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Finance for Management Decision- Making

James Brown

Donald MacAskill

Andy Moffat

Release 1.1 2012

www.napier.ac.uk/business-school

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Published by Edinburgh Napier University

The rights of James Brown, Donald MacAskill and Andy Moffat to be identified as authors of this work have been asserted by them in accordance with sections 77 and 78 of the Copyright, Designs and Patents Act 1988.

Apart from any fair dealing for the purpose of research or private study, or criticism or review, as permitted under the Copyright, Designs and Patents Act 1988, this publication may only be reproduced, stored or transmitted, in any form or by any means, with the prior permission in writing of the publishers, or in the case of reprographic reproduction in accordance with the terms and licenses issued by the Copyright Licensing Agency.

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Captured, authored, published, delivered and managed in XML CAPDM Limited, Edinburgh, Scotland www.capdm.comCapdm

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iii

Contents

1 Financial Reporting 1 1.1 Introduction 1 1.2 Annual Reports 1 1.3 Users of Financial Reporting 6 1.4 Characteristics of Accounting Information 8 1.5 Summary 10

2 Basic Financial Statements 11 2.1 Introduction 11 2.2 Accounting Concepts 11 2.3 Financial Statements 14 2.4 Summary 30

3 Limited Liability Companies 33 3.1 Introduction 33 3.2 Types of Business Entities 33 3.3 Financial Statements of Limited Liability Companies 35 3.4 Statement of Changes in Equity 40 3.5 Regulatory Framework 40 3.6 International Accounting Standards 43 3.7 Consolidated Financial Statements 43 3.8 Summary 45

4 Profit v. Cash 47 4.1 Introduction 47 4.2 Cash Budgeting 49 4.3 Cash Flow Statements 53 4.4 Summary 56

5 Interpretation of Financial Statements 59 5.1 Introduction 59 5.2 Ratio Analysis 60 5.3 Shareholders’ Investment Ratios 70 5.4 Limitations of Ratio Analysis 71 5.5 Summary 71

6 Segmental Reporting 73 6.1 Introduction 73 6.2 Discontinued Operations 74 6.3 Segmental Reporting 76 6.4 Summary 80

7 Management Accounting 81 7.1 Introduction 81 7.2 Financial v Management Accounting 82 7.3 Main Purposes of Management Accounting 83 7.4 Cost Accounting 88 7.5 Job and Service Costing 99 7.6 Summary 104

8 Decision-Making − Cost Behaviour 107 8.1 Introduction 107 8.2 Cost Behaviour 108 8.3 Breakeven Analysis 111 8.4 Decision-Making 114 8.5 Summary 117

9 Decision-Making − Relevant Information 119 9.1 Introduction 119

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Contents

9.2 Relevant Costs 120 9.3 Limiting Factors 124 9.4 Multiple Limiting Factors 126 9.5 Uncertainty 130 9.6 Attitude to Risk 133 9.7 Qualitative Factors 134 9.8 Summary 134

10 Performance Management 137 10.1 Introduction: The Crisis in Management Accounting 137 10.2 The Development of Strategic Management Systems 138 10.3 The Balanced Scorecard 138 10.4 Stern Stewart’s Economic Value Added (EVA)TM 142 10.5 Summary 147

11 Capital Investment 151 11.1 Introduction 151 11.2 Payback 152 11.3 Accounting Rate of Return 154 11.4 Discounted Cash Flow 155 11.5 Net Present Value 156 11.6 Internal Rate of Return 159 11.7 Summary 161

12 Working Capital Management 163 12.1 Introduction 163 12.2 Inventory 164 12.3 Trade Receivables 167 12.4 Trade Payables 170 12.5 Cash 171 12.6 Summary 173

Index 175

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Chapter

Chapter 1

Financial Reporting

1.1 Introduction 1 1.2 Annual Reports 1 1.3 Users of Financial Reporting 6 1.4 Characteristics of Accounting Information 8 1.5 Summary 10

Learning Objectives

After completing the study of this unit you should be able to:

• identify the key contents in a company’s annual report

• list a number of different user groups who might be interested in reviewing aspects of a company’s annual report

• appreciate the useful characteristics that information in the annual report should possess

• reflect on the objectives of financial reporting.

1.1 Introduction

Public limited companies are required, after each year-end, to publish their annual report and accounts. This document is sent to each of the shareholders of the company so that they can review how well the directors, who have been appointed by the shareholders to run the business on their behalf, have handled the company’s affairs over the past year.

The document includes financial statements, which report firstly on the company’s perform- ance over the trading period, in particular whether the company has achieved growth during the year, and secondly on the company’s financial position at the end of the year. The report is also used as a guide to predict what might happen in the future. For this reason, the annual report contains a lot of narrative identifying events which have influenced past performance, and changes that are likely to occur in the future.

Copies of the annual report and accounts must also be filed with the Registrar of Companies so that they are available for public inspection. Copies are also often sent to the company’s key customers, suppliers and other stakeholders.

Large companies also issue interim reports every six months to update their shareholders, primarily on financial matters, but these interim reports are on a much less detailed scale than the annual report.

1.2 Annual Reports

The annual report and accounts of a public limited company (plc in the UK) usually takes the form of a glossy booklet. This booklet tries to combine positive promotional messages from the management team, which often includes coloured pictures and graphs, with the not-so-exciting, statutory, legal and financial information.

The subsections which follow should give you an idea of what you might expect to find in a typical company’s annual report. In an attempt to link into the real world, the information on a recent annual report of Vodafone plc is included at the end of most sections.

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Note: As the company is based in the UK, references may be made in the text to legal and statutory requirements for UK financial reporting. However the study text will also make reference to the International Accounting Regulations which are mandatory for multi-national enterprises such as Vodafone.

1.2.1 Operating and Financial Review

The professional accounting bodies in the western world have recommended that large com- panies should include an operating and financial review (OFR) in their annual report and accounts.∗ The reason for this suggestion was that, over the past 20 years or so, businesses had become much larger, more diversified, more multinational, and therefore, much more complex. For many users it was becoming increasingly difficult to understand the information contained in financial reporting because complex financial and organisational structures made it harder to interpret the results.

The OFR gave the directors of a company an opportunity to discuss and explain, in a structured and comprehensive way, some of the key factors affecting the business and the environment in which it operates. The OFR covers two main areas:

• the operating review includes a discussion of the results for the period, indicating the factors that may affect future performance, and a discussion on the areas in which the business is investing to meet these future challenges

• the financial review covers aspects such as the capital structure of the business, current debt position and future borrowing requirements, cash flow, treasury activities and the tax situation.

Although not mandatory, most companies regard the inclusion of an OFR in the annual report as good practice.

The OFR in the annual report of Vodafone plc is a mixture of graphs and bar charts covering results, operations, product volumes, market shares and financial data. It is presented in a very user-friendly manner and gives the reader a good insight into what happened in the past and where the company might be heading in the future.

1.2.2 Chairman’s Statement

Another statement that is not mandatory, but which you often find early in the annual report, is a statement from the chairman. This gives the chairman of the company an opportunity to report on the performance of the organisation during the past financial period and on likely future developments.

The chairman of Vodafone plc included a discussion on the following in his statement:

• summary results and comment on the market position of each business segment

• economic issues affecting performance, for example effects of the recent financial crisis

• continued cost improvements in production and distribution without any loss to customer service

• acquisitions and disposals

• changing focus of the business for the future.

Typical of a chairman’s statement, the report is extremely positive, leaving the owners with the belief that shareholder returns would improve as the company faced the future with confidence.

The US equivalent is management discussion and analysis.∗

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1.2.3 Chief Executive’s Statement

Chief executives’ statements include a lot more about the detail behind the overall perform- ance. The operation of the business is broken down into products, markets and geographical areas of activity and a review of these operations outlines the factors affecting current per- formance and expected changes for the future. The statement will include some brief financial highlights including the recommended dividend payable to shareholders.

Vodafone plc covered the following in its chief executive’s report:

• turnover, profit and the recommended final dividend, which had all risen

• a report of the international divisions, highlighting market share gains, cost savings, increased production efficiency and strong international growth.

1.2.4 Directors’ Report

The Companies Act 2006 (UK Law) states that each year the directors are to prepare a report that gives information, among other things, about the activities of the business, its role in the community and its dividend recommendations. The directors’ report should also make shareholders aware of material movements in the ownership of the issued share capital.

Vodafone plc used the following subsections to comply with the statutory requirements of a directors’ report:

• group results

• dividends

• business review and future developments

• special business from the annual general meeting

• share capital movements

• payment of suppliers

• directors

• employee relations and involvement

• political and charitable contributions

• auditors.

Following the publication of the Cadbury Committee report in 1992, the directors’ report must now include a section on corporate governance, defined by the Cadbury Committee as ‘the system by which companies are directed and controlled’.

During the 1980s and 1990s, financial scandals like BCCI and Polly Peck led to a lack of confidence in many aspects of financial reporting, with shareholders questioning whether they could depend on auditors to provide the necessary safeguards for their reliance on company annual reports and accounts. The directors’ report should now include details about the company’s system of internal control and its committee structure.

If you doubted the significance of corporate governance, then a review of the annual report of Vodafone plc ought to reassure you because there are several pages devoted to this topic. Areas covered include:

• how the Board of Directors functions

• communication with institutional and private shareholders

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• the workings of the Accountability and Audit Committee

• the Board remuneration report

• statement of going concern.

As an area, corporate governance will always be relevant to the providers of accounting information. The Cadbury Code, for example, was followed by the Greenbury, Hempel, Combined and, more recently, the Higgs and Walker Review in 2010. You can access these codes and evaluate their contribution to the development of corporate governance at the website www.ecgi.org/codes/all_codes.php

1.2.5 Annual Accounts

The annual accounts section of an annual report usually contains three areas:

1. Financial statements

International Accounting Standard 1 (IAS1) covers the form and content of financial statements and the main components are likely to be: the income statement, the balance sheet, the statement of changes in equity and the cash flow statement. Taken together, these statements tell you how the company performed over the trading period and what its financial position is at the end of the trading period. You will learn a lot more about these statements as you work through the study units.

If the company operates as part of a group, the results of all the group members are consolidated and the financial statements listed above will be presented in consolidated form.

2. Accounting policies

Immediately following the financial statements in the annual report is a listing, required by the Companies Act, of the accounting policies adopted by the company in determining the amounts shown in the income statement and the balance sheet. Policies can cover such areas as how inventory (UK: stock) was valued or how research and development expenditure is accounted for.

3. Notes to the accounts

In order to keep the main financial statements as user-friendly as possible, only the key figures are required to be disclosed on the face of the statements. The detail behind each of these figures is relegated to the supporting disclosure notes.

In summary, the criteria for selecting information to appear in the published financial statements are as follows:

• the statements should present a true and fair view of the profits, assets and liabilities

• the information must comply with fundamental accounting concepts

• the statements should be presented in the prescribed formats

• the detail behind the key figures on the statements should be disclosed by way of notes to the accounts.

The accounts section in the annual report of Vodafone plc consists of the group income statement, the group and parent company balance sheets, the group statement of changes in equity and the group cash flow statement. Following these statements are pages of ‘notes to the accounts’, which include the accounting policies adopted by the company. The financial statements and related notes are presented alongside comparative figures for the previous

http://ecgi.org/codes/all_codes.php

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trading period, enabling users to see, at a glance, significant movements in the key financial areas.

1.2.6 Audit Report

Another statutory requirement for most limited companies is an annual audit of the accounts. To safeguard the interests of the shareholders, who are often not involved in the day-to-day running of the business, an external, independent firm of accountants is appointed by the shareholders to act as auditors. Their duty is to report objectively to the shareholders as to whether, in their opinion, the financial statements show a true and fair view and comply with statutory, regulatory and accounting standards’ requirements. Having made reference to the respective responsibilities of the directors and auditors in preparing and reviewing the annual report, the audit report then concludes with an opinion of the accounts and the state of the company’s affairs.

1.2.7 Environment Report

Over the past 10 years or so, companies have come under more and more pressure from the general public to include comments in their annual reports about environmental and social issues. Environmental issues naturally focus on recycling, pollution and the treatment of waste. Social issues may include equal opportunities employment, health and safety, training and the role the company plays in the local community. The increased attention paid to these topics, follows concerns that traditional reporting, with its financial emphasis, has been geared towards the requirements of the shareholders, with perhaps too little regard for the other stakeholders. Although there is no compulsory requirement for companies to comment on environmental and social issues, and there is no consensus on the best practice for reporting these topics, most large companies have reacted positively to the need for such reporting.

Vodafone plc devote a couple of pages within the annual report to ‘our stakeholders’, clearly deeming their stakeholders to be employees, shareholders, the community and environment- alists. Key issues affecting each of the stakeholders are only covered in ‘bullet point’ format within the annual report.

1.2.8 Five-year Record

A common debate among financial analysts is the issue of how many year’s worth of figures they need to review before determining whether or not a trend can be established. Comparative figures from the previous year’s financial statements are presented alongside the current year’s figures for ease of comparison. However, to enable further interpretation, companies often include a five-year summary of some of their key financial data.

Vodafone plc include the following data in their five-year summary:

• sales

• profit

• assets employed

• loans

• share capital

• dividend per share

• earnings per share.

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1.2.9 Notice of Annual General Meeting (AGM)

At the end of the annual report, shareholders are given notice of the time, date and venue of the company’s AGM. Shareholders who own any voting shares, will be entitled to vote on a number of different issues to be considered at the meeting.

The shareholders of Vodafone plc were to consider the following resolutions at its AGM:

• approve the Report of the Directors and the Annual Accounts

• re-elect the directors

• re-appoint the auditors

• special business.

1.3 Users of Financial Reporting

The objective of financial reporting is to provide information that is useful to a wide range of users, both internal and external to the enterprise. This information will encompass details about the financial position, the financial performance and changes in the financial condition of an organisation. Financial reporting consists of the financial statements as well as supplementary information provided by way of commentaries, forecasts and appraisals.

So who needs financial information, what do they need to know and what might they have found in the latest annual report of Vodafone plc?

The main users are shown in Figure 1.1.

Figure 1.1 Main users of financial reporting

1.3.1 Shareholders/Investors − Current and Potential

These are the people who have invested in the company and, as shareholders, are part-owners of the organisation. However, having appointed the directors to look after their investment, they need to check how effectively the management team is running the business. As the providers of the equity capital, they are primarily interested in the return they might receive from their investment and the risk associated with it. In the short term, returns should come in the form of an annual dividend while, hopefully, in the longer term, the capital value of their investment will increase as the company prospers.

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Current shareholders need to decide whether to retain or dispose of their investment, while potential investors need to weigh up the costs and benefits of making the investment. Both investors and shareholders need information about the profitability of the business in order to assess its financial strength and future prospects.

1.3.2 Suppliers

Suppliers are primarily interested in the ability of the company to meet its obligations and pay for goods and services received on an ongoing basis. If the supplier is highly dependent on the reporting company for a substantial proportion of its business, then it is likely to have an increased interest in the company’s long-term viability as well.

Suppliers to Vodafone plc would have been interested in the following:

• market expansion

• current creditors’ payment period

• reliance on debt to finance the business.

1.3.3 Competitors

With all users having easy access to the annual reports of public limited companies, directors need to be very careful when considering the content, particularly non-statutory, to be included in the annual report. A balance needs to be struck between providing relevant information to the company’s stakeholders while at the same time ensuring their rivals cannot gain any competitive advantage.

Competitors will want information on market share, product performance, financial strength and capital structure. They may be looking at the possibility of a take-over or a merger. Perhaps they are looking to invest in new products and new markets to pose even more of a threat within the industry.

1.3.4 Customers

The interest of customers in the financial results of a company depends on the extent to which the customer is dependent on the company for supply of the product. The customers of Vodafone plc should take heart from the statement of the annual review, ‘investing to satisfy our customers’, which makes reference to training and marketing initiatives to ensure customer satisfaction.

1.3.5 Employees

In the short term, employees, and those who represent them, are interested in the ability of the company to pay their weekly wages or monthly salaries. Looking to the longer term, employees will assess the potential for their continued employment and possible wage increases.

Potential employees, in addition to ensuring that remuneration will be paid, will review the annual report for evidence of value added. Does the company invest in training? What might future career prospects be like? Does the company operate an employee share scheme? Does it encourage employee involvement in the running of the business? What are its environmental and social policies?

1.3.6 General Public

Businesses affect the general public in a variety of different ways, perhaps as employers or customers or suppliers. A particularly large business can have a dominant role in the running

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of the local economy and the financial statements produced by such a company may provide the local community with information which can be used to deduce the extent of future contributions.

As mentioned earlier when considering environmental issues, there are particular interest groups in society who want to gauge the company’s views on social, political and environmental issues.

1.3.7 Government

The Government requires information in order to regulate the activities of companies, determ- ine taxation policies and collect VAT, income tax, corporation tax and customs and excise duties. They are also looking for potential beneficiaries of grants and other financial assist- ance. Often the information required by the Government will come from particular industrial and commercial sectors, but in certain circumstances they will still rely on general-purpose financial statements.

1.3.8 Investment Analysts

Individual and institutional investors often employ the skills of stockbrokers and other analysts to make their investment decisions. Therefore, these analysts need to know about all aspects of a company’s performance, from the quality of earnings to the solvency situation. Linking this to the strength of the company’s management team, the analysts will then weigh up the risks and rewards of investing in individual companies or specific business sectors.

1.3.9 Political Parties/Charities

If contributions for political and charitable purposes together exceed £200, companies are obliged to disclose this in the directors’ report. By reviewing annual reports, charities or political parties that are looking for funding can often get an indication of the type of events that companies might sponsor or a feel for the company’s political tendencies.

1.3.10 Lenders

Lenders are interested in knowing firstly whether the interest due on the loan will be paid and, perhaps more importantly, that at some future date the loan itself will be repaid. Their principal concern, therefore, is with the company’s solvency and cash-flow situation, although a review of the organisation’s profitability may be an indicator that future cash flows will be generated.

Potential lenders will be interested in the current level of borrowings and the ability of the company to meet its annual debt commitments. They may also review the resources owned by the company to see if loans granted could be secured against the assets of the business.

1.3.11 Managers/Directors

Although managers and directors are more likely to be using management accounts and other internal information to aid decision-making, they will still treat the annual report as the starting point for the future.

1.4 Characteristics of Accounting Information

A variety of different user groups seek financial information for their personal use. In order for this information to be useful to the users, the accounting data from which it is prepared, along with its analysis and presentation, must contain certain basic characteristics, as shown in Figure 1.2.

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Figure 1.2 Characteristics of accounting information

1.4.1 Relevance

For information to be useful, it must be relevant to the needs of the users. It must possess qualities that will influence the users in making their decisions about the enterprise. This may be past information, it may be new information about the future or it may be information that causes the users to change their views about the organisation.

1.4.2 Reliable and Objective

For information to be useful it must also be reliable. Users should be able to depend on the financial statements as a faithful representation of the transactions and events that occurred over the trading period. Financial statements that are ‘window dressed’ to present a picture that the directors of the company would like to present, rather than the picture that reflects the economic reality, are not objective financial statements. Freedom from bias is a basic requirement for reliability.

Reliability is often taken to imply prudence as well. User groups like the assurance that, if anything, the picture painted by the financial statements underplays the profitability of the company and understates the enterprise’s financial position.

1.4.3 Comprehensibility

If the users are going to make good use of the financial information presented, then the information must be clear and understandable. Of course, there will always be accounting technicalities and complex business issues with which the non-financial user will have dif- ficulties. However, the challenge for the directors preparing the financial statements is to present these issues in a manner that is as easy to understand as possible.

1.4.4 Timeliness/Cost−Benefit Clearly, the more out of date information becomes, the less useful it is going to be for the user. Timely information is needed to support good decision-making. This is a problem for companies. By the time the accountants have prepared the annual accounts, the external auditors have audited the accounts and the directors have prepared and published the annual report, the financial information is likely to be four or five months out of date. However, this is about as timely as companies can make it given the legal requirements with which they are asked to comply.

Another balance that needs to be struck is the one between cost and benefit. Improved relevance and reliability, and therefore benefit to the user, can be achieved by preparing a 500- page annual report but the cost of preparing and dispatching this to thousands of shareholders may well severely damage the business.

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1.4.5 Completeness

Information presented in financial statements has to be complete. Users do not want to hear only the good news. Relevant bad news is likely to be just as, if not even more, important than good news to those making key economic decisions. It is, therefore, vital that all the relevant information is reported in the financial statements.

1.4.6 Comparability/Consistency

For good interpretation of financial information, the user often needs to look at more than one set of financial statements. Legislation demands that all companies prepare their financial statements in the prescribed formats set out in the Companies Acts. Therefore, when you compare the performance of two different companies, at least you will find that the financial statements will have been set out in the same way.

Similarly, if you are reviewing the performance of one company over a period of time, you can expect that similar items will have been treated consistently over the trading periods. The same methods and standards of measurement of data and presentation of information are necessary to allow for any like-for-like comparisons.

1.5 Summary

Hopefully this unit has given you a good idea about the range of different people who might want to use accounting information and an insight into the sort of information available. Shareholders, lenders, suppliers, employees and many others can make good use of the main information provided in a company’s annual report. The whole idea behind financial reporting is to provide as many user groups as possible with as wide a range of information as possible in order that these user groups can make economic decisions that will ultimately benefit the organisation concerned. If the information provided is relevant and reliable then hopefully potential investors will choose to invest with the company and potential employees will choose to work with it.