400 U
(a)
2 000
K
6 000
4 000
1 000
Flexed
Budget
(b)
3000
K
9 000
6 000
1 500
Actual
Results
(c)
3 000
K
8 500
4 500
1 400
Variance
(b – c )
K
3 600
4 600
5 000
400 U
2 000
1 500
2 000
1 500
2 200
1 600
200 U
18 100
24 600
23 200
Fixed
Budget
Production (units)
Variable costs
DM
DL
Maintenance
K
500 F
1 500 F
100 F
Semi-Variable Costs
Other costs
Fixed Costs
Depreciation
Rent & Rates
100 U
1 400 F
90
UNIT 9.
WORKING CAPITAL MANAGEMENT
WORKING CAPITAL MANAGEMENT
Importance of Working Capital and its Management
Definition
Working capital is short-term net assets i.e. the total of stock, debtor and cash/bank less
creditors and other current liabilities. It is short term capital reflected in current assets
and current liabilities. This is capital which is not long term.
Working capital management is the management of current assets and current liabilities
to ensure efficiency and effectiveness.
Current assets are circulating assets in various stages of conversion into cash as shown by
the cash cycle or operating cycle – see diagram below:
Cash
Payments
Collections
Creditors
Debtors
Purchases
Raw materials
Sales
Finished goods
Completion of production
Production
Work-in-progress
Current liabilities and part of long term liabilities becoming current have to be settled
using liquid resources (i.e. cash and bank balance).
This whole process of ensuring that there are adequate liquid resources to settle short
term obligations adequate stocks, giving credit to credit worthy customers, using short
term resources profitably requires to be managed. Working capital management entails
managing current assets and current liabilities.
Sound financial management requires that short term assets be financed by short term
funds whilst fixed assets are financed with long term funds.
91
Short term funds tend to be cheaper than long term funds but carry renewal risk. They
may not be renewed by the bank. Eg overdraft. When a company uses overdraft to fund
its assets or operations the bank can demand immediate settlement of the overdraft.
Alternatively the overdraft may be withdrawn by the bank at short notice.
Long term funds are more secure but more expensive. They are not available to the
lender for a long time whilst they are being used by the borrower.
The financing policy for working capital is normally revealed by a firm’s current and
quick ratio. The current and quick ratios indicate a firm’s ability to pay short term
obligations or current liabilities. Generally if a firm is unable to pay its short-term
liabilities suppliers might force it to be wound up.
The higher the current ratio e.g. more than 2 to 1 the more conservative (or less
aggressive) the company is with its working capital policy or in it’s working capital. A
high current ratio means that the firm has more current assets for every kwacha of current
liabilities. A lower ratio shows an aggressive working capital policy.
Methods of managing (controlling) the components of working capital are discussed
below.
Management of Stock
A firm’s stock includes raw materials, work in progress and/or finished goods.
Stock of raw materials, work-in-progress and finished goods are necessary to enable a
firm to continue its operations. Raw materials are required for input into production.
Work-in-progress has to be completed into finished goods. The latter is available for sale
to customers who wish to buy them. Stocks are therefore required for sustaining
operations of the company- production operations as well as sales operations.
Managing stock involves ensuring that the money tied in stocks is not excessive and
addressing problems relating to stocks.
Advantages of holding stock




Discounts for bulk buying can be obtained from suppliers / be given to customers
Reduction in total annual order costs (order costs are fixed)
Continuity of supply/of production (avoidance of stock outs and hence avoidance
of loss of goodwill of customers and to ensure continued production).
Investment value in stocks – ensure that the investment in stocks is optimized
which means that not too much/not too little money is tied in stocks.
Disadvantages of holdings stock
When a firm holds stock it incurs holding costs.
These include:
92




Risk of damage of stock, deterioration, obsolescence and theft of stocks held
Cost of capital tied up in stocks (capital tied in stock has opportunity cost)
Subsequent price reductions will be missed by the firm because of holding
stocks
Systems costs (costs associated with the stock control system)
To optimise the investment in stock a firm should buy stocks in economic lots i.e.
purchase stocks utilising the basic EOQ model (see below).
Example.
Demand for one of X plc’s products averages 1000 units per month. It costs K60 000
each time a delivery of goods is received/to order the product from a supplier and K4 000
per unit per year to store a unit.
How many units should the company order at a time to minimize total cost?
Solution:
EOQ 
2 DC
h
Where,
D =
C =
h =
D =
C =
h =
Annual demand
Ordering costs
Cost of holding one unit per year using the above information
12000 units (1000 x 12 months)
K60,000
K4000
 the EOQ is
EOQ 
2  1000  12  60000
4000
= 600 units
Derivation of the EOQ Formula
The formula for the EOQ can be derived as follows:
93
Let h be holding costs. h(I,e, cost of holding 1 unit stock for 1 year (often includes an
element of cost of capital.)).
Let c be ordering costs; (Costs incurred for placing an order for units of the item to be
stocked).
Let q be the Economic Order Quantity (EOQ)
Let d be the annual demand (in units)
Total holding costs are : Q h
2
Total Ordering costs are
DC
Q
Number of orders is therefore total ordering costs are
Annual Demand
= D
Economic Order Quality
Q
Total costs = Holding costs + Ordering costs
Total costs
=
Q h + DC
2
Q
The objective of controlling stock is to minimise total costs consisting of costs of keeping
the stock in the firm and ordering it when more is required.
Total costs are minimised when the change in total cost as quantity orders.
dTC = 0 (The change in TC as Q changes is equal to 0)
dQ
dTC = h – DC
dQ
2 Q2
Set h - DC = 0
2
Q2
Multiply by 2 throughout
h – 2DC = 0
Q2
Multiply by Q2 throughout
Q2h – 2DC = 0
94
Add 2DC to both sides
Q2 h = 2DC
Divide by h throughout
Q2 = 2DC
h
Since Q is the square root of Q2
Therefore
EOQ 
2 DC
h
Assumptions of the EOQ model
The EOQ model is based on the following assumptions
1.
2.
3.
4.
5.
Constant purchase price
Constant demand
Constant lead time (interval between placing an order and receiving the order)
Fixed costs for each order placed (i.e. ordering costs are fixed)
Holding costs are proportional to average stock
h is proportional to
Q
2
h = Qh
2
Recorder level (ROL and Buffer Stocks)
1.
If there is constant demand and zero lead time, the Recorder Level is zero.
i.e. ROL = Zero
2.
If there is constant demand and fixed finite lead time then
ROL = Usage in Lead Time  Length of the lead time = D  LT
3.
If there is Variable LT demand
ROL = Average demand in LT + buffer stock
=DxL+B
95
DEBTORS MANAGEMENT(CONTROL OF DEBTORS
Debtors are created when a firm agree to sell goods/services. on credit. Creditors
arise as a result of granting credit based on a firm’s credit policy.
When getting balance costs of credit and benefits of credit.
Costs of credit
(Financing costs , bad debts costs of , administration of credit)
Compare these costs with
Benefits of credit increased sales and hence profit)
A liberal credit policy
aggressive credit policy.
There are benefits from a liberal credit policy as the firm makes
Profit/Contribution on the increased sales
However, there are costs from a liberal credit policy



Opportunity cost of funds tied up in huge debtors
Increase in bad debt losses
Increase in debt administration
A conservative credit policy is a stringent credit policy
Costs specified above become benefits and benefits become costs.
Benefits of - Reduction in bad debt losses
conservative Savings in debt administration costs
credit policy Reduction in opportunity costs of capital tied up in debtors
Costs:
Loss of profit/contribution on lost sales
Therefore as part of debtors management

Assess credit worthiness of new customers (make use of credit rating agencies
which exist).

Use bank references
96

Use trade references of

Analysing paying habits of prospective customer

Consider the size and nature of business of prospective customer.

Set Credit Terms
E,g, discount policy. If an account is paid within 10 days of invoice reduce a
specified percentage of debt e.g. 10% off the invoice if payment is made within
10 days.
Discount is a cost to the company hence minimize it.
When debtors discussed come down, it is a benefit to the company.

Institute a debt collection policy inducing the use of Debt Collection Agencies.

Use a Factor
A factor is an outsider who offers a service at a cost.
Services offered by a factor: include:
1.
Financing – a Factor charges interest (financing cost as a % debtors)
The firm gets cash promptly upfront from the factor and it saves overdraft
charges
2.
Commission (A factor charges a commission)
3.
A firm makes savings in debt administration costs
4.
Recourse and non-recourse arrangements. Recourse arrangement is such that
if a factor fails to collect money from debtors, he will pass the problem to the
company. Non-recourse is the opposite. The factor does not.
Savings in bad debts costs on non-recourse arrangement
Debtors turnover (in days)
Average Debtors
Credit Sales
365
Daily debtors
=
Average Debtors x 365 days
Credit
Sales
97
Examples
1. Debtors
£800,000
£800.000
Sales £12 000 000, credit sales 2 of £12,000,000 = £8000.000
3
Cash sales 1 of £12 000 000 = £4,000 000
3
Current credit period: 30 days (Debtors must pay within 30 days).
In practice, customers take longer than this to pay their accounts.
Current bad debt losses are £120,.000
The firm is thinking of introducing a discount of 2% if payment is made within 10
days of the invoice.
It is estimated that 60% of credit customers would take advantage of this benefit.
The remaining 40% of credit customers would continue paying as before. It is
estimated that there will be some savings in debt administration cost of £25,000.
Opportunity cost of funds tied up in debtors is 12%
Which policy should the firm take?
What should the company do?
SOLUTION
£000
25
Savings in debt administration
Reduction in bad debts losses
(120,000 – 50,000)
70
Discount £8m x 60% x 2%
(96)
Opportunity cost of cap of savings in debtors
£348 493 x 12% (see workings below)
Debtors
Current
Proposed
£800 000
£8000000 x 20.6
41.819
40.819
======
451.507
98
365
Proposed
Current
Current debtors Turn over
8000
8 000 000 x 365
=36.5 days
60% x 10 days
= 6.0
40% x 36.4 days = 14,6
20.6 days
* Workings to arrive at £41 819 above
800 000
348.493
======
£348 493 is used to calculate the opportunity cost of savings in debtors
Example 2
Effect of policy change on current ratio
Liquidity ratio
Employing a factor
Vs
Offering a discount
Current ratio Stock + Debtors + Cash + Bank
Creditors + Overdraft
= Current Assets
Current Liabilities
As a result of employing factor
Debtors decrease
Overdraft decreases
Cash increases
Debtor's turnover changes
99
CASH MANAGEMENT
Cash Float – Refers to money tied up between the time when a payment is
initiated by a debtor and the time when the funds become available for use in the
recipient’s effect from the bank account.
Reasons for cash float (i.e a cash float arises from):
1.
Transmission delay
2.
Lodgement delay
3.
Clearance delay
Measures to reduce the float
The cash float can be reduced by:1.
Depositing cheques for collection on the day of receipt
2.
Arranging for collection of cheques from customers
3.
Including a bank credit slip on the bottom of invoice so that the debtors banks
the payment
4.
Using bankers’ Automated Clearing Services Ltd (BACs) whereby you can
transfer funds between banks, (e.g. for salary payments).
5.
Using clearing House Automated Payment (CHAPS). Same day settlements,
minimum payment £10,000.
USING THE INVENTORY MODEL IN CASH MANAGEMENT
Cash Management Models can be used to indicate the optimum amount of cash that a
company should hold at any one time so as to be able to meet obligations as they arise.
Drawbacks
The Baumol Model has some drawbacks
1.
2.
3.
Q
=
It is impossible to make predictions of the cash requirements with certainty
There may be costs associated with running out of cash
Unsuitable for firms with erratic cash flows over time.
2 FS
i
Where
S
=
the amount of cash to be used in each time period
F
=
the fixed costs of obtaining new funds
i
Q
=
=
the interest cost of holding cash or near cash equivalents
the total amount of cash to be raised to provide the amount
of
100
cash to be used in a period.
The Miller Orr Model
Cash
Balance
Upper
Limit
---------------------------------------------------------------------------------Return Point
Sells securities
------------------------------------------------------------------------------- Lower Limit
0
Time
Setting of upper limit, lower limit and return points is dependent on:
i)
ii)
iii)
Variance of cash flows
Transaction costs
Interest rates
If day to day variability of cash flows} are high must be wider
and transaction costs
If interest rates are high limits must be closer
Return Point = Lower limit + ( 1 x spread)
3
101
The objective of using Cash Models is to indicate minimum and maximum levels of cash
holding in order to minimize the cost of holding idle cash balances and maximize interest
earned on surplus funds.
Spread
=
3
3 x transaction cost x variance of cash flow
4
3
Interest rate
1
Objective of Cash Models
Model can be effective if inputs are accurate.
Probabilities can be used explored to incorporate uncertainty in the analysis.
Cash surplus arises from the following:
i)
ii)
iii)
Profitable from trading operations
Low Capital expenditure perhaps due to absence of profitable investment
opportunities
Receipts from selling parts of business
Reasons for keeping cash surplus in liquid form are
i)
ii)
iii)
iv)
Strategic investments (takeover)
Purchase of (own) shares
To pay increased dividends
To benefit from high interest rates
Measures to overcome cash crisis
1.
Defer certain payments
-
Dividends especially for unlisted companies
For listed company delaying paying dividends may send wrong signals to the
stock market
-
Capital expenditure especially of unproductive projects
-
Tax – There may be interest on delayed tax payments provided it is lower than
interest on bank loans
2.
Sale of unproductive business segments/assets – non core businesses
3.
Sale and lease back of certain assets
102
4.
Improve capital Management. Improving working capital management involves
improving the management of:

Debtors
-

Creditors
-

Offer cash discounts to debtors for prompt payment
Engage a factor
Review credit terms
Reviewing credit terms
(bring them in line with debtors)
Stock
-
Stock control policy/production policy
-
Constant rate?
Order Stock according to demand?
5.
Buy Vs Lease certain fixed assets
6.
Seeking the assistance of venture capitalists
7.
Seek funds from
Short term
Medium
)
)
Sources of finance
8.
Adopt cost control & cost reduction. Cost reduction is better than cost
control
9.
Outsourcing of services and components. Can you differentiate between cash
flows?
103
UNIT 10. INVESTMENT APPRAISAL
Investment
To invest is to put money into a fixed asset or in a venture or project with a view
to getting more money from the asset, venture or project in future e.g. put money
in a savings account and earn interest. Another example is to buy a security (a
share/bond) in a company so as to get dividends or interest from the company in
future. Yet another is to invest in a project and generate cash flows from it for a
number of years for example the Konkola Deep Project of Konkola Copper Mines
(KCM) which will generate cash flows for KCM for a number of years to come. .
Appraisal
Appraising a project is evaluating/ determining the worth of the investment. It is
calculating the cash inflows and comparing them to cash outflows so as to find
out whether the project is viable.
Evaluating whether an investment is worthwhile is determining whether the
investment is viable? Does it generate more cash inflows than cash outflows.
Companies have to look for investment opportunities and invest in viable ones so
as to generate wealth for shareholders. Companies should invest shareholders’
money in those projects which are viable so as to make money for them. Project
appraisal is necessary because investment decisions involve a lot of money which
is tied for a number of years. Such decision once made and money invested are
irreversible.
8.1
METHODS OF INVESTMENT APPRAISAL
There are two groups of investment appraisal methods.
Non-discounted Cash Flow Methods.
Accounting rate of return
The Accounting rate of Return (ARR) compares project profit to the
capital invested in the project. First project profit must be calculated by
deducting project expenses from the project revenue. Project expenses
include depreciation. Project revenue is income from the project. Use can
104
be made of the average net profit from the project.
investment can also be made.
ARR(%)
=
The average
Average net profit x 100
Average investment
This should be compared to a specified target accounting rate of return.
An acceptable investment will be that whose accounting rate of return
equals the target rate or whose accounting rate exceeds the target rate of
return.
The major advantages of the accounting rate of return are its simplicity
and its wide application.
The major weaknesses of the accounting rate of return are that it relies on
accounting figures that are arrived at by using accounting principles and
the figures relate to the past. Another weakness is that the accounting rate
of return does not take into account the time value of money. The latter is
the fact that a Kwacha today is worth more than the same Kwacha
tomorrow because a Kwacha today can be invested in order to earn a
return between today and tomorrow. The Kwacha has a time value called
the time value of money (TVM). The accounting rate of return ignores
this fact.
THE PAYBACK PERIOD
The pay back period is the period of time in moths or years it takes to
recoup the amount invested in a project. The shorter the period, the better.
The pay back period is calculated by reference to the cash flows from the
project. The cash flow is annual. Cash inflows are used to recoup the
amount invested in the project. Viable project should have shorter
payback periods.
The advantages of payback method are that it is simple to understand and
apply. The other is this method uses the cash flow to calculate the
payback period.The shorter the period of recouping the investment in the
project, the lesser the risk of loss of the money invested.
The disadvantages of the payback method are:


It ignores the time value of money (TVM) like the accounting rate
of return.
It ignores all cash flows arising after the payback period.
105
The Discounted Cash Flow (DCF) Method
The time value of money is a concept which reconises that a Kwacha
today is worth more than a Kwacha tomorrow because today’s Kwacha
can be invested in order to earn interest. For instance, if the interest rate is
10% per annum, one Kwacha invested for 1 year will earn 10% interest, t
after 1 year and the total amount will be 1+10% of 1 = 1.1.
This process of calculating the future value of a present amount is called
COMPOUNDING.
Hence the future value of any amount, FV =
n
P(1+I) . FV is the future value, P = the present amount invested; I is the
interest rate, which is earned per period and n is the number of periods eg
years, the amount is invested . There are tables for the factor (1+i)n, future
value factors. The process of finding the present value of a future amount
is called DISCOUNTING. It is the opposite of compounding. If FV =
P(1+ i)n.
P
FV
 FV (1  i )  n
n
(1  i )
In the above expression,
FV
1
can be re-written as FV 
.
n
(1  i ) n
(1  i )
There are tables for present values or present value factors expressed as
(1  i ) n . The tables have the following structure:
i
%
n
1
2
3
4
5
6
7
.
.
.
n
1
2
3
4
5
6
.
n
106
The expression
1
is the present value factor.
(1  i) n
Net Present Value (NPV)
The net present Value is obtained by deducting the present value of cash outflows
from the present value of cash inflows. The computation is laid out as follows:
Year Investment
K’Million
Cashflows
K’Million
Present Value
Factors @ 10%
25
1.000
0.909
(100)
22.725
2
30
0.826
24.78
3
40
0.751
30.04
4
65
0.683
44.395
.
.
0.621
.
.
0.564
.
.
0.513
n
43
0.467
0
1
(100)
Present value
K’Million
The sum of positive present values minus the investment will give the net present value
(NPV). If the NPV is positive the investment is viable it should be undertaken. If it is
negative the project should be rejected.
Internal Rate of Return(IRR)
The internal rate of return is that discount rate which equates the NET PRESENT
VALUE (NPV) to zero. The IRR is calculated by trying a number of rates until two rates
are obtained one of which gives a small positive NPV and another that gives a small
negative NPV. Using extrapolation the IRR can be obtained as follows
107
IRR= Ra +
Positive NPV+ (Rb-Ra)
Positive.NPV+Neg NPV
NPV
IRR
Ra
Rb
R
108