Principles Of Accounting II 7

BBA 2301, Principles of Accounting II 1

Course Learning Outcomes for Unit VII Upon completion of this unit, students should be able to:

7. Explain how financial information influences both short-term and long-term management decisions. 7.1 Describe the use of budgets in the planning processes.

8. Discuss operational and capital budgets.

8.1 Differentiate static and flexible budgets.

Course/Unit Learning Outcomes

Learning Activity

7.1 Unit Lesson Chapter 24, pp. 24-1 to 24-25 Unit VII Scholarly Activity

8.1

Unit Lesson Chapter 25, pp. 25-1 to 25-27 Video: Static and Flexible Budgets Unit VII Scholarly Activity

Required Unit Resources Chapter 24: Budgetary Planning, pp. 24-1 to 24-25 Chapter 25: Budgetary Control and Responsibility Accounting, pp. 25-1 to 25-27 In order to access the following resource, click the link below. For the video resource below, a transcript and closed captioning are available upon accessing the video. Finance & Accounting Videos by Prof Coram. (2017, April 19). Static and flexible budgets [Video]. Cielo24.

https://c24.page/55ecsqs2rqhty827c7y7zrs74t

Unit Lesson

Introduction This unit continues the study of managerial accounting. This lesson will provide insight into both your professional life and personal life as the focus will be on budgeting. Budgeting requires you to make estimates. Many people are uncomfortable with this task, because they are used to having objective numbers given to them. However, as much as the future is unpredictable, you are still required to use your experience and judgment to chart a path forward. In this unit, you will see opportunities related to how budgets are prepared and used by management and professionals. Management accountants, no matter the title, are normally integral to the budgeting process. As you proceed through this unit lesson, be sure to review and evaluate this unit as it can transfer to your personal life as well. Consider the questions below.

UNIT VII STUDY GUIDE

Management: Budgets

BBA 2301, Principles of Accounting II 2

UNIT x STUDY GUIDE

Title

 As the chief accounting officer (CAO) or chief financial officer (CFO), what have you based next year’s budgets on?

 What organization performance measures will you use regarding the type of responsibility centers?

Effective Budgeting and the Master Budget Planning is one of management’s major (and basic) responsibilities. You may recall from Unit V the discussion about planning. Planning is all about establishing objectives for the future. The purpose of the budget is to put those objectives into a written form that can be communicated and become the basis for action that needs to be taken. This unit will focus on the short-term budget and the operational budget. In Unit VIII, you will learn about the long-term budget and the capital budget.

Budgeting and Accounting It should be no surprise that accounting information forms the base for budgeting. Accounting provides an objective view of past performance. While not the only factor, something to consider is what happened in the immediate past, which can be a very good indication of what will happen in the upcoming period. Before going further, you may ask, what exactly is a budget? You know on a personal level that a budget contains the amounts and categories of planned expenditures in the coming period (e.g., food, housing, clothing, transportation). For some of you, the budget may be a computerized spreadsheet, numbers in a personal financial planning software package, or a handwritten page. For others, it may be kept in your head as you may have internalized the amounts and categories from experience. For a company, the budget serves the same purpose, although the amounts and categories will be quite different. An operating budget is usually for a year, and a strategic budget is intended for longer periods. On a personal basis and for a company, the budget is the plan (i.e., how you personally will use the resources or how the company will use the resources in the coming period).

Benefits of Budgeting If you ask managers in an organization about their budgets, you will often hear either neutral or negative comments. Depending on the process that a firm uses to develop the budget, a manager may view the budget as the operating plan that prohibits innovation. A successful budget will provide managers throughout the organization with a practical roadmap to accomplish stated objectives. The budget will be viewed as a positive instrument to be used throughout the upcoming performance period.

Budgeting Essentials Why should you care about budgets? Accounting managers need budgets to communicate and execute operating and strategic plans within the organization. To make budgets effective, there are a few elements that need to be considered, which are described below.

 A sound organization: The firm, no matter its size, needs to be comfortable with its organization and the roles and responsibilities for each department or division.

 Length of budget period: While budgets are useful for a variety of timeframes, the most accepted period is a year. Normally, the budget covers the same time period as the firm’s fiscal year. While the overall plan is annual, measurement and evaluation is usually done on a monthly basis. In addition to the annual budget, which matches the fiscal period, most firms will roll their budgets to provide a continuous view 12 months ahead.

 The budgeting process: How is the budget developed? Is it top-down or bottom-up? For most firms, the starting point should be the goals and objectives for the upcoming period. From those items, typically profits and sales revenue and non-financial objectives noted in the balanced scorecard can be developed to create the master budget (Weygandt et al., 2018).

 Budgeting and human behavior: If the process is totally top-down, much of the organization may feel left out and not buy into the objectives and plan assumptions. Today, most firms have adopted a form that allows both top-down and bottom-up participation, hence the name participative budgeting. The goal is to reach reasonable objectives and plans that may require a stretch (i.e., a higher level of achievement) but will be accepted at all levels.

BBA 2301, Principles of Accounting II 3

UNIT x STUDY GUIDE

Title

 Budgeting and long-range planning: Long-range planning may have its own budget (e.g., objectives and goals), but the level of detail will be considerably different. A firm may have a long-range plan for 3–5 years; some industries, such as technology and energy, may require longer.

These elements support the successful use of budgeting in any organization. Without them, the budget, no matter how carefully conceived, may not be accepted and used effectively by management.

The Master Budget The master budget, often called the comprehensive budget, includes a number of separate but related budgets. It begins with the firm’s goals and objectives for the period and ends with the expected financial results. The master budget is the operating plan for the year. The master budget is illustrated on page 24-7 of the textbook. The budget has two major divisions, operating and financial. In a given organization, this distinction may or may not exist, but the individual budgets are always present. There is a third budget type, capital budgets, which will be discussed in Unit VIII. The differences between the operating and financial budgets are illustrated and outlined below.

Operating Budgets Review the components of an operating budget below.

 Firm goals and objectives

 Sales budget

 Production budget

BBA 2301, Principles of Accounting II 4

UNIT x STUDY GUIDE

Title

 Direct materials budget

 Direct labor budget

 Manufacturing overhead budget

 Sales and administrative budgets

 Budgeted income statement Financial Budgets Review the components of a financial budget below.

 Cash budget

 Budgeted balance sheet These budgets represent the firm’s roadmap for the period. While some of these specific budgets may be a stretch, think about using the majority of them by setting a budget to begin 1/1/20XX and ending 12/31/20XX.

Budgeting Outside of Manufacturing Obviously, all organizations need to prepare and manage budgets. It is not solely a tool of manufacturers. The key difference for a merchandiser (e.g., Macy’s, Nordstrom) is the substitution of a merchandiser’s purchases budget for the production budget. In addition, the merchandiser does not have direct material, direct labor, or manufacturing overhead budgets (the three components of a manufactured product cost). A service company, such as Accenture, Ernst & Young, or a legal or medical practice, has a distinctive need to budget its use of professional staff (the principle asset). Therefore, the direct labor budget will be a major item. Revenues for a service company can be developed from prior periods (projected labor usage, service revenues). Nonprofits and government organizations will use cash flows (expenditures and receipts) in their budget preparation. Otherwise, the process is the same.

Budgetary Planning You can see that budgets are used on both a personal level as well as an organizational level. You can see the benefits of the budget for planning ahead, identifying objectives for financial performance, creating an early warning system to identify potential problems, and publishing results for greater management awareness. Whether used with a small calculator, spreadsheet, enterprise resource planning (ERP) software, or pencil and paper, budgets are used by all. The challenge is to make budgets work for you and your firm rather than have you work on the budget.

Budgetary Control and Responsibility Accounting Accounting managers not only consider budgeting as planning but also as control. The topic of budgetary control naturally pairs with planning; it makes the plan actionable. Control is based on a firm’s reporting system. In addition to developing the budget (the plan), three more activities comprise control. These include analyzing differences between actual and planned results; evaluating the cause of any discrepancy and modifying plans; and, finally, taking corrective action. In addition, even though reports are often thought of as being on hard-copy paper, in most companies today, reports are electronic and available at any time and in any location. The budget reporting system must be documented. For each report, you should be able to easily identify it, its frequency, purpose, and recipients.

Static and Flexible Budget Reports Budget reports are often categorized as static or flexible. A static report will show the planned budget figure, the actual experience, and even the difference (variance) but only at one level of activity. A flexible budget will reflect planned and actual performance at several levels. If you forecast the production or the sales of 500 units, along with the appropriate materials, labor, and overhead costs to support such volume, these amounts become the budgeted amounts. Once a budget period has passed (a month, quarter, or year), you then have the actual numbers. Comparing the budget and

BBA 2301, Principles of Accounting II 5

UNIT x STUDY GUIDE

Title

the actual number gives a difference of either positive or negative. Based on the differences, management can take action. What happens if sales were much better than the forecast? What if the sales were much lower than projected? Does it mean that management did a poor job of budgeting? That may be, but it also may represent a higher-than-anticipated acceptance of the firm’s new product or service, or it may represent an external event (e.g., a hurricane that negatively impacted sales). A comparison of budget and actual results may show large differences that are not related to the firm’s effective use of resources. Flexible budgeting is a response to such situations. Budgets can be set at multiple levels of sales or production, and at the end of the period, the budget and actual numbers at the actual production level can be compared. The differences will more directly reflect management and firm actions during the period. Refer back to the scenario of producing 500 units and measuring management against the budgeted amounts for 500 units. We take the actual production (i.e., 550 units) and measure the budget and actual numbers at the higher (or lower) production volume. Another way to document (budget) for the upcoming period is to create multiple budgets. When this approach is used, three budgets may be labeled optimistic, expected, and pessimistic. As the label suggests, expected would represent the most likely outcome if all forecasts are accurate. This approach really creates three static budgets; a bad budget is one that is worse than expected, and a superior budget is one that is better than expected. Flexible budgeting calculations may be easily used at several production levels when evaluating period performance. For a clear illustration and example on flexible budgeting, take a look at pages 25-9 through 25-13 of the textbook. A case example is provided as well, which walks you through the process of flexible budgeting from the master budget amounts and through the budget reports at the actual level of activity. In summary, budgets are important management tools. They are just as useful for consumers as they are for managers and firms of all sizes. A flexible budgeting approach gives management the best information for remedial actions.

Responsibility Accounting and Responsibility Centers Responsibility accounting and responsibility centers are another tool of management accountants. The objective of responsibility accounting and responsibility centers is to allow for there to be an evaluation of management on items that are controllable. All costs and revenues are considered controllable by top-level and executive-level management of the firm. Fewer, more specific costs and revenues are controllable by management at lower levels. Budget reports are often categorized as static or flexible. A static report will show the planned budget figure (i.e., the actual experience) and even the difference (variance) but only at one level of activity.

Principles of Performance Evaluation The centerpiece of responsibility accounting is performance evaluation. How has management (and the resources under management’s control) performed (actuals) compared to expected (budget)? A very common approach is called management by exception. While there may be several items on a manager’s budget performance report, it is usually most productive to focus on the areas with the largest differences (budget less actual) and are significant to the organizational unit. To simplify the management by exception process, two elements that provide focus are materiality and controllability. If the amount is not significant or controllable by the organization, then a large percentage difference on the report will not necessarily initiate management action. Of course, the human factor is important when assessing management performance. There are five behavioral principles and five reporting principles to support performance evaluation that complement the behavioral principles.

 Managers should have direct input into the budgeting process.

 Evaluation should be based on items controllable by management.

BBA 2301, Principles of Accounting II 6

UNIT x STUDY GUIDE

Title

 Management should support of the evaluation process.

 Management should be able to respond to their evaluation.

 Both superior and inferior performance should be identifiable.

Complementing these behavioral principles are five reporting principles to support performance evaluation:

 Data is controllable by the manager under evaluation.

 Data must be both accurate and reliable.

 Significant differences should be highlighted.

 Be specific to the management under evaluation.

 Be timely and at appropriate frequency.

Responsibility Reporting System To be effective, a responsibility reporting system starts at the lower levels of responsibility and ends with the executive level. This reporting system supports management by exception at each level of the organization. Managers at higher levels can review the performance of all of the report levels below. There are three types of responsibility centers: cost, profit, and investment. Each of these are defined below.

 Cost: This center is often responsible for production or service. The manager is responsible for the controllable costs in the organization. Consider the service manager at an auto dealership or the production manager at a manufacturer. A cost center has costs, but a cost center does not directly drive revenue, so the manager is evaluated on their performance in managing controllable costs.

 Profit: The profit center also has costs but can develop a revenue stream as well. Examples of a profit center are a banking branch office and a retail store (or a department within a retail store).

 Investment: The investment center not only has cost and revenue responsibility but also has to make

decisions on assets under its management. These centers are often found within a large organization, operating as a wholly owned subsidiary or separate business unit.

The basis for evaluating investment center performance is called return on investment (ROI). ROI is net income (income from operations or a controllable margin) divided by average operating assets. These are limited to items that the manager can control. Another measure used to evaluate investment managers is residual income. This measure starts with the firm’s minimum rate of return and calculates the increase generated by an incremental investment. Using residual income, management may decide to go ahead with a project that increases the center’s total net income but does not meet the ROI hurdle. As a note, corporations with multiple investment centers will break out their financial performance on their reports if the unit represents 10% or more of the firm’s revenues or profits. The typical organization will find departments or divisions that fit into each of the three types of responsibility centers.

Conclusion You can now better understand the manager’s role in decision-making as it applies to budgets. You can also see how budgets and responsibility centers are major support tools for accounting managers. As consumers,

BBA 2301, Principles of Accounting II 7

UNIT x STUDY GUIDE

Title

you make these types of decisions every day (whether you realize it or not) and need the information provided by these tools and concepts. Now that you have learned about budgets and responsibility centers, can you now answer the questions posed at the beginning of this lesson?

Reference Weygandt, J. J., Kimmel, P. D., & Kieso, D. E. (2018). Accounting principles (13th ed.). Wiley.

https://online.vitalsource.com/#/books/9781119411017

Suggested Unit Resources In order to access the following resources, click the links below. The following web page provides a definition of responsibility accounting and discusses the use and types of responsibility centers. Accountingverse. (n.d.). What is responsibility accounting? https://www.accountingverse.com/managerial-

accounting/responsibility-accounting/what-is-responsibility-accounting.html The web page below provides a concise guide to the business planning cycle. Info Entrepreneurs. (2009). Budgeting and business planning. Chamber of Commerce of Metropolitan

Montreal. https://www.infoentrepreneurs.org/en/guides/budgeting-and-business-planning/ For the video resource below, a transcript and closed captioning are available upon accessing the video. The video below illustrates how to prepare a master budget. Hart, A. I. (2016, March 10). Preparing a master budget [Video]. Cielo24.

https://c24.page/yjzwrc9jskpdc868tkpzywt5vj

Learning Activities (Nongraded) Nongraded Learning Activities are provided to aid students in their course of study. You do not have to submit them. If you have questions, contact your instructor for further guidance and information. This is an opportunity for you to express your thoughts about the material you are studying by writing about it. Conceptual thinking is a great way to study because it gives you a chance to process what you have learned, and it increases your ability to remember it. In order to practice what you have learned, please attempt the exercises and problems below, which can be found in your textbook. Chapter 24:

 Brief Exercises (BE24.8), page 24-35

 Brief Exercises (BE24.9), page 24-35

 Exercises (E24.4), page 24-37

 Exercises (E24.11), page 24-39

 Exercises (E24.15), page 24-40

 Problems: Set A (P24.3A), page 24-43

BBA 2301, Principles of Accounting II 8

UNIT x STUDY GUIDE

Title

Chapter 25:

 Brief Exercises (BE25.3), page 25-35

 Brief Exercises (BE25.10), page 25-36

 Exercises (E25.9), page 25-39

 Exercises (E25.17), page 25-42

 Problems: Set A (P25.6A), page 25-46 If you have any questions or do not understand a concept, contact your professor for clarification. Completing these practice exercises and problems will give you practice, which will be helpful as you complete the assignment for this unit.