Beruflich Dokumente
Kultur Dokumente
Niall Lothian
John Small
This course text is part of the learning content for this Edinburgh Business School course.
In addition to this printed course text, you should also have access to the course website in this subject, which will provide you with
more learning content, the Profiler software and past examination questions and answers.
The content of this course text is updated from time to time, and all changes are reflected in the version of the text that appears on
the accompanying website at http://coursewebsites.ebsglobal.net/.
Most updates are minor, and examination questions will avoid any new or significantly altered material for two years following
publication of the relevant material on the website.
You can check the version of the course text via the version release number to be found on the front page of the text, and compare
this to the version number of the latest PDF version of the text on the website.
If you are studying this course as part of a tutored programme, you should contact your Centre for further information on any
changes.
Full terms and conditions that apply to students on any of the Edinburgh Business School courses are available on the website
www.ebsglobal.net, and should have been notified to you either by Edinburgh Business School or by the centre or regional partner
through whom you purchased your course. If this is not the case, please contact Edinburgh Business School at the address below:
Edinburgh Business School
Heriot-Watt University
Edinburgh
EH14 4AS
United Kingdom
Tel + 44 (0) 131 451 3090
Fax + 44 (0) 131 451 3002
Email enquiries@ebs.hw.ac.uk
Website www.ebsglobal.net
Accounting
The Accounting programme is written by Niall Lothian, Professor at Edinburgh Business School, Heriot-Watt
University, and John Small, Professor Emeritus at Heriot-Watt University. Both have previously occupied chairs in the
Universitys Department of Accountancy & Finance.
Professor Lothian has taught at IMEDE (now IMD) in Lausanne and is currently a member of the visiting faculty of
INSEAD, Fontainebleau. He has conducted seminars and managerial briefings in Europe, Africa and China, the latter
under the auspices of the United Nations Industrial Development Organisation.
Professor Lothian has been consultant to British government agencies such as the Ministry of Defence and the
Cabinet Office and to a number of international companies including IBM, Atos Origin, Philips, Clifford Chance, Swire
and T-Systems.
His current research and consulting interests include the study of managerial controls over R&D expenditure, a field
in which he has published widely, and the accounting implications of flexible manufacturing systems. A chartered
accountant by professional training, he is a Past President of the Institute of Chartered Accountants of Scotland. He is
the current chairman of the audit advisory board of The Scottish Parliamentary Corporate Body and chairman of
Chiene + Tait CA.
Professor Small was Chairman of the Accounts Commission in Scotland from 1982 to 1991. The Accounts
Commission is responsible for arranging the audit of local government in Scotland and ensuring the proper steps are
taken to achieve economy, efficiency and effectiveness. He has recently served on the board of Scottish Homes.
He is a member of the Council of the Chartered Association of Certified Accountants and was its President in
1982/83. He has been Chairman of the Education Committee of the International Federation of Accountants and a
member of the executive Board of the Union Europenne des Experts Comptables, Economiques et Financiers. He is
an honorary member of the Arab Society of Certified Accountants. He has also held visiting professorships and
external examinerships at various universities and business schools.
His special interest is in the use of financial information in decision making for planning and control. In this area he is a
consultant to a number of organisations and has advised companies and government agencies in the UK and abroad.
Professor Small was made a Commander of the Order of the British Empire in the Queens Birthday Honours, 1991.
Contents
PART 1
Module 1
Module 2
1/1
1.1
Approaching Accounting
1.2
The Reality of Accounting
1.3
What Accounting Is
1.4
Focus on Profit-Seeking Businesses
1.5
Who Are the Users of a Companys Accounting Information?
1.6
For what Sort of Decisions Do these Users Value Accounting Information?
1.7
Common Information Requirements among Users
1.8
The Accounting Equation
1.9
The Accounting Statements
1.10 Sole Trader versus MBA
1.11 Accounting: The External and Internal Functions
Review Questions
Case Study 1.1
1/2
1/2
1/3
1/5
1/5
1/6
1/8
1/8
1/10
1/18
1/19
1/20
1/24
2/1
2.1
Introduction
2.2
What Is Profit?
2.3
The Measurement of Accomplishment
2.4
Another Reason for Opting for Ship and Invoice
2.5
Conventions Underlying Measurement of Sales Accomplishment
2.6
The Measurement of Effort
2.7
Task One: Determining the Consumption of the Means of Production
2.8
Task Two: Determining the Value of Closing Work-in-Progress and Inventories
2.9
Types of Inventory in a Manufacturing Company
2.10 Inventory Valuation Methods
2.11 Valuation of Work-in-Progress and Finished Goods
2.12 Interpreting Profit
2.13 Summary
Appendix 2.1: The Impact of Changing Money Values
Review Questions
Case Study 2.1
Case Study 2.2
Case Study 2.3
2/2
2/3
2/4
2/7
2/8
2/8
2/10
2/15
2/16
2/16
2/18
2/20
2/21
2/21
2/25
2/30
2/30
2/31
Contents
Module 3
Module 4
Module 5
vi
3/1
3.1
Introduction
3.2
The Anatomy of the Balance Sheet
3.3
Fixed Assets
3.4
Current Assets
3.5
Current Liabilities
3.6
Net Current Assets and Net Assets
3.7
Why Does a Balance Sheet always Balance?
3.8
Summary
Review Questions
Case Study 3.1
Case Study 3.2
3/1
3/2
3/3
3/7
3/8
3/9
3/12
3/13
3/14
3/19
3/20
4/1
4.1
Introduction
4.2
Why Are Cash Flow Statements Needed?
4.3
What Is Cash in a Cash Flow Statement?
4.4
Cash: Where Does it Come from? Where Does it Go to?
4.5
Eight Major Categories of Cash Flow
4.6
Worked Example with Commentary
4.7
Do-it-Yourself Example
4.8
Summary
Review Questions
Case Study 4.1
Case Study 4.2
4/1
4/2
4/3
4/3
4/6
4/7
4/10
4/13
4/14
4/19
4/19
5/1
5.1
5.2
5.3
5.4
5.5
5.6
5.7
5.8
5.9
5.10
5.11
5.12
5.13
5/2
5/3
5/4
5/4
5/5
5/6
5/6
5/6
5/8
5/9
5/11
5/12
5/15
Introduction
The Concept of Disclosure
Sources of Disclosure Requirements
Government Legislation The UK Experience
Accounting Standards A Brief History of the UK Experience
Stock Exchange Requirements The UK Experience
Financial Reporting in Action
An Introductory Note on Groups of Companies
Abstract of Annual Reports: The MBA Company and The Award Company
The Accounting Policies
The Consolidated (or Group) Profit and Loss Account (or Income Statement)
The Consolidated (or Group) Balance Sheet
A Concluding Note on MBAs Balance Sheet
Contents
Module 6
Module 7
5/16
5/18
5/21
5/22
5/24
5/28
5/28
5/67
5/113
5/120
6/1
6.1
Introduction
6.2
Ratio Analysis
6.3
Group 1: Liquidity Ratios
6.4
Group 2: Profitability Ratios
6.5
Group 3: Capital Structure Ratios
6.6
Group 4: Efficiency Ratios
6.7
Other Possible Ratios
6.8
Window Dressing
6.9
Putting it all Together: The Dupont Chart
6.10 A One Hundred Per Cent Statement
6.11 Basic Stock Market Ratios
6.12 Summary
Review Questions
Case Study 6.1
Case Study 6.2
6/1
6/3
6/4
6/5
6/7
6/10
6/12
6/12
6/13
6/15
6/16
6/17
6/18
6/24
6/25
7/2
7/3
7/9
7/15
7/19
7/24
7/28
7/32
7/34
7/35
7/36
7/41
vii
Contents
PART 2
Module 8
Module 9
viii
8/1
8.1
What Accounting Is: A Refresher
8.2
Management Accounting Looks Forward
8.3
Where Accounting Fits into a Company
8.4
A Brief Note on what a Manager Does
8.5
The Role of Accounting Information
8.6
Management Accounting in MBA
8.7
Differences between Management Accounting and Financial Accounting
8.8
Management Accounting and Cost Accounting
8.9
Where Costs Come from and an Overview of the Modules to Follow
8.10 Process Costing
8.11 Costs Relevant to Management Decisions
8.12 Other Topics in the Management Accounting Course
8.13 Summary
Review Questions
8/2
8/3
8/4
8/5
8/7
8/7
8/10
8/11
8/11
8/13
8/13
8/15
8/15
8/16
9/1
9.1
Introduction
9.2
Cost: A Deceptively Simple Word
9.3
Variable and Fixed Costs
9.4
Beware the Unitising of Fixed Costs!
9.5
Direct and Indirect Costs
9.6
Traceable and Common Costs
9.7
Product Costs and Period Costs
9.8
Controllable and Non-Controllable Costs
9.9
Standard and Actual Costs
9.10 Engineered and Discretionary Costs
9.11 Another Look at Variable and Fixed Costs: The Break-Even Chart
9.12 Profit from Different Cost Structures
9.13 The Break-Even Chart: An Alternative Display
9.14 Other Ways of Calculating Break-Even Points
9.15 Break-Even Analysis and the Multi-Product Firm
9.16 Contribution and Limiting Factors of Production
9.17 Assumptions Underpinning CostVolumeProfit Analysis
9.18 Summary
Review Questions
Case Study 9.1
Case Study 9.2
9/2
9/2
9/3
9/6
9/8
9/10
9/10
9/10
9/11
9/11
9/11
9/14
9/15
9/16
9/18
9/20
9/21
9/24
9/24
9/31
9/32
Contents
Module 10
Module 11
10/1
10.1 Introduction
10.2 Cost Gathering
10.3 Where Do these Costs Come from?
10.4 Plantwide versus Departmental Rates
10.5 Joint Products and By-Products
10.6 Process Costing
10.7 Process Costing and the Equivalent Unit
10.8 Cost per Equivalent Unit
10.9 Activity-Based Costing
10.10 Traditional Costing versus ABC
10.11 Summary
Review Questions
Case Study 10.1
Case Study 10.2
Case Study 10.3
10/2
10/3
10/3
10/7
10/11
10/15
10/16
10/18
10/22
10/22
10/31
10/32
10/42
10/43
10/43
11/1
11.1 Introduction
11.2 The Dilemma of the Denominator
11.3 Managerial Implications of Absorption versus Variable Costing
11.4 Cost Information for Management Decisions
11.5 Routine and Non-Routine Decisions
11.6 Developing an Analytical Framework
11.7 Finding the Relevant Costs
11.8 The Pitfalls of Full Costing
11.9 Opportunity Costs
11.10 Department versus Company
11.11 Sunk Costs
11.12 Management Decisions in Action
11.13 Closing Down a Unit
11.14 The Special Sales Order
11.15 Should we Process Further?
11.16 Summary
Review Questions
Case Study 11.1
Case Study 11.2
11/2
11/2
11/7
11/7
11/8
11/8
11/11
11/12
11/12
11/13
11/13
11/14
11/15
11/17
11/18
11/20
11/21
11/29
11/30
ix
Contents
Module 12
Module 13
Module 14
Budgeting
12/1
12.1 Introduction
12.2 Why Bother with Budgets?
12.3 Why Budgeting Gets a Bad Name
12.4 Budgeting in Action: The Go-Straight Trolley Company
12.5 Discretionary Expenditure and Zero-Base Budgeting
12.6 Summary
Review Questions
Case Study 12.1
12/1
12/2
12/3
12/7
12/18
12/21
12/22
12/31
Standard Costing
13/1
13.1 Introduction
13.2 Setting Standards
13.3 A Word about Motivation
13.4 Flexible Budgets
13.5 The Anatomy of Variances: Materials and Labour
13.6 Responsibility for Variances
13.7 Variable and Fixed Overhead Analysis
13.8 Investigation of Variances
13.9 Sales Variances
13.10 Summary
Review Questions
Case Study 13.1
13/2
13/3
13/5
13/5
13/7
13/9
13/11
13/16
13/17
13/20
13/21
13/28
14/1
14.1 Introduction
14.2 Why Divisionalise?
14.3 Types of Divisions
14.4 Defining Profits and Investments
14.5 Asset Base Valuation
14.6 Residual Income: An Alternative to ROI
14.7 The Imputed Rate of Interest Does Matter!
14.8 A Cautionary Note about Performance Measures
14.9 Transfer Pricing
14.10 Criteria for Establishing a Transfer Price
14.11 The International Dimension
14.12 Summary
Review Questions
Case Study 14.1
14/1
14/2
14/4
14/5
14/8
14/9
14/10
14/14
14/15
14/16
14/18
14/21
14/22
14/29
Contents
Module 15
Module 16
Investment Decisions
15/1
15.1 Introduction
15.2 The Investment Process
15.3 Concept of Present Value
15.4 Discounted Cash Flow Approach
15.5 Net Present Value (NPV)
15.6 Discounted Cash Flow (DCF) Rate of Return
15.7 Comparison of Net Present Value and DCF Rate of Return
15.8 Investment Appraisal in Non-Revenue and Not-for-Profit Situations
15.9 Risk and Uncertainty and Inflation
15.10 Risk and Uncertainty
15.11 Payoff or Payback Period
15.12 Sensitivity Analysis
15.13 Risk Analysis
15.14 The Key Investment Factors
15.15 Projected Average Cost of Capital
15.16 Average Cost of Capital
15.17 Opportunity Cost, Risk and the Cost of Capital
15.18 Investment Appraisal and Inflation
15.19 Post-Assessment/Continuous Post-Audit of Capital Expenditure Projects
15.20 Summary
Appendix 15.1: Present Value Table
Appendix 15.2: The Calculation of the Internal Rate of Return
Review Questions
Case Study 15.1
15/2
15/3
15/4
15/5
15/6
15/8
15/9
15/11
15/12
15/12
15/14
15/16
15/18
15/20
15/22
15/24
15/24
15/27
15/27
15/28
15/29
15/30
15/31
15/38
16/1
16.1 Introduction
16.2 Target Costing
16.3 Life Cycle Costing
16.4 Throughput Accounting
16.5 Costing for Competitive Advantage
16.6 The Balanced Scorecard
16.7 Time-Driven Activity-Based Costing
16.8 Summary
Review Questions
Case Study 16.1
Case Study 16.2
16/1
16/3
16/11
16/14
16/17
16/21
16/29
16/31
16/32
16/37
16/38
xi
Contents
Appendix 1
Appendix 2
Glossary
Index
xii
A1/1
1/2
1/9
A2/1
Module 1
Module 2
Module 3
Module 4
Module 5
Module 6
Module 7
Module 8
Module 9
Module 10
Module 11
Module 12
Module 13
Module 14
Module 15
Module 16
2/1
2/6
2/14
2/19
2/25
2/31
2/39
2/43
2/45
2/52
2/66
2/75
2/85
2/93
2/99
2/109
G/1
I/1
PART 1
Module 1
Learning Objectives
By the end of this module you should understand:
the value to various groups in society of a knowledge of accounting;
the role of accounting in management;
the need for, and use of, accounting information in decision making within any organisation;
the accounting equation;
the basic layout of the profit and loss account (sometimes called the income statement),
the balance sheet and the cash flow statement;
the distinction between financial accounting and management accounting.
1/1
1.1
Approaching Accounting
Few subjects in a Masters degree course in Business Administration are approached by
students with a greater sense of awe than accounting. Put another way, of all the subjects
typically on offer in an MBA programme, accounting is the one which students would most
prefer to avoid! Why should this be? Here are some reasons which may reflect the readers
thinking as he or she embarks on this course.
Unlike many other MBA disciplines, such as marketing, economics and organisational
behaviour, which are viewed as being intuitive, that is the reader has a fairly good idea of
what the subject is about without prior study, accounting is non-intuitive, requiring the
mastery of rules from the outset.
Accounting is seen to deal exclusively with numbers; many people prefer to deal with
words and ideas.
Because of its concentration on numbers, accounting is considered to be concerned with
precision and accuracy, both of which require a highly developed mathematical mind.
Readers know friends and relatives who have studied for a degree or professional
qualification in accounting; since these people spent many years studying, how can an
MBA course deal with complexities so quickly?
Accounting and accountants are treated by society as being dull and boring! The image,
bolstered by the perceived obsession with numbers and accuracy, is picked up by TV
scriptwriters and producers who stereotype the accountant as being humourless, repetitive, pedantic, unimaginative and incapable of forming close personal relationships!
In an effort to put the readers mind at ease at the outset of the course, two points should
be made.
1. Virtually everyone (whether studying for an MBA or not) who is not a trained accountant views accounting and accountants as set out above.
2. They are all wrong!
1.2
1/2
dividends payable, are not easily discernible in the full set. Shareholders need this information so that they can assess the performance of the company in which they have a stake.
A simple presentation and the medium of communication are as important to accounts as
the financial message.
Accounting numbers attempt to reflect economic activity in an organisation. But there is
no one given view of this activity; two people can form different views. It follows that there
can be no one given set of accounting numbers which must be used. Choice, judgement and
the reconciliation of vested interest prevent the accountant from ever becoming dull and
boring.
Example
A company purchased a residential house in 19x1 in the Georgian New Town of Edinburgh for
use by its senior executives when on company business in Scotland. It cost 100000. In 20x1 the
companys property advisers consider the house would sell for 1500000. The companys
insurers require buildings insurance to be based on its replacement value of 2000000. Which
value should the companys accountant select for recording the asset in the 20x1 accounts?
Precision, accuracy and the need for a mathematical turn of mind may be desirable but not
essential. So often these attributes are confused with numeracy, the skills of reading and
handling numbers and applying to them the basic arithmetical rules of addition and subtraction. A modestly priced calculator will prove to be invaluable! This course is written not only
for those studying for a degree by distance learning but also for managers and others who need
to use accounting numbers in their work. The underlying methodology of accounting will be
explained only where it is essential to the readers understanding of the concepts and his or her
appreciation of how to apply the techniques in the world of business.
1.3
What Accounting Is
Accounting may be defined as a series of processes and techniques used to identify,
measure and communicate economic information which users find helpful in
making decisions.
A definition is like a completed jigsaw: the whole picture is readily visible but it is not
nearly as interesting as the process of fitting all the pieces together. What are the constituent
pieces of the definition?
1.3.1
Example
A cathedral is planning to replace its organ. The organ committee has asked the treasurer for the
following financial information: the range of competitive tenders in money terms; the potential
impact of exchange rates on overseas organ builders tenders; the cost of old organ removal and
preparatory site works; and the impact on power and maintenance costs as compared with the
existing organ. But this information is only one factor in the committees decision making process;
ultimately the decision will also take into account musical and liturgical issues.
1/3
1.3.2
Example
The governments defence procurement establishment is weighing up the potential of placing a
long-term contract with one of three civilian suppliers of laser equipment. Alongside the results of
the militarys experiences with the prototypes under simulated battlefield conditions, the
accountants will lay their estimates of costs of production, the suppliers requirements for capital
equipment to build the production models, the rate at which equipment will depreciate and the
pricing formulae being used by the suppliers.
1.3.3
Example
The charismatic founder and chief executive of a recently Stock Exchange quoted company
suffered a near-fatal coronary thrombosis while golfing two weeks before the end of the financial
year-end. On the same day one of the companys sales reps replaced the two rear tyres on his
company car. Because the accountant can identify and measure the economic impact of the latter
event, it is accounted for, while the former event, one which could have a long-term negative
effect on the performance of the company, escapes recording.
1.3.4
Example
A national charity is about to launch a fund-raising campaign. The financial controller compiles
financial information in pie-chart format which reveals that all but a small percentage of income is
spent directly on the charitys objectives; on the other hand the information required by the
governments tax authorities, the Inland Revenue, require accounting numbers to be presented in
a totally different manner. It would not be unfair to say that accountants have a lot of work still to
do to improve their communications skills: too often accountants forget that users cannot
understand accounting numbers as easily as they can.
1/4
1.4
Answer
They are all concerned with the raising and spending of money and the control of scarce
resources through budgets. To this extent, accounting is a universally applicable
management tool employing universally applicable principles. But the detailed procedures and rules governing, say, a brewery and a government department are so diverse
that it would be wise to focus on only one sector during this course. We have selected
the profit-seeking private sector, and specifically manufacturing industry within this
sector. We do this for three reasons.
1. Managers and other readers who work for the not-for-profit sector very often have
personal investments in profit-seeking private sector companies and are interested in
tracking the performance of their investments.
2. The thrust of governments financial management in many countries today is towards
privatisation, i.e. adopting the techniques and performance measures of the private
sector.
3. We believe that a manufacturing industry setting enables students to grasp the
principles and procedures of accounting more easily than any other. Once these
principles are understood they can be applied in other commercial and social settings. Reference will be made to other settings where appropriate.
1.5
Directors
Senior executives
Managers
Employees (and trade unions)
1/5
External users
1.6
Shareholders
Analysts
Creditors
Tax authorities
The public
Senior executives
Managers
Employees
Shareholders
1/6
Number of ordinary
shareholders accounts
Number of shares
(millions)
4 770
41 386
69 002
475
275
187
2
5
66
17
23
31
Percentage of
issued share
capital
0.3
0.8
10.6
2.7
3.7
5.0
335
478
622
76.9
100
116 430
The law recognises all shareholders as being equal, but note that the 335 shareholders
(institutional investors like pension funds) who own over one million shares each combine
to own just under 77 per cent of the entire share capital while the 4770 shareholders who
each own fewer than 100 shares possess just 2 per cent on this scale!
Analysts
Creditors
Tax authorities
The Public
1/7
1.7
1.8
OWNERS EQUITY
LIABILITIES
or
ASSETS
LIABILITIES
OWNERS EQUITY
This accounting equation underpins the entire accounting recording system. A simple
example will show how this equation works by examining a series of actions through a
period of time. For illustration, we use the economic events associated with an individual
starting up in business rather than using the more complex world of companies like MBA.
But exactly the same accounting equation would be used to record the activities of MBA or
any company or partnership as the ones we will employ below.
Action 1
The amount of owners equity signifies the owners claim over the assets of the enterprise.
At the conclusion of this action, the individuals stake in the business is worth 20000,
represented by cash of 20000.
1/8
Action 2
Action 3
Here we see an acquisition of another asset, inventories, financed by the suppliers of the
inventories. Eventually the business will have to pay this amount in cash; until it does, the
creditors remain a liability. How much is the owner now worth? Still 20000, represented by
assets totalling 26000 less 6000 owed to his creditors.
Action 4
Here, the 20 cash spent on labour is assumed to add value to the raw material inventory of
500 all of which the business would hope to recover in the eventual selling price.
Action 5
1/9
The finished goods inventory has been reduced to zero. The company has made 230 profit
on this transaction, which increases the owners equity. An asset called debtors is created
because cash has not yet been received for the sales. On its own the above transaction looks
like this:
Change in finished goods inventories 520
Change in debtors 750
Change in owners equity 230
Action 7
3000 of the amount due to suppliers is paid along with an advertising bill
of 10. At this point the machine which has an effective working life of
24000 hours has been used for 100 hours.
= Owners equity 20160 +
Cash 4960 + Plant 11 950 +
Raw material inventories 5500
Creditors 3000
+ Debtors 750
The payments to suppliers are a straightforward matter, reducing cash and creditors by the
amount 3000 paid over. The advertising bill is paid in cash too and must reduce the owners
equity this is an expense of being in business, just like the accountants fee.
The use of machinery implies that the machine wears out, a process known as depreciation, yet another expense of operations. Since the effective working life was 24000 hours
and the equipment cost 12000, for every hour used the machine will cost 0.50. (This
method of calculating depreciation is known as the consumption method; there are others.)
For 100 hours the depreciation charge is 50: the value of the plant is reduced by 50 and
the owners equity is reduced by 50. Note that no cash outlay is involved with the depreciation charge. Depreciation is examined in Module 2.
At this stage, or any earlier one for that matter, it is possible to determine the profit made
by comparing the owners equity at the beginning of the period under review with the
balance on the owners equity at the end of the period. If it has increased the owner has
made a profit; if it has decreased he has made a loss. In the example the profit is 160
(20160 less 20000).
The accounting equation is a collection of balances after each transaction has been completed and recorded. Note that the accounting entries involve a mixture of cash-driven items
and judgement-driven items. This equation can also be laid out in a more meaningful fashion
called a balance sheet.
1.9
Assets
Cash
Plant and equipment
Inventories
Debtors
4 960
11 950
5 500
750
23 160
1/10
Owners equity
20160
Creditors
3000
23160
The layout of this balance sheet could be improved to give a clearer picture of the financial
position of the company at the end of Action 7.
Fixed assets
Plant and equipment at cost
Less: Depreciation
Current assets
Inventories
Debtors
Cash
Less: Current liabilities
Creditors
Net assets of the company
Represented by:
Capital introduced
Profits earned
Owners equity
12000
50
11950
5500
750
4960
11210
3000
8210
20160
20000
160
20160
10
+230
10
50
+160
1/11
500
20
50
10
10
750
570
180
20
160
As can be seen, profit is simply the excess of sales revenue over costs incurred in generating
the revenue. Items of expenditure accounted for via the profit and loss account we call
revenue expenditure; items of expenditure accounted for via the balance sheet we call capital
expenditure. In the example the profit and loss account has been created from the preceding
data relatively easily. However, this procedure can become very complex in a multi-product,
multi-plant company engaging in thousands of transactions daily. Accountants have
therefore devised a continuous recording system based on the double-entry procedure
encountered in the previous section which eliminates the need to calculate the effect on
profit and owners equity after every transaction but which will continue to provide the
useful information in profit and loss account format whenever it is required. These detailed
procedures of bookkeeping are the accountants job, not the managers.
So far the two accounting statements have produced information on:
(a) the profitability of the company for the seven actions listed; and
(b) the financial position of the business at the end of Action 7.
Neither statement, however, reveals anything about the cash position which is important
to many users of financial information:
Directors
Senior executives
Managers
Employees
Shareholders
Creditors
Tax authorities
Profit is not the same as cash. There are many reasons for this: one such reason can be
readily understood by considering the nature of the sales figure of 750 which gives rise to
the reported profit. The business has not received payment for the sales at the time the
profit and loss account is drawn up. But, provided the owner believes the debtors will pay
the amount shortly, it is an accounting convention that recognises this figure as if the money
1/12
has been received when calculating profit. Also, depreciation is a deduction from sales
revenue before profit is determined but has no effect on cash.
A third accounting statement, the cash flow statement, portrays only those economic
events of a business which affect cash flows. For the example above the cash flow statement
would be as follows:
Cash flow statement for the period to Action 7
Sources of cash
Profit from operations
Adjusted for non-cash items: depreciation
160
50
210
Capital introduction
Increase in creditors
20000
3000
Uses of cash
Purchase of plant
Increase in debtors
Increase in inventories
Closing balance of cash
12000
750
5500
23000
23210
18250
4960
1/13
Note that the layout of the cash flow statement above, and the profit and loss account
and balance sheet before it, are skeletal and simplistic. Readers will be guided through more
realistic layouts of the three financial statements in the next three modules.
Do-it-Yourself Example
In the space provided below each action for Forth Enterprises you should construct the
accounting equation which reflects the transaction(s). At the end of Action 12 draw up a
balance sheet, profit and loss account and cash flow statement adopting the layouts given in
the text.
Action 1
Fred Forth commences business with 40000 from his own savings and a further 10000
cash from his cousin. His cousin informs Forth that he is not looking for interest or early
repayment.
Action 2
Forth buys the following assets: plant and equipment 5000 cash, factory and warehouse
25000 cash, and raw materials 8000 (half by cash, half by credit).
Action 3
Before the equipment can function properly, it requires a post-installation lubrication costing
200. Forth pays for this in cash. Raw materials worth 4000 are then processed into
finished goods through the equipment at a labour cost of 400.
Action 4
Forth pays his creditors in full and sells half of the finished goods (recorded at cost of
2200) for 4000 credit.
Action 5
Forth buys a second-hand delivery van for 3000 on credit and a typewriter for his secretary
for 200 cash.
Action 6
Forth sells the remainder of the finished goods (recorded at a cost of 2200) for 3900 cash,
and receives payment of 3900 from his debtors.
Action 7
The delivery van breaks down and requires 100 of repairs which Forth pays for in cash. He
buys further raw materials for 6000 cash and processes the remainder of his first batch of
raw materials (which had cost 4000) at a cash cost for labour of 300.
1/14
Action 8
At Christmas, Forth buys his wife a foodmixer costing 100 and his secretary a designer
evening gown costing 1200. He pays for both items using his credit card.
Action 9
He sells his second batch of finished goods (which are recorded at a cost of 4300) for
6000, receiving half of the money in cash and giving credit for the other half. He pays off
his creditors.
Action 10
Forth pays 400 cash for advertising and 200 cash for audit fees; he also has all of his raw
materials (cost 6000) processed, his labour force incurring 1000 wages in so doing.
Action 11
His auditors advise him that he should write off the debt of 100 which has been outstanding since Action 4; in their opinion this debt is now irrecoverable. They also recommend that
he provides for depreciation on plant and equipment at a rate of 10 per cent and on motor
vehicles at 25 per cent.
Action 12
Forth considers that one-fifth of his factory and warehouse space is excessive for his needs;
he sells that part for 7000 in cash. He withdraws 2000 in cash for personal needs.
1.9.1
Worked Solution
Action 1
Cash 50000 = Owners equity (OE) 40000 + Long-term loan (LTL) 10000.
Action 2
Plant and equipment (P&E) 5000 + Factory and warehouse (F&W) 25000 + Raw material
inventory (RMI) 8000 + Cash 16000 = OE 40000 + LTL 10000 + Creditors 4000.
Action 3
P&E 5200 + F&W 25000 + RMI 4000 + Finished goods inventory (FGI) 4400 + Cash
15400 = OE 40000 + LTL 10000 + Creditors 4000.
Note that the post-installation lubrication has been capitalised. We can gather from the
action that the equipment would not work without this lubrication and so we can add this
cost to the original purchase price. Any further maintenance on this equipment would be
expensed, i.e. written off against Owners equity.
1/15
Action 4
P&E 5200 + F&W 25000 + RMI 4000 + FGI 2200 + Debtors 4000 + Cash 11400
= OE 41800 + LTL 10000 + Creditors 0.
Action 5
P&E 5400 + F&W 25000 + Motor vehicles (MV) 3000 + RMI 4000 + FGI 2200 +
Debtors 4000 + Cash 11200 = OE 41800 + LTL 10000 + Creditors 3000.
Action 6
P&E 5400 + F&W 25000 + MV 3000 + RMI 4000 + FGI 0 + Debtors 100 + Cash
19000 = OE 43500 + LTL 10000 + Creditors 3000.
Action 7
P&E 5400 + F&W 25000 + MV 3000 + RMI 6000 + FGI 4300 + Debtors 100 +
Cash 12600 = OE 43400 + LTL 10000 + Creditors 3000.
Action 8
No change from Action 7. This action represents personal expenditure and does not affect
Freds business records.
Action 9
P&E 5400 + F&W 25000 + MV 3000 + RMI 6000 + FGI 0 + Debtors 3100 +
Cash 12600 = OE 45100 + LTL 10000 + Creditors 0.
Action 10
P&E 5400 + F&W 25000 + MV 3000 + RMI 0 + FGI 7000 + Debtors 3100 +
Cash 11000 = OE 44500 + LTL 10000.
Action 11
P&E 4860 + F&W 25000 + MV 2250 + FGI 7000 + Debtors 3000 + Cash 11000
= OE 43110 + LTL 10000.
Action 12
P&E 4860 + F&W 20000 + MV 2250 + FGI 7000 + Debtors 3000 + Cash 16000
= OE 43110 + LTL 10000.
1/16
Sales
Less: Cost of sales
Raw materials
Labour
Depreciation on plant and
equipment
13900
8000
700
540
Gross profit
General expenses
Motor repairs
Advertising
Depreciation on motor vehicles
Bad debt
Audit
Net profit from operations
Extraordinary profit from sales of factory (see note)
Net profit
100
400
750
100
200
9240
4660
1550
3110
2000
5110
Note: The sale of a fixed asset produces a gain (or loss) when the proceeds received by the
business exceed (or are less than) net book value, that is, purchase price less depreciation
charged to date. Such gains (or losses) are not part of the normal profits from operations
and should be shown separately in the profit and loss account.
Balance sheet at the end of Action 12
Fixed assets
Factory and warehouse
Plant and equipment
Motor vehicles
Current assets
Finished goods
Debtors
Cash
Less: Current liabilities
Net assets of the company
Represented by:
Capital introduced
Profit
Less: Drawings
Owners equity
Long-term loan
7 000
3 000
16 000
20000
4860
2250
26000
40000
5110
45110
2000
43110
10000
27110
26000
53110
53110
1/17
Sources of cash
Profit from operations
Adjusted for non-cash items depreciation
Capital introduction
Long-term loan
Sale of factory and warehouse
Uses of cash
Purchase of assets
1.10
3 110
1 290
40 000
10 000
25 000
5 400
3 000
7 000
3 000
4400
50000
7000
61400
33400
10000
2000
45400
16000
1.10.1
Sole Trader
A sole trader like the individual in the example (Actions 1 to 7) can start trading at any time
with assets at his disposal. He must, however, distinguish between the transactions that
pertain to his business and those that are domestic in nature. For example he would record
as business expenditure petrol for his delivery van but his weekly groceries would not go
through his books of account. The link between the two would be the drawings or salary he
paid himself out of the business profits.
In law he has unlimited liability. This means that if a customer or supplier or other person
connected with his business sues him for poor workmanship or providing goods which are
dangerous, not only are his business assets at risk but so too are his personal assets such as
his home and domestic possessions. Because his creditors can pursue him beyond the limit
of his business there is no requirement for him to make public his profit and loss account
and balance sheet each year. He will, of course, make an annual tax return to the tax
authorities and be taxed on his yearly profit.
1/18
1.10.2
Partnership
A partnership is very similar to the situation of a sole trader. Here a number of individuals
agree to set up business together, bringing to the partnership assets in varying proportions.
Before they start trading they will normally draw up a partnership agreement which sets out,
inter alia, how they will share the annual profit. As with the sole trader, a partnership need
not make public its annual results because its creditors can pursue the partners beyond the
limit of their equity in the partnership. Some worldwide accounting partnerships are facing
legal actions from clients which, if successful, may put in jeopardy the continuance of the
partnerships. One such firm, Arthur Andersen, has already gone out business over its work
with Enron. Various defences are currently being mounted by the Big Four accounting firms
including pressing governments to permit proportional liability and limited liability partnerships.
1.10.3
Company
A company structure avoids the risk of unlimited liability described above by limiting the
liability of the owners (called shareholders) to the amount of equity (called share capital) paid
into the company. In the event of legal action being taken against the company, shareholders
cannot lose any more money than the sum paid for the shares (provided the full face value
of the shares has been called up by the company).
To protect creditors and others against abuse of this legal privilege companies must make
public their annual accounts which must be audited by a registered firm of auditors. This is
an expensive procedure and forces disclosure of business activities which sole traders and
partnerships do not experience.
A companys owners equity is termed share capital and is split into individual shares
usually expressed in small units of, say, 1. This small amount is the face value of the share,
called the par value, or nominal value (MBAs nominal value is 1). When a company grows in
size and number of shareholders, its accounting equation is unaffected by any market
transaction in its shares, even though the price struck between buyer and seller is considerably in excess of par value. The company still has access to the original paid-in capital.
1.11
1/19
management need detailed and relevant information. From the accounting process they need
actual and projected costs and prices of individual products, actual and projected costs of
individual departments and individual processes, projected sources and uses of cash,
proposals for major investment in plant and equipment, and many other details. This
information is called management accounting.
The first seven modules of this course are devoted to financial accounting for managers;
the following nine modules address management accounting for decision making.
Review Questions
Multiple Choice Questions
1/20
1.1
1.2
Accounting information is used by different groups of people for different primary purposes. They
are:
i. shareholders concerned with the level of employee remuneration;
ii. managers concerned with the profitability of product lines;
iii. creditors concerned with the companys ability to settle debts on time;
iv. analysts concerned with the companys environmental record.
Which of the following is correct?
A. (i) and (ii) only.
B. (i) and (iv) only.
C. (ii) and (iii) only.
D. (ii) and (iv) only.
1.3
Which of the following reflects the effects on the accounting equation of a payment to creditors?
A. Assets decrease; owners equity decreases.
B. Assets decrease; owners equity increases.
C. Assets increase; liabilities decrease.
D. Assets decrease; liabilities decrease.
1.4
Which of the following reflects the effect on the accounting equation of a sale of finished goods
inventory, on credit?
A. Assets decrease; owners equity unchanged.
B. Assets decrease; owners equity increases.
C. Assets increase; owners equity increases.
D. Assets increase; owners equity decreases.
Edinburgh Business School Accounting
1.5
Which of the following reflects the effect on the accounting equation of a purchase of an item of
plant, for cash?
A. Assets increase; owners equity decreases.
B. Assets unchanged; owners equity increases.
C. Assets decrease; owners equity unchanged.
D. Assets unchanged; owners equity unchanged.
1.6
Which of the following economic actions reduces the amount of owners equity?
A. A payment of administration wages.
B. A receipt of cash from debtors.
C. A receipt of a loan from the owners brother.
D. A payment for production wages.
1.7
Which of the following economic actions increases the amount of owners equity?
A. A purchase of raw material inventory, on credit.
B. A sale of finished goods, on credit.
C. A payment for a motor vehicle.
D. A payment to creditors.
1.8
Which of the following economic actions increases the amount of current assets?
A. A receipt of cash from debtors.
B. A purchase of raw material inventory, on credit.
C. A purchase of raw material inventory, for cash.
D. A payment to creditors.
1.9
Which of the following economic actions decreases the amount of current assets?
A. A payment for production wages.
B. A purchase of plant, on credit.
C. A purchase of plant, for cash.
D. A receipt of cash, from debtors.
The following information applies to Questions 1.10 to 1.22.
Action 1
T. Harding & Co. has commenced business with a start-up cash balance of 15000, comprising
the initial owners equity. His first actions are to purchase a van, costing 5000, for cash; he then
acquires 8000 of raw materials inventory, on credit.
1.10
1/21
1/22
1.11
1.12
Action 2
Plant is purchased at a cost of 4000, on credit, and 200 is paid in wages to the production staff
for the conversion of the raw materials into finished goods inventory, half of which is sold for cash
of 7000.
What is the amount of cash after Action 2?
A. 8800.
B. 16800.
C. 21800.
D. 24800.
1.13
1.14
1.15
Action 3
Payment of 5000 is made to creditors. The van breaks down, incurring repair costs of 350, paid
for in cash. Depreciation of 400 on plant is to be taken into account.
What is the amount of finished goods inventory after Action 3?
A. 3700.
B. 4100.
C. 4500.
D. 4850.
1.16
1.17
1.18
Action 4
The remaining finished goods inventory is sold for 8500, on credit. Payments of administration
wages of 500 are made, together with a further 2000 to creditors.
What is the amount of cash after Action 4?
A. 8950.
B. 9350.
C. 17 050.
D. 22 450.
1.19
1.20
1.21
1.22
If a profit and loss account were to be prepared at the end of Action 4, what should be the
amount of sales?
A. 7000.
B. 8200.
C. 8500.
D. 15 500.
1.23
1.24
1/23
1.25
Which of the following should be the primary source of cash in the preparation of a cash flow
statement?
A. Profit from operations.
B. Decrease in debtors.
C. Increase in creditors.
D. Introduction of capital.
1.26
In which of the following is owners equity divided into individual shares with a nominal value?
A. A university.
B. A partnership.
C. A company.
D. A sole trader.
1/24
Prepare the accounting equations after each of these economic actions; include depreciation with
Action 6.
Prepare a profit and loss account for the six months to 30 June and a balance sheet as at that
date.