ACCOUNTING
Basic Analytical Procedures
Lesson5of38
Financial Investments
Assume Apple Inc.’s common stock is trading at $125 per share. If you had
funds to invest, would you invest in Apple common stock? Apple is a well-
known company. However, some other well-known companies, including
United Airlines, Kmart, Polaroid, and Planet Hollywood, share the common
characteristic of having once declared bankruptcy!(
Obviously, being well known is not necessarily a sufficient basis for an
investment decision. Knowledge that a company has a good product, by
itself, may also be an inadequate basis for investing in the company. Even
with a good product, inadequate financing and a variety of other reasons
could cause a company to be unprofitable or even go bankrupt.(
How, then, does one decide upon companies in which to invest? Investors
can improve decision making by considering, understanding, and analyzing
financial data and other information included in financial statements and
corporate reports.(
The basic financial statements provide information that is useful for making
investment and other economic decisions about businesses. Investors can
use analytical procedures to examine relations between items included with
a single company’s financial statements. Analytical procedures are also
widely used to examine financial statement information across time and
across companies. Common analytical measures are not ends in themselves
but tools for evaluating financial and operating data. Many other factors,
such as industry trends and general economic conditions, can play important
roles in making investment decisions.(
Horizontal Analysis
Although financial statement line items can be analyzed as dollar amounts,
expressing amounts as percentages can facilitate comparison and
interpretation. Analysis of percentage increases and decreases in financial
statements items across time is called horizontal analysis. In horizontal
analysis, the amount of each line item on the most recent statement is
compared with the related item on earlier statements and expressed as a
percentage change. When horizontal analysis is used to compare data from
two or more dates or periods, amounts from the earliest statement are used
as the base for computing percentage increases and decreases. While
computing the percentage change in various financial statement line items is
straightforward, interpreting the significance of the increases and decreases
usually benefits from additional information. The example below illustrates a
horizontal analysis of the current asset section of Grand Company’s balance
sheet.(
G Company
C Schedule of Current Assets
D 31, 20X1 and 20X2
20X2 20X1
Increase or (Decrease)
Amount Percent(%)
Cash $90,500 $64,700 $25,800 3.9
Marketable Securities 75,000 60,000 15,000 25.0
Accounts Receivable (net) 115,000 120,000 (5,000) (4.2)
Inventories 264,000 283,000 (19,000) (6.7)
Prepaid Expenses 5,500 5,300 200 3.8
Total Current Assets $550,000 $533,000 $17,000 3.2%
Vertical Analysis
Percentage analysis may also be used to show the relationship of each
component to the total within a single statement. This type of analysis is
called vertical analysis. In vertical analysis, the balance sheet is analyzed by
stating each asset item as a percent of total assets. Each liability and
stockholders’ equity item is stated as a percent of total liabilities and
stockholders’ equity. Although vertical analysis is a technique that is applied
to an individual statement, comparative vertical analyses are useful. The
exhibit below is a comparative vertical analysis of Grand Company’s balance
sheet.(
Like horizontal analysis, vertical analysis may be applied to financial
statements in either detailed or condensed form. In the latter case,
additional details of the changes in individual items may be presented in
supporting schedules. In supporting schedules, the percentage analysis may
be based on either the total of the schedule or the statement.(
G Company
C Balance Sheet
D 31, 20X1 and 20X2
20X2 Amount 20X2 Percent
(%) 20X2 Amount 20X2 Percent
(%)
Current Assets $550,000 48.3 $533,000 43.3
Long-Term Investments 95,000 8.3 177,500 14.4
Property, Plant, and
Equipment (net) 444,500 39.0 470,000 38.2
Intangible Assets 50,000 4.4 50,000 4.1
Total Assets $1,139,500 100.0% $1,230,500 100.0%
Common-Size Statements
Horizontal and vertical analyses are useful in assessing trends and
relationships in financial conditions and operations of a business. Vertical
analysis is also useful in comparing one company with another or with
industry averages. Such comparisons are easier to make with the use of
common-size statements where all items are expressed as percentages of
statement totals.(
This following exhibit is a comparative common-size income statement for
two businesses.
G Company and Noble Company
C Common-Size Income Statement
F the Year Ended+December 31, 20X2
Grand Co. (%) Noble Co. (%)
Sales, net 100.0 100.0
Cost of Goods Sold 82.6 70.0
Gross Profit 17.4 30.0
Selling and Administrative 2.8 15.6
Income from Operations 14.6 14.4
Other Expense 1.4 0.2
Income before Income Tax 13.2 14.2
Income Tax Expense 4.8 5.3
Net Income 8.4% 8.9%
Solvency Analysis
Lesson6of38
Solvency and Profitability Analysis+
Two major areas of financial performance include solvency and profitability.
Stakeholders may have more interest in one area of financial performance
than others. Creditors, for example, may be most concerned about an
entity’s ability to repay debts (i.e., solvency). Shareholders may focus on the
ability to generate income (i.e., profitability) but will likely be interested in all
dimensions of financial performance, including solvency.(
Many techniques for financial statement analysis involve ratio analysis. By
computing ratios, financial statement amounts can be scaled so that more
meaningful comparisons can be made across entities of different sizes. Ratio
analysis also exploits meaningful economic relationships between financial
statement items to provide insights about several dimensions of financial
performance. Ratio analysis can be used to assess both solvency and
profitability.
Although solvency and profitability may be analyzed separately, these
dimensions of financial performance are interrelated. For example, a
business that cannot pay its debts on a timely basis may experience
difficulty in obtaining credit. A lack of available credit may, in turn, lead to a
decline in the business’s profitability.
Solvency Analysis
Solvency analysis focuses on the ability of a business to pay or otherwise
satisfy its current and noncurrent liabilities. It is normally assessed by
examining balance sheet relationships.
Analyses used in assessing solvency include the following:
1. Current position or liquidity analysis including working capital, current ratio, and
the acid-test ratio or quick ratio
2. Accounts receivable analysis including accounts receivable turnover and number
of days’ sales in receivables
3. Inventory analysis including inventory turnover and number of days’ sales in
inventory
4. Ratio of fixed assets to long-term liabilities
5. Ratio of liabilities to stockholders’ equity
6. Number of times interest charges are earned
Current Position Analysis: Working Capital
Metrics useful in assessing solvency must relate to a business’s ability to pay
or otherwise satisfy its liabilities. Using metrics to assess a business’s ability
to pay its current liabilities is called current position analysis or liquidity
analysis. Current position analysis is relevant for many stakeholders but may
be of special interest to short-term creditors.(
An analysis of a firm’s current position normally includes determining the
working capital, the current ratio, and the quick ratio. The current and quick
ratios are most useful when analyzed together and compared to previous
periods and other firms in the industry.(
The excess of the current assets of a business over its current liabilities is
called working capital. Working capital is generally expressed as a dollar
amount, not a ratio, that is used in evaluating a company’s ability to meet
currently maturing debts. When expressed as a ratio, the current ratio is
generally the one being referenced. Various forms of this ratio are used in
the computation of liquidity ratios. Working capital is especially useful in
making monthly or other period-to-period comparisons for a company.
However, amounts of working capital are difficult to assess when comparing
companies of different sizes or in comparing such amounts with industry
figures. For example, working capital of $250,000 may be adequate for a
small local hardware store, but it would be inadequate for a much larger
retailer such as Home Depot.
Current Position Analysis
Current Ratio
The current ratio is another way to express the relationship between current
assets and current liabilities and assess liquidity. This ratio, sometimes called
the working capital ratio or bankers’ ratio, is computed by dividing total
current assets by total current liabilities. For Grand Company, working capital
and the current ratio for 20X2 and 20X1 are as follows:
G Company
20X2 20X1
Current Assets $550,000 $533,000
Current Liabilities $210,000 $243,000
Working Capital $340,000 $290,000
Current Ratio 2.6 2.2
Although both working capital and the current ratio are computed using the
same components (i.e., current assets and current liabilities), working capital
is an unscaled metric and does not control for size. Thus, the current ratio
can be a more useful indicator of liquidity when making comparisons across
companies or with industry averages.
(To illustrate, assume that as of December 31, 20X2 one of Grand Company’s
competitors has $1 million of working capital and a current ratio of 1.3.
Grand Company’s much higher current ratio suggests that despite having
less working capital, Grand Company will be able to more easily repay its
short-term debt and will be in a more favorable position to obtain short-term
credit than this competitor.
Quick Ratio
Neither working capital nor the current ratio considers the makeup of the
current assets. A ratio that measures the “instant” debt-paying ability of a
company is called the quick ratio or acid-test ratio, which is the ratio of the
total quick assets to total current liabilities. Quick assets are cash and other
current assets that can be quickly converted to cash. Quick assets normally
include cash, marketable securities, and receivables. The quick ratio is a
more stringent measure of liquidity than the current ratio.
Included in Grand Company’s current assets, the quick assets are cash,
marketable securities, and accounts receivables that can generally be
converted to cash rather quickly to pay current liabilities. Relevant financial
statement data can be used to compute Grand Company’s quick ratio as
follows:
G Company
20X2 20X1
Cash $90,500 $64,700
Marketable Securities $75,000 $60,000
Accounts Receivable (net) $115,000 $120,000
Total Quick Assets $280,500 $244,700
Current Liabilities $210,000 $243,000
Quick Ratio 1.3 1.0
Accounts Receivable Analysis
The amount and makeup of accounts receivable changes constantly during
business operations. Sales on account increase accounts receivable, whereas
collections from customers decrease accounts receivable. Firms that grant
long-term credit usually have larger accounts receivable balances than those
granting short-term credit. Increases or decreases in the volume of sales and
changes in credit policies also affect the balance of accounts receivable.(
For many reasons, it is desirable to collect receivables as promptly as
possible. The cash generated by prompt collections from customers may be
used to pay or avoid current liabilities and be used in operations for such
purposes as purchasing merchandise in large quantities at lower prices. Cash
has many uses, including investing and financing purposes. Prompt collection
also reduces the risk of loss from uncollectible accounts.(
Accounts Receivable Turnover
Turnover ratios generally reflect activity and are sometimes referred to as
activity ratios. Accounts receivable turnover is a ratio that expresses the
relationship between sales and accounts receivable. It is computed by
dividing net sales by the average net accounts receivable. It is desirable to
base the average on monthly balances, which allows for seasonal changes in
sales. When such data are not available, it may be necessary to use the
average of the accounts receivable balance at the beginning and the end of
the year. If there are trade notes receivable as well as accounts receivable,
the two may be combined. The accounts receivable turnover data for Grand
Company are as follows:
G Company
20X2 20X1
Net Sales $1,498,000 $1,200,000
Accounts Receivable (net):
Beginning of Year
End of Year
Total
Average Accounts Receivable (Total÷2)
$120,000
$115,000
( ( $235,000 ( (
$117,500
$140,000
$120,000
( ( $260,000 (
$130,000
Accounts Receivable Turnover 12.7 9.2
G Company
(net sales ÷ average accounts receivable)
Number of Days’ Sales in Receivables
Another metric that relates sales and accounts receivable is the number of
days’ sales in receivables. This ratio is computed by dividing the average
accounts receivable by the average daily sales, which is determined by
dividing net sales by 365 days. The number of days’ sales in receivables is
an estimate of the length of time (in days) that the accounts receivables
have been outstanding. Comparing this measure with the credit terms
provides information on the efficiency in collecting receivables. A comparison
with other firms in the industry and with prior years also provides useful
information. Such comparisons may indicate efficiency of collection
procedures and trends in credit management. The number of days’ sales in
receivables is computed for Grand Company as follows:
G Company
20X2 20X1
Average Accounts Receivable $117,500 $130,000
Net Sales
Average Daily Sales (Net Sales ÷ 365)
$1,498,000
4,104
$1,200,000
3,288
Number of Days' Sales in Receivables
(average accounts receivable ÷ average daily
sales)
28.6 39.5
Grand Company improved its collections of accounts receivable by 10.9 days
in 20X2, measured in days that receivables have been outstanding.
Inventory Analysis
Inventory Turnover
A business needs to keep enough inventory on hand to meet the needs of its
customers and operations. However, an excessive amount of inventory
reduces solvency by tying up funds. Excess inventories also increase
insurance expense, property taxes, storage costs, and other expenses. These
expenses use funds that otherwise could be used to improve operations.
Finally, excess inventory also increases the risk of losses due to price
declines or inventory obsolescence.
(Two useful measures for evaluating inventory management are inventory
turnover and the number of days’ sales in inventory. The relationship
between the cost of the goods (merchandise or inventory) sold and the
inventory remaining may be stated as the inventory turnover. It is computed
by dividing the cost of goods sold by the average inventory. If monthly data
are unavailable, the average of the inventories at the beginning and the end
of the year may be used. For each business or department within a business,
there is a reasonable turnover rate. Turnover below this rate could mean
that inventory is not being properly managed. Grand Company’s inventory
turnover is computed as follows:
G Company
G Company
Cost of Goods Sold $1,043,000 $820,000
Inventories:
Beginning of Year
End of Year
Total
Average Inventory (Total÷2)
$283,000
264,000
( ( $547,000 ( (
$273,000
$311,000
283,000
( ( $594,000 (
$297,000
Inventory turnover
(cost of goods sold ÷ average inventory) 3.8 2.8
Number of Days’ Sales in Inventory
Another measure of the relationship between the cost of goods sold and
inventory is the number of days’ sales in inventory. This measure is
computed by dividing the average inventory by the average daily cost of
goods sold (cost of goods sold divided by 365). The number of days’ sales in
inventory for Grand Company is computed as follows:
G Company
20X2 20X1
Average Inventory $273,500 $297,000
Cost of goods sold
Average Daily Cost of Goods Sold (COGS ÷ 365)
$1,043,000
$2,858
$820,000
$2,247
Number of Days' Sales in Inventory
(average inventory ÷ average daily cost of goods
sold)
95.7 132.2
The number of days’ sales in inventory is a rough measure of the length of
time it takes to acquire, sell, and replace the inventory. Grand Company
reduced the time it held inventory by nearly 28% in 20X2, as measured in
days the inventory was held in warehouses. However, a comparison with
earlier years and similar firms would be useful in assessing Grand Company’s
overall inventory management.
Ratio of Fixed Assets to Long-Term Liabilities
Long-term notes and bonds are often secured by fixed assets. The ratio of
fixed assets to long-term liabilities is a solvency measure that indicates the
margin of safety for noteholders and bondholders. It also indicates the ability
of a business to borrow additional funds on a long-term basis. Grand
Company’s ratio of fixed assets to long-term liabilities is as follows:
G Company
20X2 20X1
Fixed Assets (net) $444,500 $470,000
Long-term Liabilities $210,000 $200,000
Ratio of Fixed Assets to Long-term Liabilities 2.1 2.4
The increase in Grand Company’s ratio of fixed assets to long-term liabilities
indicates that it decreased the margin of safety in financing fixed assets. A
review of the changes in the two components of this ratio suggests that
Grand Company achieved this outcome primarily by increasing its
outstanding long-term debt. If the company needs to borrow additional funds
on a long-term basis in the future, it will be in a weaker position to do so.
Ratio of Liabilities to Stockholders’ Equity+
Claims against the total assets of a business are divided into two groups: (1)
claims of creditors and (2) claims of owners. The relationship between the
total claims of the creditors and owners – the ratio of liabilities to
stockholders’ equity – is a solvency measure that indicates the margin of
safety for creditors. It also indicates the ability of the business to withstand
adverse business conditions. When the claims of creditors are large in
relation to the equity of the stockholders, there are usually significant
interest payments. If earnings decline to the point where the company is
unable to meet its interest payments, the business may be taken over by the
creditors. The ratio of liabilities to stockholders’ equity for Grand Company is
as follows:
G Company
20X2 20X1
Total Liabilities $310,000 $443,000
Total Stockholders' Equity $829,500 $787,500
Ratio of Liabilities to Stockholders’ Equity 0.37 0.56
Grand Company’s balance sheet shows that the major factor explaining the
change in the ratio was the $133,000 increase in long-term liabilities during
20X2. The ratio at the end of both years shows a large margin of safety for
the creditors.
Times Interest Earned+
In some industries, (e.g., airlines) corporations normally have high ratios of
debt to stockholders’ equity. One way to measure the relative risk of the
debt-holders is the times interest earned ratio, sometimes called the fixed
charge coverage ratio. The higher the ratio, the lower the risk that interest
payments will not be made if earnings decrease. In other words, the higher
the ratio, the greater the assurance that interest payments will be made on a
continuing basis. This metric also indicates the general financial strength of
the business, which is of interest to many stakeholders including
stockholders, employees, and creditors.(
Because interest is deductible in determining taxable income, the amount
available to meet interest charges is not affected by income taxes. The
Times Interest Earned Ratio is computed by dividing the sum of Income
before Taxes and Interest Expense (i.e., the amount available to meet
interest charges) by Interest Expense as shown below:(
G Company
20X2 20X1
Income Before Income Tax $900,000 $800,000
Interest Expense $300,000 $250,000
G Company
Amount Available to Meet Interest Charges $1,200,000 $1,050,000
Times Interest Earned 4.0 4.2
This analysis indicates that Grand Company generates income sufficient to
cover its interest costs 4 times each year. A similar analysis can also be
applied to dividends on preferred stock by dividing net income by the
amount of preferred dividends to yield the number of times preferred
dividends are earned, a metric indicating the risk that dividends to preferred
stockholders may not be paid.(
Profitability Analysis
Lesson7of38
Profitability & Market Analysis
The ability of a business to earn profits depends on the effectiveness and
efficiency of its operations as well as the resources available to it.
Profitability analysis, therefore, focuses primarily on the relationship between
operating results as reported in the income statement and resources
available to the business as reported in the balance sheet. Market analysis
focuses on how well a company is doing from a financial market perspective.
Major analyses used in assessing profitability include the following:(
1. Return on Sales
2. Return on Assets
3. Return on Stockholders’ Equity
4. Return on Common Stockholders’ Equity
5. Earnings per share on Common Stock
Analyses regarding the market include the following:
1. Price-earnings Ratio(
2. Dividends per Share(
3. Dividend Yield
Return on Sales
The ratio of net income to net sales is a profitability measure that is is often
called net profit margin. This ratio shows how much of each dollar in sales
flows through to net income after all expenses are subtracted. The basic
data and the computation of this ratio for Grand Company are as follows:
G Company
20X2 20X1
Net Income $91,000 $76,500
Net Sales $1,498,000 $1,200,000
Return on Sales 6.1% 6.4%
Although Grand Company’s sales increased in 20X2, its return on sales
decreased. There are several possible explanations for this observation. For
example, net profit margin might have declined due to increasing costs or
expenses. Grand Company managers will want to further investigate to
determine the explanation for declining return on sales.
Return on Assets
Return on assets measures the profit generated on investments in assets,
without considering how the assets are financed. The return on assets is
computed by adding interest expense to net income and dividing this sum by
the average total assets. Adding interest expense to net income eliminates
the effect of whether the assets are financed by debt or equity; however, it is
important to note that the adding of interest is not always done. Grand
Company’s return on assets is computed as follows:
G Company
20X2 20X1
Net Income
Plus Interest Expense
Total
$91,000
( 6,000 (
$97,000
$76,500
( 12,000 (
$88,500
Assets:
Beginning of Year
End of Year
Total
Average (Total ÷ 2)
$1,230,500
$1,139,500
( $2,370,000 (
$1,185,000
$1,187,500
$1,230,500
( $2,418,000
$1,209,000
Return on Sales 8.2% 7.3%
As with any ratio, it can be helpful to compare it to that of similar companies
and industry averages. In some instances, it may be desirable to adjust the
way this ratio is computed. For example, if net income includes significant
amounts of non-operating income and expenses, it may be helpful to
compute the ratio of income from operations to total assets. Since income
from operations is before tax, using this for the numerator also eliminates
the effect of tax. When income from operations is used for the numerator,
any assets related to the non-operating income and expense items should be
excluded from the denominator. Because ratios can be computed in different
ways, it is important to understand the specific way a ratio has been
computed when using published ratios.(
Return on Stockholders’ Equity
Another measure of profitability is return on stockholders’ equity, which is
computed by dividing net income by average total stockholders’ equity. In
contrast to return on assets, this metric emphasizes the rate at which
income is earned relative to the amount invested by the stockholders.(
The stockholders’ equity balance may vary throughout a period. For
example, a business may issue or retire stock, pay dividends, and earn net
income. If monthly amounts are not available, the average of the
stockholders’ equity at the beginning and the end of the year is normally
used to compute this ratio. For Grand Company, return on stockholders’
equity is computed as follows:
G Company
20X2 20X1
Net Income $91,000 $76,500
Stockholder's Equity:
Beginning of Year
End of Year
Total
Average (Total ÷ 2)
$787,500
$829,500
( $1,617,000
$808,500
$750,000
$787,500
( $1,537,500
$768,750
Return on Sales 11.3% 10.0%
Leverage
For most businesses, return on equity is usually higher than return on assets.
This occurs when the amount earned on assets acquired with creditors’ funds
is more than the interest paid to creditors. This difference in the rate of
return on stockholders’ equity and the rate of return on assets is called
leverage.(
The example below demonstrates that Grand Company’s leverage of 3.1%
for 20X2 compares favorably with the 2.7% leverage for 20X1.(
Return on Common Equity
A corporation may have both preferred and common stock outstanding. In
this case, the common stockholders have the residual claim on earnings.
Return on common equity focuses only on the profits earned on the amount
invested by common stockholders. It is computed by subtracting preferred
dividend requirements from net income and dividing this amount by average
common stockholders’ equity. The return on common equity for Grand
Company is computed as follows:
G Company
20X2 20X1
Net Income
Preferred Dividends
Income Available to Common Shareholders
$91,000
9,000
$82,000
$76,500
9,000
$67,500
Common Stockholder's Equity:
G Company
Beginning of Year
End of Year
Total
Average (Total ÷ 2)
$637,500
$679,500
( $1,317,000
$658,500
$600,000
$637,500
( $1,237,500
$618,750
Return on Sales 12.5% 10.9%
The concept of leverage can also be applied to the use of funds from the sale
of preferred stock as well as borrowing. Funds from both sources can be
used in an attempt to increase the return on common equity.(
Earnings per Share
One of the profitability measures often quoted by the financial press is
earnings per share (EPS). It is also normally reported in the income
statement in corporate annual reports. As a result, corporate managers
closely monitor the impact of decisions on earnings per share. Thus, one of
the many factors that influences the decision of whether to finance
operations using debt or equity is the effect of each alternative on earnings
per share.
If a company has only one class of stock outstanding, earnings per share is
computed by dividing net income by the number of shares of stock
outstanding. If preferred and common stock are outstanding, earnings per
share is normally computed to reflect earnings per share of common stock.
In this case, net income is first reduced by preferred dividends. If the number
of shares of stock outstanding varies, it is common to use a weighted
average number of shares outstanding. For Grand Company, earnings per
share of common stock is computed as follows:
G Company
20X2 20X1
Net Income
Preferred Dividends
Income Available to Common Shareholders
$91,000
9,000
$82,000
$76,500
9,000
$67,500
Shares of Common Stock Outstanding 50,000 50,000
Earnings Per Share of Common Stock $1.64 $1.35
Grand Company earned more for each share of common stock in 20X2 than
it did in 20X1.
Price-Earnings Ratio
Another profitability measure often quoted by the financial press is the price-
earnings (P/E) ratio on common stock. The price-earnings ratio is an indicator
of a firm’s future earnings prospects. It is computed by dividing the market
price per share of common stock at a specific date by the annual earnings
per share. Assume the market prices per common share are 41 at the end of
20X2 and 27 at the end of 20X1. The price-earnings ratio on common stock
of Grand Company is computed as follows:
G Company
20X2 20X1
Market Price Per Share of Common Stock $41.00 $27.00
Earnings Per Share of Common Stock ÷ 1.64 ÷ 1.35
Price-Earnings Ratio for Common Stock 25 20
The price-earnings ratio indicates that a share of common stock of Grand
Company was selling for 20 times the amount of earnings per share at the
end of 20X1. At the end of 20X2, the common stock was selling for 25 times
the amount of earnings per share. The stock price has increased as a
multiple of its earnings on common stock. This suggests that investors
believe that Grand Company has good prospects for growth!
Dividends per Share and Dividend Yield
Ordinary dividends represent a distribution of earnings to stockholders and
are one of the primary ways that a company can return value to its owners.
Thus, dividend-related metrics including dividends per share and dividend
yield are commonly used by investors to evaluate equity investment
alternatives.(
Dividends per share is computed by dividing the dividends distributed to
common stockholders during the period by the number of common shares
outstanding. For Grand Company, dividends per share was $0.80 ($30,000 ÷
50,000 shares) in 20X2 and $0.60 ($30,000 ÷ 50,000 shares) in 20X1.(
Dividends per share can be reported along with earnings per share to
indicate the relationship between dividends and earnings. The comparison of
the two per-share amounts suggests the extent to which a company is
retaining its earnings for internal uses and investments. The following exhibit
illustrates these relations for Grand Company. (
Dividends per Share and Dividend Yield
The dividend yield on common stock is a profitability measure that shows the
rate of return to common stockholders in terms of cash dividends. It is of
special interest to investors whose main investment objective is to receive
current returns (dividends) on an investment rather than an increase in the
market price of the investment. The dividend yield is computed by dividing
the annual dividends paid per share of common stock by the market price
per share on a specific date. Assume that the market price was 41 at the end
of 20X2 and 27 at the end of 20X1. The dividend yield on common stock of
Grand Company is as follows:
G Company
20X2 20X1
Market Price Per Share of Common Stock $0.80 $0.60
G Company
Earnings Per Share of Common Stock ÷ 41.00 ÷ 27.00
Price-Earnings Ratio for Common Stock 1.95% 2.22%
The dividend yield reflects the proportion of the common stock’s market
value that is distributed as dividends. For Grand Company, the 20X2
decrease in dividend yield relates to a stock price that rose more than the
company’s dividend.(
Summary of Analytical Measures
Lesson8of38
Meaningful analytical measures can be computed for most businesses. While
solvency and profitability can be considered two broad categories of financial
analysis, characteristics generally evaluated in ratio analysis include
liquidity, profitability, and solvency. Depending on the specific business
being analyzed, some measures might be omitted, or additional measures
could be developed. The type of industry, the capital structure, and the
diversity of the business’s operations usually affect the choice of metrics
used. For example, analysis for an airline might include metrics that include
non-financial components such as revenue per passenger mile and cost per
available seat. Likewise, analysis for a hotel might focus on occupancy
rates.(
Percentage analyses, ratios, turnovers, and other measures of financial
position and operating results are useful analytical measures. They are
helpful in assessing a business’s past performance and predicting its future.
They are not, however, a substitute for sound judgment. In selecting and
interpreting analytical measures, conditions peculiar to a business or its
industry should be considered as well as the influence of the general
economic and business environment.(
In determining trends, the interrelationship of the measures used in
assessing a business should be carefully studied. Comparable indexes of
earlier periods should also be studied. Data from competing businesses may
be useful in assessing the efficiency of operations for the firm under analysis.
In making such comparisons, however, it is important to consider the effects
of any differences in accounting methods.(
Corporate Annual Reports
Lesson9of38
Corporations normally issue annual reports to their stockholders and other
interested parties. Such reports summarize the corporation’s operating
activities for the past year and plans for the future. A major component of
annual reports are the financial statements and accompanying notes.
(In order to enhance investor confidence, publicly held corporations are
subject to a number of requirements with respect to their financial
statements. All publicly held corporations are required to have an
independent audit (examination) of their financial statements. Certified
Public Accountants are responsible for conducting these audits and rendering
an opinion on the extent to which the financial statements are presented in
accordance with appropriate accounting standards. In addition, the
independent auditor must provide an additional report attesting to
management’s assessment of internal control.
The Management Discussion and Analysis (MD&A) is a required disclosure
within the annual report filed with the Securities and Exchange Commission.
The MD&A provides critical information in interpreting the financial
statements and assessing the future of the company. It includes an analysis
of the results of operations and discusses management’s opinion about
future performance. It compares the prior year’s results of operations with
the current year’s to explain changes in sales, significant expenses, gross
profit, income from operations, and other items reported on the income
statement. For example, an increase in sales may be explained by referring
to higher shipment volume and/or stronger prices. The MD&A also includes
an analysis of the company’s financial condition. It compares significant
balance sheet items between successive years to explain changes in liquidity
and capital resources. In addition, the MD&A discusses the company’s
exposure to significant risks.(
Analyses used in assessing solvency:
1
1
Current position or liquidity analysis including working capital, current
ratio, and the acid-test ratio or quick ratio
2
2
Accounts receivable analysis including accounts receivable turnover
and number of days’ sales in receivables
3
3
Inventory analysis including inventory turnover and number of days’
sales in inventory
4
4
Ratio of fixed assets to long-term liabilities
5
5
Ratio of liabilities to stockholders’ equity
6
6
Number of times interest charges are earned
Major analyses used in assessing profitability:
1
1
Return on Sales
2
2
Return on Assets
3
3
Return on Stockholders’ Equity
4
4
Return on Common Stockholders’ Equity
5
5
Earnings per share on Common Stock
Analyses regarding the market:
1
1
Price-earnings Ratio(
2
2
Dividends per Share(
3
3
Dividend Yield
Nature of Capital Investment Analysis
Lesson11of38
The Importance of Capital Investment
Analysis
Why are you spending time and money on a higher education? Most people
believe that the money and time spent now will return them more income in
the future. In other words, a higher education is an investment in future
earning ability. How would you know if this investment is worth it? One
method would be to compare the cost of a higher education against the
estimated future increased earning power. The more your expected future
increased earnings exceed the investment, the more attractive the
investment.
In the same sense, business organizations analyze potential capital
investments by using various methods that compare investment costs to
future earnings and cash flows. Analyses are useful for making investment
decisions, which may involve thousands, millions, or even billions of dollars.
A businessperson will need to understand the similarities and differences
among the most commonly used methods of evaluating investment
proposals as well as the uses of diverse methods.(
It is important to know the qualitative considerations affecting investment
analyses, as well as understanding the considerations complicating
investment analyses. Allocating available investment funds among
competing proposals is a critical decision in a capital investment program.
The Nature of Capital Investment Analysis
How do companies decide to make significant investments such as the
following?(
Should General Electric invest $100 million in improving efficiency in an
aircraft engine facility, spend $50 million for a new household appliance
factory, or invest $75 million in research and development related to wind
energy?(
Companies use capital investment analysis to help evaluate long-term
investments and compare alternatives. Capital investment analysis (or
capital budgeting) is the process by which management plans, evaluates,
and controls investments in fixed assets. Capital investments involve the
long-term commitment of funds and affect operations for many years. Thus,
these investments must earn a reasonable rate of return, so the business
can meet its obligations to creditors and provide dividends to stockholders.
Because capital investment decisions are some of the most important
decisions that management makes, capital investment analysis must be
carefully developed and implemented.(
Companies use capital investment analysis to help evaluate long-term
investments and compare alternatives. Capital investment analysis (or
capital budgeting) is the process by which management plans, evaluates,
and controls investments in fixed assets. Capital investments involve the
long-term commitment of funds and affect operations for many years. Thus,
these investments must earn a reasonable rate of return, so the business
can meet its obligations to creditors and provide dividends to stockholders.
Because capital investment decisions are some of the most important
decisions that management makes, capital investment analysis must be
carefully developed and implemented.(
A capital investment program should encourage managers to submit
proposals for capital investments. It should communicate to employees the
long-range goals of the business so that useful proposals are submitted. All
reasonable proposals should be considered and evaluated with respect to
economic costs and benefits. The program may reward those whose
proposals are accepted.(
Methods of Evaluating Capital Investment Proposals
Lesson12of38
Capital investment evaluation methods can be grouped into the following
categories:(
1. Methods that do not use present values
2. Methods that use present values
Two methods that do not use present values are the average rate of return
method and the cash payback method. These methods are often used to
initially screen proposals and are useful for proposals with relatively short
useful lives because the timing of cash flows is less important.
The two methods that use present values are the net present value method
and the internal rate of return method. These methods consider the time
value of money. The time value of money concept recognizes that an
amount of cash invested today will earn income and, therefore, has value
over time.(
Management often uses a combination of methods in evaluating capital
investment proposals. Each method has advantages and disadvantages. In
addition, some of the computations are complex. Computers, however, can
perform the computations quickly and easily. Computers can also be used to
analyze the impact of changes in key estimates in evaluating capital
investment proposals.(
Average Rate of Return Method
The average rate of return and the cash payback methods are easy to use.
As already stated, these methods are often initially used to screen proposals.
Management normally sets minimum standards for accepting proposals, and
those not meeting these standards are dropped from consideration. If a
proposal meets the minimum standards, it is often subject to further
analysis.(
The average rate of return method focuses on accounting income rather
than cash flows. In computing the average rate of return, the numerator is
the average of the annual income expected to be earned from the
investment over the investment life, an amount that is net of depreciation.
The denominator is the average book value of the investment over the
investment life. Thus, if straight-line depreciation and no residual value are
assumed, the average investment over the useful life is equal to one-half of
the original cost.(
The average investment is the midpoint of the depreciable cost of the asset.
Since a fixed asset is never depreciated below its residual value, this
midpoint is determined by adding the original cost of the asset to the
estimated residual value and dividing by two.
The average rate of return, sometimes called the accounting rate of return,
is a measure of the average income as a percent of the average investment
in fixed assets as shown in this example: (Assume management is
considering purchasing a machine for $500,000. The machine has a 4-year
useful life with no residual value and is expected to yield total income of
$200,000.
Avg. Rate of Return = Estimated Avg. Annual Income( (/( (Average
Investment
Ave. Rate of Return = (($200,000/4) ((/+( [($500,000 cost + $0 residual)/2]
=(20%
The 20% average rate of return for this project should be compared with
management’s minimum rate for such investments. If the average rate of
return equals or exceeds the minimum rate, the analysis suggests the
machine should be purchased or further analyzed by applying additional
methods.
When several capital investment proposals are considered, they can be
ranked by their average rates of return. The higher the average rate of
return, the more desirable the proposal. In addition to being easy to
compute, the average rate of return method has several advantages. One
advantage is that it includes the amount of income earned over the entire
life of the proposal. In addition, it emphasizes accounting income, which is
often used by investors and creditors in evaluating management
performance. Its main disadvantage is that it does not directly consider the
expected cash flows from the proposal and the timing of these cash flows.(
Cash Payback Method+
Cash flows are important because cash is necessary for both operations and
investments. Very simply, capital investment uses cash and must, therefore,
return cash in the future in order to be successful. The expected period of
time that will pass between the date of an investment and the complete
recovery in cash (or equivalent) of the amount invested is the cash payback
period. The more rapidly an investment generates enough cash to cover its
cost, the less risky the investment. The excess of the cash flowing in from
revenue over the cash flowing out for expenses is termed net cash flow. The
time required for the net cash flow to equal the initial outlay for the fixed
asset is the payback period.(
Assume management is considering a proposed $200,000 investment in a
fixed asset with an 8-year life. Annual cash revenues are $50,000 and annual
cash expenses are $10,000, so the annual net cash flow is expected to be
$40,000. The estimated cash back period for the investment is 5 years.
Payback Period = ( Initial Cash Investment (/ ( Annual Net Cash Flow(
Payback Period = ( $200,000 / ($40,000 = ( 5 years
In this illustration, the annual net cash flows are the same each year
($40,000 per year).
If annual cash flows are not equal, the cash payback period is determined by
adding the annual net cash flows until the cumulative sum equals the
amount of the proposed investment. To illustrate, in the below example, the
cumulative net cash flow equals the initial $400,000 investment at the end of
year 4, so the payback period for this investment is 4 years. ((
Y N Cash Flow C N Cash Flow
1 $60,000 $60,000
2 $80,000 $140,000
3 $105,000 $245,000
4 $155,000 $400,000
5 $100,000 $500,000
6 $90,000 $590,000
Cumulative Net Cash Flow
$400,000 Investment
Years
Line chart with the following items: 1: 60000, 2: 140000, 3: 245000, 4:
400000, 5: 500000, 6: 590000
The cash payback method is widely used to evaluate proposals for
investments in new projects. A short payback period is desirable because the
sooner the cash invested is recovered, the sooner it becomes available for
reinvestment in other projects. In addition, when the payback period is short,
there is less risk of loss due to obsolescence, changing economic conditions,
and other factors. The cash payback period is important to bankers and
other creditors who may depend on net cash flow for repayment of debt
used to fund the investment. The sooner the cash is recovered, the sooner
the debt or other liabilities can be paid. Thus, the cash payback method is
especially useful to managers whose primary concern is liquidity.(
A disadvantage of the cash payback method is that it ignores cash flows
occurring after the payback period and the time value of money.(
Present Value Methods+
An investment in fixed assets may be viewed as the acquisition of a series of
net cash flows over a period of time. The period of time over which these net
cash flows will be received may be an important factor in determining the
value of an investment. Present value methods use both the amount and the
timing of net cash flows in evaluating an investment. Present value concepts
can be divided into the present value of an amount and the present value of
an annuity.(
Present value of an amount: If you were given the choice, would you prefer
to receive $1 now or $1 three years from now? You would prefer to receive
$1 now because you could invest the $1 today and earn interest for three
years. As a result, the amount you would have after three years would be
greater than $1.(
To illustrate, assume that on January 1, 20X1, you invest $1 in an account
that earns 12% interest compounded annually. After 1 year, the $1 will grow
to $1.12 because interest of $.12 (is added to the investment. The $1.12
earns 12% interest for the second year. Interest earning interest is called
compounding. By the end of the second year, the investment has grown to
$1.254; by the end of the third year to $1.404. Thus, if money is worth 12%,
you would be equally satisfied with $1 on January 1, 20X1, or $1.404 three
years later.
Present value of an annuity: An annuity is a series of equal cash flows at
fixed time intervals. Annuities are very common in business. Monthly rental,
salary, and bond interest cash flows are all examples of annuities. The
present value of an annuity is the sum of the present values of each cash
flow. In other words, the present value of an annuity is the amount of cash
that could be invested today to yield a series of equal net cash flows at fixed
time intervals in the future.
To illustrate, a $100 annuity for three periods at 12% is a series of three
annual $100 payments assuming a 12% interest rate.
The present value of this annuity can be computed by utilizing present value
factors from this chart. Each $100 net cash flow could be multiplied by the
present value of $1 at 12% factor for the appropriate period and summed to
determine a present value of $240.20 at the end of a three-year period.
[(100*0.893) + (100*0.797) + (100*0.712) = 240.20] Alternatively, the $100
annual cash flow could be multiplied by the sum of the three individual
present value of $1 factors at 12%, or (0.893 + 0.797 + 0.712 = 2.402) to
compute the $240.20 present value of the annuity.
Net Present Value Method+
The net present value method analyzes capital investment proposals by
comparing the initial cash investment with the present value of the expected
net cash flows generated by the investment. It is sometimes called the
discounted cash flow method. The interest rate (minimum desired rate of
return) used in net present value analysis is set by management. This rate,
sometimes called the hurdle rate, is typically based on such factors as the
nature of the business, the purpose of the investment, the cost of securing
funds for the investment, and the minimum desired rate of return. If the
present value of the cash flows expected from a proposed investment
exceeds the amount of the initial investment, the investment will generate a
return that is greater than management’s hurdle rate, and the proposal is
deemed desirable.(
Present Value Index+
When capital investment funds are limited and the alternative proposals
involve different amounts of investment, it is useful to prepare a ranking of
the proposals by using a present value index. The present value index is
calculated by dividing the total present value of the net cash flow by the
amount to be invested. The present value index for the investment in the
previous example is calculated as follows:(
Present value index = Total present value of net cash flow/amount to be
invested
Present value index = $202,900/$200,000=1.0145
If a business is considering three alternative proposals and has determined
their net present values, the present value index for each proposal is as
follows:(
P A P B P C
Total Present Value of
Net Cash Flow $107,000 $86,400 $93,600
Amount to be Invested $100,000 $80,000 $90,000
Net Present Value $7,000 $6,400 $3,600
Present Value Index 1.07
($107,000 ÷ $100,000)
1.08
($86,400 ÷ $80,000)
1.04
($93,600 ÷ $90,000)
Although Proposal A in the previous example has the largest net present
value, the present value indexes indicate that it is not the most desirable
proposal. Proposal B returns $1.08 present value per dollar invested,
whereas Proposal A returns only $1.07. In addition to the present value
index, the initial investment amounts should also be considered. (Proposal B
requires an $80,000 investment, an amount that is less than the $100,000
required for Proposal A. Although Proposal A has a higher present value
index, management should consider the possible uses for the $20,000
difference between Proposal A and Proposal B investments before making a
final decision.(
An advantage of the net present value method is that it considers the time
value of money. A disadvantage is that the computations are more complex
than those for the methods that ignore present value. In addition, the net
present value method assumes the cash received from the proposal during
its useful life can be reinvested at the rate of return used in computing the
present value of the proposal. Because of changing economic conditions, this
assumption may not always be reasonable.(
Internal Rate of Return Method
The internal rate of return method uses present value concepts to compute
the expected rate of return for capital investment proposals. This method is
sometimes called the time-adjusted rate of return method. It is similar to the
net present value method in that it focuses on the present value of the net
cash flows. However, rather than establishing a minimum return on
investment, the internal rate of return method starts with the net cash flows
and, in a sense, works backward to determine the rate of return expected
from the proposal. (
To illustrate the intuition underlying the internal rate of return method,
assume that a manager is evaluating a proposal to invest in equipment
costing $33,530. The equipment is expected to provide net cash flows of
$10,000 per year for 5 years. If we assume a 12% discount rate, we can use
the appropriate factor from a present value of an annuity table to calculate
the present value of the net cash flows, as follows:
Annual Net Cash Flow (at the end of each of 5 years) $10,000
Present Value of an Annuity of $1 at 12% for 5 Years x 3.605
Present Value of Annual Net Cash Flows $36,050
Less Amount to be Invested - 33,530
Net Present Value $2,520
The $36,050 present value of the cash flows, based on a 12% rate of return,
is greater than the $33,530 to be invested. Therefore, the internal rate of
return must be greater than 12%. Through trial-and-error procedures, a
manager could determine that a 15% rate of return equates the $33,530
cost of the investment with the present value of the expected net cash flows.
Thus, the internal rate of return is 15%.
When equal annual net cash flows are expected from a proposal, the
calculations to determine the internal rate of return can be simplified by
determining a present value factor for an annuity of $1 by dividing the
amount to be invested by the equal annual net cash flows as follows:(
(Present value factor for an annuity of $1 = ( Amount to be invested / Equal annual net
cash flows
To illustrate, assume a manager is evaluating a proposal to purchase
equipment costing $97,360. The equipment is expected to provide equal
annual net cash flows of $20,000 for 7 years. We can compute a present
value factor for an annuity of $1 as follows:
Present value factor for an annuity of $1 = $97,360 / ($20,000 = 4.868
By consulting a table for the present value of an annuity of $1, using a
financial calculator or spreadsheet software, we can determine that for a
period of 7 years, the present value of an annuity of $1 factor of 4.868 is
related to a 10% discount rate. Thus, 10% is the internal rate for this
proposal. If the minimum acceptable internal rate of return for similar
proposals is 10% or less, then the proposed investment should be considered
acceptable. When several proposals are considered, management often
ranks the proposals by their internal rate of return. The proposal with the
highest rate is considered the most desirable.(
The primary advantage of the internal rate of return method is that the
present values of the net cash flows over the entire useful life of the proposal
are considered. In addition, by determining a rate of return for each
proposal, all proposals are compared on a common basis, and application of
the method does not require an assumption about a minimum rate of return.
The primary disadvantage of the internal rate of return method is the
complexity of the computations relative to those required for some other
methods. However, spreadsheet software has internal rate of return
functions that simplify the calculation.(
Like the net present value method, this method assumes that the cash
received from a proposal during its useful life will be reinvested at the
internal rate of return. Because of changing economic conditions, this
assumption may not always be reasonable, and it may represent a limitation
of both methods.(
Factors That Complicate Capital Investment Analysis
Lesson13of38
Additional factors may affect the outcome of a capital investment decision.
Some of the most important of these factors that may warrant consideration
include the following:
Income tax
Proposals with unequal lives
Lease versus capital investment
Uncertainty
Changes in price levels
Qualitative considerations
Income Tax
In many cases, federal income tax may have a material impact on capital
investment decisions. For example, in determining depreciation for federal
income tax purposes, statutory useful lives are often much shorter than
actual useful lives. Since depreciation is deductible in determining taxable
income, accelerated depreciation allowed under tax regulations can affect a
project’s expected cash flows. (
The total cost subjected to depreciation is the same for tax and book
purposes, but rules for tax depreciation often result in the acceleration of
depreciation. Thus, depreciation for tax purposes often exceeds the
depreciation for financial statement purposes in the early years of an asset’s
use. Tax reductions in early years of an asset’s life are offset by higher taxes
in the later years when depreciation is lower. Thus, accelerated depreciation
does not result in a long-run saving in taxes, but it can affect the timing of
cash flows.
The timing of the cash outflows for income taxes can have a significant
impact on capital investment analysis.
Proposals with Unequal Lives+
Previous discussions of alternative methods of analyzing capital investment
proposals were based on the assumption that all investments had the same
useful lives. In practice, however, alternative proposals may have unequal
lives. Ignoring differences in the useful lives of alternative investments can
distort the present value analysis and adversely affect decisions. The
difference in useful lives can be addressed by adjusting the cash flow
assumptions of the proposals to end at the same time.(
To illustrate, assume that alternative investments, a truck and computers,
are being compared. The truck has a useful life of 8 years, and the computer
network has a useful life of 5 years. Each proposal requires an initial
investment of $100,000, and the company desires a rate of return of 10%. To
equate the investment periods, we assume the truck will be sold at the end
of 5 years. The residual value of the truck at the end of five years, i.e., the
proceeds that would be generated by selling the truck, is estimated and this
value is then included as a cash flow at that date. Both investments will then
have 5-year lives, and net present value analysis can be used to compare
the proposals over the same 5-year period. (
If the truck’s estimated residual value is $40,000 at the end of year 5 but the
computers have no residual value, the net present value for the truck will
exceed the net present value for the computers. Using the 10% rate and
residual values to analyze the projects over 5 years, the net present value of
the truck is $18,640 and the net present value of the computers is $16,805.
The net present value of the truck exceeds the net present value for the
computers by $1,835. Thus, the truck may be viewed as the more attractive
proposal.(
Lease versus Capital Investment
Leasing fixed assets is common in many industries. For example, hospitals
often lease diagnostic and other medical equipment. Leasing allows a
business to use fixed assets without tying up the large amounts of cash that
would be needed to purchase them. Leasing may be particularly attractive
when managers believe that a fixed asset has a high risk of becoming
obsolete. When compared to purchasing an asset, leasing may provide an
opportunity to manage and reduce the obsolescence risk. (Certain provisions
of the tax law can also make leasing assets more attractive.(
Normally, leasing assets is more costly than purchasing because the lessor
must charge a rental price that includes not only the costs associated with
owning the assets but also a profit. In many cases, however, it makes sense
for management to consider leasing assets before a final purchase decision
is made. The ability to deduct lease payments from taxable income, costs of
borrowing, and other factors may affect the economics of lease versus buy
decisions. (Applying methods for evaluating capital investment proposals can
help management consider whether it is more profitable to lease, rather than
purchase, an asset. ((
Uncertainty in Capital Investment Analysis
Analyzing capital investment alternatives requires assumptions and
estimates, and these require judgment. (For example, the expected net cash
flows from an investment are usually estimated. Estimates and assumptions
are necessary, but regardless of skill and knowledge of managers, they also
introduce uncertainty. Capital investments typically have relatively long
lives. The need to forecast cash flows and make other assumptions about the
future increases uncertainty when investments have long lives. (
Uncertainty cannot be eliminated, but managers can work to reduce and/or
analyze its effects. Uncertainty may be reduced by incorporating the best
available information. The risks associated with uncertainty can be analyzed
and considered by subjecting capital investment analyses to sensitivity
analysis. This might involve re-computing a net present value under several
different assumptions and/or using alternative discount rates. (Comparing
results of analysis that incorporate assumptions that are more and less
conservative than the manager’s best estimate will help determine how
sensitive the investment analysis is to uncertainty and the assumptions
used. (
Price Levels and Exchange Rates
In performing investment analysis, management must be concerned about
changes in price levels. Price levels may change due to inflation, which
occurs when general price levels are rising. Thus, while general prices are
rising, the returns on an investment must exceed the rising price level or
else the cash returned on the investment becomes less valuable over time.(
Price levels may also change for foreign investments as the result of
currency exchange rates, which are the rates at which a foreign currency can
be exchanged for U.S. dollars. If the amount of foreign currency that must be
exchanged for one U.S. dollar increases, then the foreign currency is said to
be weakening to the dollar. Thus, if a U.S. company made an investment in
another country where the local currency was weakening, the return on the
investment expressed in U.S. dollars would be adversely affected. Even if the
expected amount of the foreign currency returned on the investment is
realized, the change in exchange rates would mean that fewer U.S. dollars
could be purchased.(
Managers should consider potential future price level changes and consider
their effects on the estimates used in capital investment analyses. Changes
in assumptions about price levels and foreign currency exchange rates can
significantly affect analyses.(
Qualitative Considerations
Some benefits of capital investments are qualitative in nature and cannot be
easily measured or expressed in terms of dollars. Since these qualitative
factors can’t readily be incorporated into methods commonly used to
evaluate investment alternatives, they will be ignored if managers do not
take an additional step to consider possible qualitative factors. (
Qualitative considerations in capital investment analysis are most
appropriate for strategic investments. Strategic investments are those that
are designed to affect a company’s long-term ability to generate profits.
Strategic investments often have many uncertainties as well as potential
intangible benefits. Unlike capital investments that are designed to cut costs,
strategic investments may have few “hard” cost savings. Instead, they are
more likely to affect future revenues, which are difficult to estimate. (A well-
known example of a strategic investment is Nucor’s decision to be the first to
invest in new continuous casting technology that had the potential to make
thin gauge sheet steel and thus open new product markets. Nucor’s
investment was justified more on the strategic importance of the investment
than on the economic analysis. As it turned out, the investment was very
successful.
Improvements that increase competitiveness are often difficult to quantify.
Qualitative considerations that may influence capital investment analysis
include product quality, reduction in the number of defective units,
manufacturing flexibility, reduced inventories needed to operate efficiently,
employee morale, manufacturing productivity, reduction or elimination of the
need for inspection to determine product quality, and market opportunity.
Many of these qualitative factors may be as important, if not more important,
than the results of quantitative analysis. Thus, considering both economic
analysis and qualitative factors is often appropriate when making strategic
decisions. ( (
Capital Rationing
Lesson14of38
Funding for capital projects may be obtained from issuing stock, borrowing,
or operating cash. Most companies have some limitations in the amount of
capital available for investment. Capital rationing is the process by which
management makes choices and allocates available funds among competing
capital investment proposals. In this process, management often uses a
combination of the methods discussed thus far.(
In capital rationing, alternative proposals are often screened by establishing
minimum standards for the cash payback and the average rate of return. The
proposals that survive this screening are further analyzed using the net
present value and internal rate of return methods. Throughout the capital
rationing process, qualitative factors related to each proposal should also be
considered. The acquisition of new, more efficient equipment that eliminates
several jobs could lower employee morale to a level that could decrease
overall plant productivity. Alternatively, new equipment might improve the
quality of the product and thus increase consumer satisfaction and sales.(
The final steps in the capital rationing process are ranking proposals
according to management’s criteria, comparing the proposals with the funds
available, and selecting the proposals to be funded. Funded proposals are
included in the capital expenditures budget to assist planning and financing
for operations. Unfunded proposals may be reconsidered if funds become
available later. The decision process for capital rationing is diagrammed
below.
Factors that Complicate Capital Investment Analysis
Income tax
Proposals with unequal lives
Lease versus capital investment
Uncertainty
Changes in price levels
Qualitative considerations
Elements of an Accounting System
Lesson16of38
A financial accounting system is designed to collect and record data from
economic transactions and produce financial statements. Basic financial
statements include the income statement, retained earnings statement,
balance sheet, and statement of cash flows. Each of these individual financial
statements provides different information, but all of the basic financial
statements are interconnected. Accountants refer to this connection
between financial statements as the articulation of financial statements.(
The basic elements of a financial accounting system include (1) standards for
determining what, when, and the amount that should be recorded for
economic events, (2) a framework for preparing financial statements, and (3)
controls to determine whether errors may have arisen in the recording
process. These basic elements are found in all financial accounting systems.(
In the United States, the standards for determining what, when, and the
amount that should be recorded for an entity's economic events are derived
from concepts that form the foundation for Generally Accepted Accounting
Principles (GAAP). International Financial Reporting Standards (IFRS) are
used by companies domiciled in other countries. In recent years, standard
setting bodies have made progress to converge GAAP and IFRS standards.(
The Income Statement
Although financial statements can be prepared on a cash basis, publicly
traded companies must use accrual accounting. In accrual accounting,
business transactions are recorded when the economic effect occurs
regardless of the timing of the related cash flows. For example, if a customer
purchases merchandise on credit, the sale is recorded in the period the
goods are delivered even though the customer is not required to make
payment until the next period. This results in financial statements that are
more useful since profit, resources, and claims to resources are reported. (
The income statement reports results of operations for a given time period.
Investors and creditors use income statements to assess past performance
and predict future performance. The income statement starts with revenue,
deducts expense, and finally adds the effects of gains and losses for a period
of time, ending with the resulting net income. Net income is a measure of
profitability. Investors are particularly interested in this summary measure of
performance. The exhibit illustrates an income statement prepared for
Capital Company for the year ended 20XX.
The Balance Sheet
The balance sheet reports the resources, obligations, and claims of owners
on a particular date.(
A balance sheet is organized to reflect the accounting equation, i.e., assets
equal the sum of liabilities and stockholders’ equity. It shows the assets
available to the organization and the debt and equity used to acquire the
assets. The accounting equation organization of the balance sheet also
demonstrates the equality of the claims of owners, stockholders’ equity, and
the organization’s net assets (assets less liabilities). (
The exhibit illustrates Capital Company’s balance sheet at December 31,
20XX. Note that current assets are listed first. These are assets expected to
be converted to cash within a year. Cash is the first asset listed with other
assets listed in order of liquidity, i.e., the ability to be converted to cash.
Liabilities are listed in order of the payment due date, beginning with current
liabilities, e.g., those due within a year.
The Statement of Cash Flows
The statement of cash flows explains the changes in cash occurring over the
financial statement period. It reports the cash balance at the beginning of
the period, sources and uses of cash during the period, and the cash balance
at the end of the period. The ending cash balance reported on the cash flow
statement will equal the balance reported for cash on the balance sheet at
that date. (
The statement of cash flows presents cash flows organized by type of activity
so that cash flows generated by core business activities can be distinguished
from those related to investing and financing activities. (
The exhibit illustrates Capital Company’s statement of cash flows for the
year ended December 31, 20XX. Note that cash at the end of the year equals
the cash reported on the Capital Company’s balance sheet on the previous
slide.
The Statement of Retained Earnings
The statement of retained earnings explains the changes in retained
earnings over the financial statement period. It reports the retained earnings
balance at the beginning of the period, items that increase or decrease
retained earnings during the period, and the retained earnings balance at
the end of the period. The ending retained earnings balance reported on the
retained earnings statement will equal the balance reported for retained
earnings on the balance sheet at that date. (
Retained earnings represents internally generated capital. It is increased by
net income and decreased by dividends distributed to owners. (
The exhibit illustrates Capital Company’s statement of retained earnings for
the year ended December 31, 20XX. Note that retained earnings at the end
of the year equals the cash reported on the Capital Company’s balance sheet
presented on a previous slide.
Elements of an Accounting System
In order to prepare financial statements, transactions must be analyzed,
recorded, and summarized using a framework. The accounting equation
provides a starting point for designing such a framework. The accounting
equation is expressed as follows:
Assets = Liabilities + Stockholders’ Equity
To illustrate an accounting system, we use an integrated financial statement
approach. This approach facilitates analyzing, recording, and summarizing
transactions by expanding the accounting equation. As illustrated in the next
lesson, this approach reveals the points of articulation between financial
statements and establishes the balance sheet as the nexus among the basic
financial statements. The integrated financial statement approach is a useful
aid in analyzing the financial condition, and changes in the financial
condition, of a company. This is because, without understanding how a
company’s financial statements are prepared and integrated, important
trends or events could easily be missed.(
The integrated financial statement approach has built-in controls that help
ensure that transactions are analyzed, recorded, and summarized correctly.
Specifically, the accounting equation ensures that total assets must equal
total liabilities plus total stockholders' equity on the balance sheet. If at the
end of the period this equality does not hold, then it is clear an error has
occurred in either recording or summarizing transactions. The integrated
financial statement approach provides two additional controls. First, the
ending cash amount shown in the statement of cash flows column must
agree with the amount of cash reported under assets on the balance sheet.
Second, the net income or loss reported on the income statement must
agree with the net effects of revenues and expenses on retained earnings.
Recording a Corporation's First Period of Operations
Lesson17of38
Integrated Financial Statement Framework
Starting Family Health Care, P.C. & Recording First Period
On September 1, 20X1, Lee Landry, M.D., organizes a professional
corporation to practice general medicine. The business will be known as
Family Health Care, P.C., where P.C. refers to “professional corporation,” and
a bank account is opened in this name.(
In this example, Family Health Care’s transactions will be recorded using an
integrated financial statement framework. The first transaction (a) occurs
when Dr. Landry deposits $6,000 into Family Health Care’s bank account in
return for shares of the corporation’s stock. Owners of corporations are
known as stockholders, and stock issued to owners is known as capital stock.
This transaction increases cash from financing activities by $6,000 under the
statement of cash flows column of the worksheet. Increases are recorded as
positive numbers, and decreases are recorded as negative numbers in the
worksheet. This transaction also increases assets (cash) by $6,000 in the left
side of the accounting equation under the balance sheet column. To record
Dr. Landry’s interest in Family Health Care’s net assets and balance the
equation, stockholders' equity (capital stock) on the right side of the
equation is increased by the same amount. Since the transaction does not
affect revenues or expenses, there are no entries in the income statement
column.(
Note that the framework reflects only the business’ (Family Health Care,
P.C.) transactions. Dr. Landry's personal assets (i.e., a home or personal
bank account) and personal liabilities are excluded. The business is treated
as an entity that is separate from its owner.
Borrowing Money
Transaction (b): Family Health Care's next transaction is to borrow $10,000
from Community Bank to finance its operations. To borrow the $10,000, Lee
Landry signed a note payable in the name of Family Health. The note
payable is a liability or a claim on assets that Family Health must satisfy
(pay) in the future. In addition, the note payable requires the payment of
$100 of interest each month until the note is due and repaid in full on
September 30, 20X4. The effect of this transaction is to increase cash from
financing activities by $10,000 under the statement of cash flows column. In
addition, both cash and liabilities (notes payable) are increased under the
balance sheet columns. Observe how this transaction changed the mix of
assets and liabilities on the balance sheet but did not change Family Health
Care's stockholders' equity. That is, assets minus liabilities still equals the
stockholders' equity of $6,000 on the balance sheet. Since no revenues or
expenses are affected, no entries are made under the income statement
column on September 1. At the end of September 20X1, the $100 interest
payment will be recorded.(
Buying Land
Transaction (c): Next, Family Health Care buys land for $12,000 cash. The
land is located near a new suburban hospital that is under construction. Lee
Landry plans for Family Health Care to rent office space and equipment for
several months and build on the land when the hospital is completed. The
effect of this transaction is an outflow of cash as an investing activity. Thus,
a negative $12,000 is entered in the statement of cash flows column as an
investing activity. On the balance sheet, the purchase of the land changes
the makeup of assets, but it does not change the total amount of assets
because cash is decreased, and land is increased by $12,000.
Transactions (b) and (c) have not changed the stockholders' equity of Family
Health Care. They have simply changed the mix of assets and increased the
liability, notes payable. However, the objective of businesses is to increase
stockholders' equity through operations.
Earning Fees
Transaction (d): During the first month of operations, Family Health Care
earns patient fees of $5,500, receiving this amount in cash. The effect of this
transaction is a $5,500 inflow of cash flows from operating activities. Thus, a
positive $5,500 is entered in the statement of cash flows column as an
operating activity. Since cash has been received, cash is increased by $5,500
under the balance sheet column for assets. Fees earned of $5,500 is a
revenue item that is entered in the income statement column as a positive
amount. Because net income retained in the business increases
stockholders' equity (retained earnings) and because revenues contribute to
net income, $5,500 is also entered as an increase in retained earnings in the
stockholders' equity column of the balance sheet. Entering the increases of
$5,500 for cash and retained earnings in the balance sheet columns
maintains the equality of the accounting equation.(
Paying Expenses
Transaction (e): Family Health Care paid the following expenses during the
month: wages, $1,125; rent, $950; utilities, $450; interest, $100; and
miscellaneous, $275. Miscellaneous expenses include small amounts paid for
such items as postage, and newspaper and magazine purchases. The effect
of this transaction is an outflow of cash of $2,900 for operating activities.
Thus, a negative $2,900 is entered in the statement of cash flows column as
an operating activity. Expenses reduce net income and retained earnings. As
a result, each of the expenses is listed as a negative amount in the income
statement column. Finally, a negative $2,900 is also entered in the cash and
retained earnings columns of the balance sheet.(
Paying Dividends
Transaction (f): At the end of the month, Family Health Care pays $1,500 to
stockholders (Dr. Lee Landry) as dividends. Dividends are distributions of
business earnings to stockholders. The effect of this transaction is an outflow
of cash of $1,500 for financing activities. Thus, a negative $1,500 is entered
in the statement of cash flows column as a financing activity. In addition, the
cash and retained earnings are each decreased under the balance sheet
column by $1,500. The effect of this transaction on Family Health Care's
financial statements is summarized below. Be careful not to confuse
dividends with expenses. Dividends are not an expense since they do not
represent assets consumed or services used in the process of earning
revenues. The decrease in stockholders' equity from dividends is listed in the
equation under "Retained Earnings” because dividends are considered a
distribution of retained earnings to the owners.
Family Health Care: September Transactions
In the schedule below, Family Health Care’s September transactions are
identified by letter, and the balances are shown as of the end of September.
Note that under the balance sheet columns, the accounting equation
balances. That is, total assets of $17,100 ($5,100 cash + $12,000 land)
equals total liabilities plus stockholders' equity of $17,100 ($10,000 payable
+ $6,000 capital stock + $1,100 retained earnings).
Stockholders’ Equity
Capital Stock and Retained Earnings are components of Stockholders’ Equity.
The effects of the various transactions on the two components of
stockholders’ equity are summarized below.
CAPTIAL STOCK INCREASED BY STOCKHOLDERS’ INVESTMENTS
RETAINED EARNINGS
Increased by revenues
Decreased by expenses and dividends
Financial Statements for a Corporation's First Period of Operations
Lesson18of38
Preparation of Financial Statements
The September transactions for Family Health Care were recorded in the
order that they occurred. This organization of transactions is not very user-
friendly or helpful in analysis since it does not group and summarize like
transactions together.(
The income statement is normally prepared first using the income statement
column. The income statement is prepared first because the net income or
loss is needed to prepare the retained earnings statement. The retained
earnings statement is prepared second because the ending balance of
retained earnings is needed for preparing the balance sheet. The retained
earnings statement is prepared using the income statement and the amount
recorded for dividends for the period. The balance sheet is prepared next
using the balances as of September 30. The statement of cash flows is
normally prepared last using the statement of cash flows column.
Each financial statement includes a title that identifies the name of the
business, the title of the statement, and the date or period of time.
Income Statement
The income statement for Family Health Care reports fee revenue of $5,500,
total operating expenses of $2,900, and a net income of $2,600. The $5,500
of fee revenue was taken from the income statement column. Likewise, the
expenses were summarized from the income statement column. The
expenses are listed in order of size, beginning with the largest expense.
Miscellaneous expense is usually shown as the last item, regardless of the
amount. The total expenses are subtracted from the fees earned to arrive at
the net income of $2,600. This net income will increase retained earnings
(and thus total stockholders' equity) on the balance sheet.
Retained Earnings Statement
Since Family Health Care has been in operation for only one month, it has no
retained earnings at the beginning of September 20X1. The ending
September balance thus equals the change in retained earnings that results
from the month’s net income and dividends. This balance, $1,100, will be the
beginning retained earnings balance for October 20X1.
Balance Sheet
The amount of Family Health Care's assets, liabilities, and stockholders'
equity as of September 30 are reported on the balance sheet. In the
liabilities section of Family Health's balance sheet, notes payable is the only
liability. When a company has two or more categories of liabilities, each
should be listed in the order they will be paid and the total amount of
liabilities reported. For Family Heath, the September 30, 20X1 Stockholders’
Equity balance consists of $6,000 of Capital Stock and Retained Earnings of
$1,100. Note that the balance sheet equation holds because total assets
equals total liabilities and stockholders’ equity, and this is readily apparent
on the face of the Balance Sheet. The Retained Earnings balance is also
reported on the Retained Earnings Statement.
Statement of Cash Flows
Family Health Care’s Statement of Cash Flows for September is prepared
from the statement of cash flows column of the framework worksheet. Cash
increased from a zero balance at the beginning of the month to $5,100 at
the end of September. A number of cash flows contributed to this net change
in cash. Cash inflows from operating totaled $2,600. Family Health Care’s
cash outflows for investing activities totaled $12,000 spent to acquire land.
This purchase was financed by net cash inflows from financing activities,
including $6,000 contributed by Dr. Landry and $10,000 borrowed on a note
payable, less the $1,500 distributed in cash dividends.
Integration of Financial Statements
This exhibit illustrates the integration of Family Health Care's financial
statements for September and identifies the points of articulation. The
ending cash balance of $5,100 on the balance sheet equals the ending cash
balance reported on the statement of cash flows. Since all revenues and
expenses were received and paid in cash during September, the cash flows
from operating activities of $2,600 reported on the statement of cash flows
equals net income on the income statement. Net income is reported on the
income statement and the retained earnings statement. The ending retained
earnings balance of $1,100 is reported on both the retained earnings
statement and the balance sheet.(
Recording a Corporation's Second Period of Operations
Lesson19of38
To reinforce the understanding of recording transactions and preparing
financial statements, we continue with Family Health Care's October
transactions. During October, Family Health Care entered into the following
transactions: (
Performed patient services and received fees of $6,400 in
cash.
Paid expenses in cash, as follows: wages, $1,370; rent, $950;
utilities, $540; interest, $100; and miscellaneous, $220.
Paid dividends of $1,000 in cash.
These transactions have been analyzed and entered into a summary of
transactions for October. The balance sheet columns begin with the ending
balances as of September 30, 20X1. This is because the balance sheet
reports the cumulative total of assets, liabilities, and stockholders' equity
since the entity’s inception.(
In other words, as of October 1, Family Health Care has cash of $5,100, land
of $12,000, notes payable of $10,000, capital stock of $6,000, and retained
earnings of $1,100. The October transactions are combined with these
beginning balances. In contrast, the income statement and the statement of
cash flows report only transactions for the period. While the retained
earnings statement covers a period of time, it reconciles the beginning
balance to the ending balance.
Financial Statements for a Corporation's Second Period of
Operations
Lesson20of38
The income statement for October reports net income of $3,220. This is an
increase of $620, or 23.8% ($620/$2,600), from September's net income of
$2,600. This increase in net income was due to fees increasing from $5,500
to $6,400, a $900 (or 16.4%) ($900/$5,500) increase from September. At the
same time, total operating expenses increased only $280, or 9.7%
($280/$2,900). This suggests that Family Health Care's operations are
profitable and expanding.
The retained earnings statement reports an increase in retained earnings of
$2,220. This increase results from the addition of net income ($3,220) less
dividends ($1,000) paid to Dr. Landry.
The balance sheet shows that total assets increased from $17,100 on
September 30, 20X1 to $19,320 on October 31. This increase of $2,220 was
due to an increase in cash from operations of $3,220 less the dividends of
$1,000 that were paid to Dr. Landry. Total liabilities remained the same, but
retained earnings and stockholders' equity increased by the same amount
($2,220) as the increase in total assets.
The statement of cash flows shows net cash receipts from operations of
$3,220 and a cash payment for dividends of $1,000. The ending cash
balance of $7,320 reported in the statement of cash flows also appears on
the October 31 balance sheet.(
Basic Elements of an Accounting System:
1 Standards for determining what, when, and the amount that should
be recorded for economic events
2 A framework for preparing financial statements
3 Controls to determine whether errors may have arisen in the
recording process
Sarbanes-Oxley Act of 2002
Lesson22of38
02:15
In the early 2000s, investors and creditors lost millions of dollars in a series
of financial reporting scandals involving companies including Enron,
WorldCom, Tyco, and Adelphia. The resulting public outcry and loss of
investor confidence led Congress to pass the Sarbanes-Oxley Public
Company Accounting Reform and Investor Protection Act in July 2002.
Commonly known as the Sarbanes-Oxley Act or SOX, the Act’s objective was
to restore public confidence in securities markets and to reduce the risk of
corporate fraud.(
Many view SOX as the most significant securities law since the Securities and
Exchange Acts of 1933 and 1934 were passed in the wake of the great
depression. SOX has a variety of provisions including ones that address
responsibility for, and reliability of, financial statements. While SOX applies
only to companies whose stock is traded on public exchanges in the United
States, its internal control provisions have become the standard for
assessing financial controls of all companies, and it has had widespread
influence.(
Internal control is broadly defined as the procedures and processes used by
a company to safeguard its assets, reliably process and report information,
and ensure compliance with laws and regulations. These controls are
important because they can deter fraud and prevent misleading financial
statements. SOX requires companies to maintain strong and effective
internal controls over recording transactions and financial statement
reporting.(
SOX not only requires companies to maintain effective internal controls, but
it also requires companies and their independent accountants to report on
the effectiveness of the company’s internal controls. These reports must be
filed with the company's annual 10-K report with the Securities and
Exchange Commission.(
The Sarbanes-Oxley Act is considered one of the most significant laws
affecting publicly held companies in recent history.
Promotes effective internal controls.
Internal Control
Lesson23of38
Effective internal controls are required by Sarbanes-Oxley. In addition,
effective internal controls help businesses guide their operations and prevent
theft and other abuses. Internal control will be described using the
framework developed by the Committee of Sponsoring Organizations
(COSO), which was formed by five major business associations. The
committee's deliberations were published in Internal Control-Integrated
Framework. This framework has become the standard by which companies
design, analyze, and evaluate internal control.
The COSO framework covers reporting, operating, and compliance
objectives. More specifically, it describes the objectives of internal control as
providing reasonable assurance that (1) financial and nonfinancial reporting
is reliable, timely, and transparent; (2) assets are safeguarded and
operations are effective and efficient; and (3) employees comply with laws
and regulations. Effective internal control supports decision-making by
generating reliable information and reduces the risk of theft, fraud, and
misuse of assets.(
Employee fraud is the intentional act of deception for personal gain and
often involves a breach of internal controls. Examples of employee fraud
may range from purposely overstating expenses on a travel expense report
to embezzling millions of dollars through complex schemes. Employee fraud
illustrates the interconnections between objectives related to reliable
information, safeguarding assets, and compliance with regulations.
Employees attempting to defraud a business will likely seek to both
improperly divert assets from the business and adjust the accounting records
in order to hide their illegal behavior.(
Elements of Internal Control
Management is responsible for designing and applying five elements of
internal control to meet the three internal control objectives. The elements
are:
1. the control environment
2. risk assessment
3. control procedures
4. monitoring
5. information and communication
These elements form an umbrella over the business to protect it from control
threats. The business's control environment is represented by the size of the
umbrella. Risk assessment, control procedures, and monitoring are the fabric
that keeps the umbrella from leaking. Information and communication link
the umbrella to management.
Control Environment
A business's control environment is the overall attitude about the importance
of controls, and it forms the foundation for the system of internal controls.
The control environment is influenced by the tone at the top that is set by
management's philosophy and operating style. A management that
overemphasizes operating goals may indirectly encourage employees to
ignore controls. For example, management pressure to achieve revenue
targets may motivate employees to fraudulently record sham sales. On the
other hand, management’s emphasis of ethical values and internal controls
will likely encourage adherence to control policies and create an effective
control environment.
The COSO Framework identifies the following five principles regarding the
control environment:(
1. The organization demonstrates commitment to integrity and
ethical values.
2. The board of directors demonstrates independence from
management and exercises oversight of the development
and performance of internal control.
3. Management establishes, with board oversight, structures,
reporting lines, and appropriate authorities and
responsibilities in the pursuit of objectives.
4. The organization demonstrates a commitment to attract,
develop, and retain competent individuals in alignment with
objectives.
5. The organization holds individuals accountable for their
internal control responsibilities in the pursuit of objectives.
Risk Assessment
All organizations face risks, and risk is often related to opportunities and
returns. A business’s reporting, operating, and compliance objectives are all
subject to risk. Examples of risks include changes in customer demands,
competitive threats, regulatory changes, changes in economic conditions,
and employee violations of policies and procedures.(
Risk assessment processes identify and respond to risks. Identifying and
controlling risk will help management achieve the objectives of the business.
Once identified, risks can be analyzed to estimate their significance, assess
their likelihood of occurring, and determine actions that will minimize them.
For example, the manager of a warehouse operation may analyze the risk of
employee back injuries, which might give rise to lawsuits. If the manager
determines that the risk is significant, the company may introduce employee
training programs to reduce the risk of injury.
The COSO Framework identifies the following four principles related to an
entity’s risk assessment process:(
specifying objectives with clarity
identifying and analyzing risks related to objectives
how to manage them considering the potential for fraud
identifying and assessing changes that could affect the system of internal
control. (
Control Activities
Control activities are policies and procedures that help ensure that
management’s directives are followed to address risks and provide
reasonable assurance that business objectives are achieved. Control
activities include a variety of activities and occur at all levels and functions
of an organization.
Segregation of duties:(To decrease the possibility of inefficiency, errors,
and fraud, responsibility for custody of assets, authorization of transactions,
and recording transactions should be separated so one person cannot
perpetuate and hide a fraud. With proper segregation of duties, collusion
among multiple employees may be required for a fraud to be perpetrated
and go undetected.
Competent Personnel, Rotating Duties, and Mandatory
Vacations:(Procedures that ensure that employees are adequately trained
and supervised, rotating duties, and mandated vacations encourage
employees to adhere to prescribed procedures and help detect errors or
fraud. Numerous cases of employee fraud have been discovered after a long-
term employee, who never took vacations, missed work because of an illness
or other unavoidable reasons.(
Physical Controls:(Physical controls safeguard assets and ensure reliable
accounting data. These controls include various dimensions of securing
assets, including restricting access to authorized individuals, approval
procedures, and periodic reconciliations of assets on hand with the
accounting records.
Information Processing Controls:(Information processing controls help
ensure that data recorded in systems is complete, valid, and accurate. These
controls relate to both the overall information processing environment and to
the way data is captured and recorded.(
Performance Reviews:(These include a variety of reviews of performance
such as the comparison of actual to budgeted results or the relation between
financial and nonfinancial data.(
Monitoring
Monitoring assesses the performance of the internal control system and
improves control effectiveness by identifying weaknesses, evaluating and
communicating deficiencies to responsible parties, and taking appropriate
corrective actions. The internal control system can be monitored either
through ongoing efforts by management or by separate evaluations. Ongoing
monitoring efforts may include observing both employee behavior and
warning signs from the accounting system.(
Separate monitoring evaluations are generally performed when there are
major changes in strategy, senior management, business structure, or
operations. In large businesses, internal auditors who are independent of
operations normally are responsible for monitoring the internal control
system.(
Internal auditors can report issues and concerns to an audit committee of the
board of directors, who are independent of management.(
In addition, external auditors also evaluate internal control as a normal part
of their annual financial statement audit.
Indicators of Internal Control Problems
These indicators may be clues to internal control problems.
Information and Communication
Information and communication are essential elements of internal control.
Information about the control environment, risk assessment, control
procedures, and monitoring is needed by management to guide operations
and ensure compliance with reporting, legal, and regulatory requirements.
Management can also use external information to assess events and
conditions that impact decision-making and external reporting. For example,
management uses information from the Financial Accounting Standards
Board (FASB) to assess the impact of possible changes in reporting
standards.
Cash Controls over Receipts and Payments
Lesson24of38
Control of Cash Receipts
Cash includes coins, paper money, checks, money orders, and deposits that
are available for withdrawal from banks and financial institutions. Because of
its transferability, cash is the asset most likely to be diverted and used
improperly by employees. In addition, many transactions either directly or
indirectly affect the receipt or the payment of cash. Businesses must
therefore design and use controls that safeguard cash and control the
authorization of cash transactions.
To protect cash from theft and misuse, a business must control cash from
the time it is received until it is deposited in a bank. Businesses normally
receive cash from two main sources: (1) customers purchasing products or
services, and (2) customers making payments on account.
Cash Received from Cash Sales:(Every business must properly safeguard
and record its cash receipts. The following discussion provides an example of
common controls over cash receipts in a retail setting. While business-to-
business transactions would rarely be paid in cash, there would nevertheless
be control procedures.
(In a retail setting, a cash register is an important control protecting cash
received in over-the-counter sales. When a clerk (cashier) enters the amount
of a sale, the cash register normally displays the amount. This is a control to
ensure that the clerk has charged the customer the correct amount. The
customer also receives a receipt to verify the accuracy of the amount.
At the beginning of a work shift, each cash register clerk is given a cash
drawer that contains a predetermined amount of cash for making change for
customers. At the end of the shift, the clerk and the supervisor count the
cash in that clerk's cash drawer. The amount of cash should equal the
beginning amount plus cash sales for the day. Differences will occur if errors
are made in recording cash sales or making change, and any differences
would be recorded.(
At the end of the accounting period, a negative balance in the cash short and
over account is included in Miscellaneous Expense in the income statement.
A positive balance is included in the Other Income section. If a clerk
consistently has significant cash short and over amounts, the supervisor may
require the clerk to take additional training or take other corrective actions.
After a cash register clerk's cash has been counted and recorded on a
memorandum form, the cash is then placed in a store safe in the Cashier's
Department until it can be deposited in the bank. The supervisor forwards
the clerk's cash register receipts to the Accounting Department, where they
serve as the basis for recording the transactions for the day.
Some retail companies use debit card systems to transfer and record the
receipt of cash. In a debit card system, a customer pays for goods at the
time of purchase by presenting a card that authorizes the electronic transfer
of cash from the customer's checking account to the retailer's bank account.
Cash Received in the Mail
Cash is received in the mail when customers pay their bills. This cash is
usually in the form of checks and money orders. Most companies' invoices
are designed so that customers return a portion of the invoice, called a
remittance advice, with their payment. The employee who opens the
incoming mail should initially compare the amount of cash received with the
amount shown on the remittance advice. If a customer does not return a
remittance advice, an employee prepares one. Like the cash register, the
remittance advice serves as a record of cash initially received. It also helps
ensure the payment is accurately posted to the customer's account. Finally,
as a control, the employee opening the mail normally also stamps checks
and money orders "For Deposit Only" in the bank account of the business.(
All cash received in the mail is sent to the Cashier’s Department where an
employee combines it with the receipts from cash sales and prepares a bank
deposit ticket. The remittance advices and their summary totals are
delivered to the Accounting Department. An accounting clerk then prepares
the records of the transactions and posts them to the customer accounts.
When cash is deposited in the bank, the bank normally stamps a copy of the
deposit ticket with the amount received. The bank receipt is returned to the
Accounting Department, where a clerk compares the receipt with the total
amount that should have been deposited. This control helps ensure that all
the cash is deposited and that no cash is lost or stolen on the way to the
bank. Any shortages are thus promptly detected.
Segregating the duties of the Cashier's Department, which handles cash, and
the Accounting Department, which records cash, is a control. An employee
who both handles and records cash could steal cash and change the
accounting records to hide the theft.
Cash Received by EFT
Cash may also be received from customers through electronic funds
transfers (EFTs). For example, customers may authorize automatic electronic
transfers from their checking accounts to pay monthly bills for such items as
cell phone, cable, internet, and electric services. In such cases, the company
sends the customer’s bank a signed form from the customer authorizing the
monthly electronic transfers from the customer’s checking account to the
company’s bank account. Each month, the company electronically notifies
the customer’s bank of the amount of the transfer and the date the transfer
should take place. On the due date, the company records the electronic
transfer as a receipt of cash to its bank account and posts the amount paid
to the customer’s account.
Most companies encourage automatic electronic transfers by customers for
several reasons. First, electronic transfers are less costly than receiving cash
payments through the mail since it eliminates the handling of cash by
employees. Second, electronic transfers enhance internal controls over cash
since the cash is received directly by the bank without the handling of cash
by employees. Thus, the potential for loss or theft of cash is reduced. Finally,
electronic transfers reduce late payments from customers and speed up cash
receipts processing.
Control of Cash Payments
Controls over cash payments should provide reasonable assurance that
payments are made for only authorized transactions. In addition, controls
should ensure that cash is used efficiently. For example, controls should
ensure that all available discounts, such as purchase discounts, are taken. In
a small business, an owner/manager may authorize payments based upon
personal knowledge of goods and services purchased. In a large business,
however, the duties of purchasing goods, inspecting the goods received, and
verifying the invoices are usually performed by different employees. These
duties must be coordinated to ensure that checks for proper payments are
made to creditors. One system used for this purpose is the voucher system.
Voucher System:(A voucher system is a set of procedures for authorizing
and recording liabilities and cash payments. A voucher is any document that
serves as proof of authority to pay cash or issue an electronic funds transfer.
For example, an invoice properly approved for payment could be considered
a voucher. In many businesses, however, a voucher is a special form for
recording relevant data about a liability and the details of its payment. A
voucher system may be either manual or computerized. In a computerized
system, properly approved supporting documents (such as purchase orders
and receiving reports) would be entered directly into computer files. At the
due date, the checks would be automatically generated and mailed to
creditors. At that time, the voucher would be automatically transferred to a
paid voucher file.
Cash Paid by EFT:(Cash can also be paid by electronic funds transfer
systems by using computers rather than paper money or checks. A company
may pay its employees by means of EFT, and many companies are using EFT
systems to pay their suppliers and vendors. Electronic funds payments are
becoming more widely accepted by individuals. TeleCheck Services Inc. and
PayPal offer online real-time check payment options for purchases made
over the Internet.
Bank Accounts
Lesson25of38
Use of Bank Accounts
A business often maintains several bank accounts. For example, a business
with multiple branches or retail outlets such as Target or The Gap Inc. will
often maintain a bank account for each location. In addition, businesses
usually maintain a separate bank account for payroll and other special
purposes.
A major reason that businesses use bank accounts is for control purposes.
Use of bank accounts reduces the amount of cash on hand at any one time.
For example, many merchandise businesses deposit cash receipts twice daily
to reduce the amount of cash on hand that is susceptible to theft.
In addition to reducing the amount of cash on hand, bank accounts provide
an independent record of cash transactions that can be used to verify the
business's records of transactions. That is, the use of bank accounts provides
a double recording of cash transactions. The company's recorded cash
account balance corresponds to the bank's liability (deposit) account for the
company. This double recording of cash transactions allows for a
reconciliation of the cash account on the company's records with the cash
balance recorded by the bank.
Finally, the use of bank accounts facilitates the transfer of funds. For
example, electronic funds transfer systems require bank accounts for the
transfer of funds between companies. Within a company, cash can be
transferred between bank accounts through the use of wire transfers. In
addition, online banking allows companies to transfer funds and pay bills
electronically as well as monitor cash balances on a real-time basis.
Bank Statement
Banks usually maintain a record of all checking account transactions. A
summary of all transactions, called a bank statement, is mailed to the
depositor or made available online, usually each month.(
The bank statement shows the beginning balance, additions, deductions, and
the balance at the end of the period. A typical bank statement is shown in
the exhibit.
Banks may issue a debit or credit memorandum to make adjustments to the
bank account balance for items that are not initiated by the account holder.
One example of a memorandum entry is a customer’s checks returned for
not sufficient funds. Often called NSF checks, these are checks that were
initially deposited and recorded but were not paid when they were presented
to the customer’s bank for payment. Since the bank initially increased the
depositor’s account when the check was deposited, the bank decreases the
depositor’s account when the check is returned without payment.
The reasons for any credit or debit memoranda are indicated on the bank
statement. Some common types of credit and debit memorandum entries
include:
EC – Error correction to correct a bank error
NSF – Not sufficient funds check
SC – Service charge(
ACH – Automated clearing house entry for electronic funds
transfer
MS – Miscellaneous item such as collection of a note
receivable on behalf of
the account holder
Some of the items on the preceding list always result in reduction in the
bank balance. These include NSF checks and service charges. Other items
may result in either an increase or a decrease in the account balance. ACH is
a network for clearing electronic funds transfers among individuals,
companies, and banks. Because electronic funds transfers may be either
deposits or payments, ACH entries may indicate either an increase or a
decrease in the account balance. Similarly, entries to correct bank errors and
miscellaneous items may involve an increase or a decrease to the bank
account balance. (
Bank Accounts as a Control over Cash
Bank accounts are one of the primary tools that companies use to control
cash. Companies often require that all cash receipts are deposited in a bank
account. Except for very small amounts, companies usually use checks or
bank account transfers to make all cash payments. This ensures that there
are two records of cash transactions - one kept by the company and the
other by the bank.
Using a bank statement, a company can compare the cash transactions
recorded in its accounting records to those recorded by the bank. The cash
balance shown on a bank statement is usually different from the cash
balance in the company’s accounting records. This difference is often due to
factors that cause a company and their bank to record the same transaction
at different times. For example, there is often time lag of a day or more
between the date a company writes a check and the date that it is presented
to the bank for payment. In this case, the company records the check when
it is written, but the bank does not record it until the check is presented for
payment. If the company mails deposits to the bank or uses the night
depository, there will usually be a time lag between the date the company
records the deposit and the date that it is recorded by the bank. Similarly, a
bank may also increase or decrease the company’s account for transactions
about which the company will not be informed until later. Examples include
interest on account balances and bank service fees.
A difference could also be the result of errors made by either the company or
the bank. For example, the company might incorrectly post $450 to cash in
the accounting records when the check was written for $4,500. Likewise, a
bank might incorrectly record the amount of a check.
In the example provided, Power Networking should determine the reason for
the difference between the ending balance listed in their bank statement and
the ending balance listed in their records.
Bank Reconciliation
Lesson26of38
For effective control, the reasons for the difference between the cash
balance on the bank statement and the cash balance in the accounting
records should be analyzed by preparing a bank reconciliation. A bank
reconciliation is an analysis of the items and amounts that cause the cash
balance reported in the bank statement to differ from the balance of the
cash account in the company’s ledger in order to determine the proper
(adjusted) cash balance.
A bank reconciliation is usually divided into two sections. The first section,
referred to as the bank section, begins with the cash balance according to
the bank statement and ends with the adjusted balance. The second section,
referred to as the company section, begins with the cash balance according
to the company's records and ends with the adjusted balance. The two
amounts designated as the adjusted balance must be equal. The objective of
reconciling bank accounts is to control cash by reconciling the company’s
records to the records of an independent source, the bank. In doing so,
errors or misuse of cash may be detected.
For effective control, the bank reconciliation should be prepared by an
employee who does not take part in, or record, cash transactions. When
these duties are not properly separated, mistakes are more likely to occur,
and it is more likely that cash will be stolen or otherwise misapplied. For
example, an employee who takes part in all of these duties could prepare
and cash an unauthorized check, omit it from the accounts, and omit it from
the reconciliation.
Bank Reconciliation for Power Networking
Power Networking bank reconciliation begins with the cash balance
according to the bank statement. Add any deposits not recorded by the
bank, usually because they were made after the statement closed. Deduct
any outstanding checks to get an adjusted balance.
Look at the cash balance according to Power Networking records. Add note
and interest collected by the bank. Deduct check returned for insufficient
funds, bank service charge or errors in recording checks. This gives an
adjusted balance that should match the bank balance.
Special-Purpose Cash Funds
Lesson27of38
It is usually not practical for a business to write checks to pay small amounts,
such as postage. Yet, these small payments may occur often enough to add
up to a significant amount. Thus, it is desirable to control such payments. A
special cash fund, called a petty cash fund, is used for this purpose.(
A petty cash fund is established by first estimating the amount of cash
needed for payments from the fund during a period, such as a week or a
month. After necessary approvals, a check is written and cashed for this
amount. The money obtained from cashing the check is then given to an
employee, called the petty cash custodian, who is authorized to disburse
cash from the fund. For control purposes, the company may place
restrictions on the maximum amount and the types of payments that can be
made from the fund. Each time a payment is made from petty cash, the
custodian records the details of the payment on a petty cash receipt form.
The petty cash fund is normally replenished at periodic intervals, when it is
depleted, or when it reaches a minimum amount. When a petty cash fund is
replenished, the accounts are adjusted by summarizing the petty cash
receipts. A check is then written for this amount, payable to petty cash.
In addition, businesses often use other cash funds to meet special needs,
such as travel expenses for salespeople. Retail businesses use change funds
for making change for customers. Finally, most businesses use a payroll
bank account to pay employees. Such cash funds are called special-purpose
funds. Just like a petty cash fund, any of these other special-purpose cash
funds are initially established by first estimating the amount of cash needed
for payments from the fund during a period, such as a week or a month.
After necessary approvals, a check is written and cashed for this amount.
The money obtained from cashing the check is then given to an employee,
called the custodian, who is authorized to disburse money from the fund. For
control purposes, the company may place restrictions on the fund.
Reporting Cash on Financial Statements
Lesson28of38
Cash is the most liquid asset, and therefore it is listed as the first asset on
the balance sheet. Most companies present only a single cash amount on the
balance sheet that represents the total of all their bank and cash fund
accounts. A company may have cash in excess of its immediate operating
needs. In such cases, the company may invest in highly liquid investments in
order to earn interest. These investments are called cash equivalents.
Examples of cash equivalents include U.S. Treasury Bills, notes issued by
major corporations (referred to as commercial paper), and money market
funds. Companies that have invested excess cash in cash equivalents usually
report cash and cash equivalents as one amount on the balance sheet. Large
corporations often disclose the details of their cash and cash equivalents in
the notes to the financial statements, an example of which follows:(
Banks may require companies to maintain minimum cash balances in their
bank accounts. Banks may impose requirements such as compensating
balance as a part of a loan agreement or line of credit. A line of credit is a
preapproved amount that the bank is willing to lend to a customer upon
request. If significant, compensating balances should be disclosed in notes to
the financial statements.
Management is responsible for designing and applying five elements of
internal control to meet the three internal control objectives. The elements
are:
1 the control environment
2 risk assessment
3 control procedures
4 monitoring
5 information and communication
Control Activities/Procedures Include:
1 Competent personnel, rotating duties, and mandatory vacations
2 Separating responsibilities for related operations
3 Separating operations custody of assets and accounting
4 Proofs and security measures
Nature and Objectives Budgeting
Lesson30of38
09:13
Objectives of Budgeting
A budget charts a course for a business by outlining its plans in monetary
terms. The budgeting process requires planning, establishing and
communicating goals, monitoring and evaluating performance, and taking
corrective action. This makes budgets an important tool that helps
businesses navigate through the budget period and manage risk.
Budgets are used by all types of entities, including profit-making businesses,
governments, and non-profit entities. There are a variety of budgeting
approaches, but in general, budgeting involves (1) establishing specific goals
for the overall entity and its units, (2) executing plans to achieve the goals,
(3) periodically comparing actual results with the goals, and (4) considering
appropriate actions in response. Establishing specific goals for future
operations relates to management’s planning function, while executing
actions to meet the goals is part of management’s directing function.
Periodically comparing actual results with these goals and taking appropriate
action is the controlling function of management. The relationships of these
functions are illustrated below.
Human Behavior and Budgeting
Business, team, and individual goals are established in the budgeting
process. Since organizations are composed of individuals, human behavior is
an important consideration when establishing budget goals. Employee
behaviors may not maximize odds of achieving the organization’s goal if (1)
a budget goal is unachievable (too tight), (2) a budget goal is very easy to
achieve (too loose), or (3) budget goals of the business conflict with the
objectives of employees (goal conflict).
People can become discouraged if performance expectations are set too
high. If employees view budget goals as unrealistic or unachievable, the
budget may actually discourage employees from working hard or
internalizing the goals. On the other hand, aggressive but attainable goals
can inspire employees to achieve the goals. Therefore, participative
budgeting, where employees participate in the budget process, may be
helpful in establishing appropriate budget goals.
Although employees can be incentivized by attainable goals, it is undesirable
to set goals that are far below what is possible. Such budget "padding” is
termed budgetary slack. Managers may incorporate slack into budgets in
order to provide a "cushion" for unexpected events or to improve the
appearance of operations. Budgetary slack may be an unintended
consequence of participative budgeting, but it can be reduced or avoided by
requiring lower and mid-level managers to support their spending
requirements with operational plans.
Goal conflict occurs when an individual’s self interest differs from business
objectives. This can happen when budget goals for individual units conflict
with overall business objectives. Such conflicts can be subtle. For example,
the Sales Department manager may be given a sales goal, while the
Manufacturing Department manager may be given a cost reduction goal. It
may be difficult to satisfy both goals since selling more will likely require that
more goods are manufactured. When designing goals, considering
consistency across the organization can reduce goal conflict.
Budgeting Systems
Budgeting systems vary among businesses because of such factors as
organizational structure, complexity of operations, and management
philosophy. Differences in budget systems are even more significant among
different types of businesses, such as manufacturers and service
businesses.(
The budgetary period for operating activities usually includes the fiscal year
of a business. A year is short enough that future operations can be estimated
fairly accurately, yet long enough that the future can be viewed in a broad
context. However, to achieve effective control, annual budgets may be
subdivided into shorter time periods such as quarters, months, or weeks.
Two examples of budget periods that do not have a fixed length include life-
cycle budgeting and continuous budgeting. In life-cycle budgeting, the full
length of a project defines the budget period. This method can incorporate
all phases of a product from R&D through phase-out and recycling. Life-cycle
budgeting typically spans multiple years. Continuous budgeting is a variation
of fiscal-year budgeting that maintains a rolling 12-month period. The 12-
month budget is continually revised by removing the data for the month just
ended and adding estimated budget data for the same month next year, as
shown below:
Developing budgets for the next fiscal year usually begins several months
prior to the end of the current year. This responsibility may be assigned to a
budget committee that often consists of the budget director and such high-
level executives as the controller, the treasurer, production managers, and
sales managers. Once the budget has been approved, the budget process is
typically monitored, summarized, and communicated to the committee by
accountants. There are several approaches for developing budgets.(
In incremental approaches, last year's budget is revised based on actual
results and expected changes for the coming year. Two types of budgets
using an incremental approach are the static budget and the flexible
budget.(
In minimum level approaches, a base budget amount is established for
specific items, and budgeting more than this amount requires justification.
One variant of this method, zero-based budgeting, requires managers to
estimate sales, production, and other operating data as though operations
are being started for the first time. This approach is often used by
governmental units and has the benefit of taking a fresh view of operations
each year.
In activity-based approaches, activities that incur costs are identified, costs
drivers are established for the various activities, and these are used to
compile budgeted amounts based on expected activity levels. This approach
often involves detailed cost planning and strong links between budgets and
the entity’s goals, but it is also costly when compared to other more
traditional budgeting approaches.(
Static Budgets
A static budget shows expected results for only one activity level. Once the
budget is determined, it is not changed, even if a unit’s level of activity
changes. This is a disadvantage of static budgets. Static budgeting is used
by many service companies and some administrative functions of
manufacturing companies, such as purchasing, engineering, and accounting.
The following is an example of a static budget.(
ACME M Company
A Department Budget
F the Year Ended July 31, 20XX
Direct Labor
Electric Power
Supervisor Salaries
$40,000
5,000
15,000
Total Department Costs $60,000
Flexible Budgets
Unlike static budgets, flexible budgets show the expected results of a
responsibility center for several activity levels. A flexible budget is thus a
series of static budgets for different levels of activity. Flexible budgets are
especially useful for estimating and controlling factory costs and operating
expenses. The example below is a flexible budget for Acme Manufacturing
Company’s Assembly Department.
ACME M Company
A Department Budget
F the Year Ended July 31, 20XX
Units of Production 8,000 9,000 10,000
Variable Costs:
Direct Labor ($5 per Unit)
Electric Power ($0.50 per Unit) ( ( ( ( ( (
Total Variable Costs
$40,000
( ( ( ( ( ( ( 4,000
$44,000
$45,000
( ( ( ( ( ( ( 4,500
$49,500
$50,000
( ( ( ( ( ( ( 5,000
$55,000
Fixed Costs:
Electric Power
Supervisor Salaries ( ( ( ( ( ( ( ( ( ( ( ( ( ( (
Total Fixed Costs
$1,000
( ( ( ( ( ( 15,000
$16,000
$1,000
( ( ( ( ( ( 15,000
$16,000
$1,000
( ( ( ( ( ( 15,000
$16,000
Total Assembly Department Costs $60,000 $65,500 $71,000
With the flexible budget, the Assembly Department’s performance can be
evaluated by comparing actual costs to amounts budgeted for the actual
level of activity. For example, if the department produced 10,000 units and
spent $70,000, the department would be $1,000 under the $71,000
budgeted for this level of activity. If a static budget had been prepared at the
8,000 unit level of activity, the department would have been $10,000 over
the $60,000 budgeted. A flexible budget is much more helpful in evaluating
performance relative to activity level.
Budgeting Systems
Computerized budgeting systems are commonly used in developing budgets.
Such systems can help businesses prepare a budget more quickly and at a
lower cost. Computerized systems facilitate the timely comparison of actual
results with budgeted amounts. Computers can play a particularly important
role in continuous budgeting.(
Managers often use computer spreadsheets or simulation models to analyze
operating and budget relationships. By using computer simulation models,
the impact of various operating alternatives on the budget can be assessed.
For example, the budget can be revised to show the impact of a proposed
change in wage rates. Likewise, the overall budgetary effect of a proposed
product line can be estimated.
A common objective of using computer-based budgeting is to tie all the
budgets of the organization together. Some budgeting and planning systems
accomplish this by using web-based applications to tie thousands of
employees together.
Master Budget
Lesson31of38
Organizations prepare a series of budgets that are linked together in a
master budget that facilitates coordination of operations and preparation of
budgeted financial statements. Many types of organizations use master
budgets. This example illustrates the budgeting process for a manufacturer.
The major parts of the master budget for a manufacturer:(
The budgeting process begins by estimating sales for a sales budget. The
sales budget is then provided to the various units as the basis for estimating
production and selling and administrative expenses for budgets. The
production budgets are used to prepare the direct materials purchases,
direct labor cost, and factory overhead cost budgets. These three budgets
are used to develop the cost of goods sold budget. Once all these budgets
have been completed, the budgeted income statement can be prepared.
After the budgeted income statement is developed, the budgeted balance
sheet can be prepared. Two major budgets related to the budgeted balance
sheet are the cash budget and the capital expenditures budget.(
Income Statement Budgets
This exhibit illustrates the relationship among the various income statement
budgets. A small manufacturing business, Elite Accessories Inc., will be used
as the basis to illustrate the major elements of the income statement
budget.(
Sales Budget
The sales budget forecasts sales revenues. For each product, it normally
includes (1) the estimated quantity of unit sales and (2) the expected unit
selling price. These data are often reported by regions or by sales
representatives.
In estimating the quantity of sales for each product, past sales volumes are
often used as a starting point. These amounts are revised for factors
expected to affect future sales, such as the following:
Backlog of unfilled sales orders
Planned advertising and promotion
Expected industry and general economic conditions
Productive capacity
Projected pricing policy
Findings of market research studies
Once an estimate of the sales volume is made, the expected sales revenue is
determined by multiplying the volume by the expected unit sales price.(
For control purposes, management can compare actual sales and budgeted
sales by product, region, or sales representative. Management would
investigate any significant differences and take possible corrective actions.
Sales Budget for Elite Accessories Inc.
Production Budget
Production should be carefully coordinated with the sales budget to ensure
that production and sales are kept in balance during the period. The number
of units to be manufactured to meet budgeted sales and inventory needs for
each product is set forth in the production budget. The budgeted volume of
production is determined as follows:
Expected units to be sold + Desired units in ending inventory - Estimated units in
beginning inventory = Total units to be produced
Below is the production budget for Elite Accessories Inc.
Direct Materials Purchases Budget
The production budget is the starting point for determining the estimated
quantities of direct materials to be purchased. Multiplying these quantities
by the expected unit purchase price determines the total cost of direct
materials to be purchased.(
Materials required for production + Desired ending materials inventory - Estimated
beginning materials inventory = Direct materials to be purchased
In Elite Accessories Inc.’s production operations, leather and lining are
required for wallets and handbags. The direct materials purchases budget is
prepared. As shown in the budget, for Elite Accessories Inc. to produce
520,000 wallets, 156,000 square yards (520,000 units x 0.30 square yard per
unit) of leather are needed. Likewise, to produce 292,000 handbags, 365,000
square yards (292,000 units x 1.25 square yards per unit) of leather are
needed. We can compute the needs for lining in a similar manner. Then
adding the desired ending inventory for each material and deducting the
estimated beginning inventory determines the amount of each material to be
purchased. Multiplying these amounts by the estimated cost per square yard
yields the total materials purchase cost.
The direct materials purchases budget helps management maintain
inventory levels within reasonable limits. For this purpose, the timing of the
direct materials purchases should be coordinated between the Purchasing
and Production Departments.
Direct Materials Purchases Budget for Elite
Accessories Inc.
Direct Labor Cost Budget
The production budget also provides the starting point for preparing the
direct labor cost budget. As shown in the budget, for Elite Accessories Inc. to
produce 520,000 wallets, 52,000 hours (520,000 units X 0.10 hour per unit)
of labor in the Cutting Department are required. Likewise, to produce
292,000 handbags, 43,800 hours (292,000 units X 0.15 hour per unit) of
labor in the Cutting Department are required. In a similar manner, we can
determine the direct labor hours needed in the Sewing Department to meet
the budgeted production. Multiplying the direct labor hours for each
department by the estimated department hourly rate yields the total direct
labor cost for each department. The direct labor needs should be
coordinated between the Production and Personnel Departments. This
ensures there will be enough labor available for production.
Factory Overhead Cost Budget
The estimated factory overhead costs necessary for production make up the
factory overhead cost budget. This budget usually includes the total
estimated cost for each item of factory overhead, as shown below.
A business may prepare supporting departmental schedules, in which the
factory overhead costs are separated into their fixed and variable cost
elements. Such schedules enable department managers to direct their
attention to those costs for which they are responsible and to evaluate
performance.
Cost of Goods Sold Budget
The direct materials purchases budget, direct labor cost budget, and factory
overhead cost budget are the starting point for preparing the cost of goods
sold budget.(
These data are combined with the desired ending inventory and the
estimated beginning inventory data to determine the budgeted cost of goods
sold shown below.
Looking at the example, the cost of goods sold budget for Elite Accessories
Inc. begins with a finished goods inventory of $1,095,600 as of Jan 1st.(
We show a work in process inventory, as of Jan 1st(of $214,400.(
We take the direct materials, which shows a direct materials inventory of
$99,000 and direct materials purchased of $2,587,500 (from the direct
materials purchases budget) for a total cost of direct materials available for
use of $2,686,500.(
We take out the material inventory as of Dec 31 of $104,400, giving us a
total cost of direct materials placed in production of $2,585,100. We add in
direct labor of $4,851,600 and factory overhead of $2,089,080 (both come
from their respective budgets). Our total manufacturing cost is $9,522,780
(the total of cost of direct materials, direct labor and factory overhead). We
add in the work in process inventory of Jan 1, which gives us a total work in
process during the period of $9,737,180.
Subtract the work in process inventory Dec 31 of $220,000, leaving a cost of
goods manufactured of $9,517,180. We add the beginning finished goods
inventory Jan 1 to the cost of goods manufactured for a total of $10,615,780,
which is our cost of finished goods available for sale. Subtract the less
finished good inventory Dec 31 of $1,565,000 for a cost of goods sold of
$9,047,780.
We see Note A regarding leather of 18,000 square yards multiplied by $4.50
per square yard totaling $81,000; and lining of 15,000 square yards
multiplied by $1.20 per square yard totaling $18,000. The sum of these two
are the direct materials inventory on Jan 1st of $99,000.
Note B shows leather of 20,000 square yards multiplied by $4.50 per square
yard totaling $90,000; and lining of 12,000 square yards multiplied by $1.20
per square yard totaling $14,400. The sum of these two are the direct
materials inventory on Jan 1st of $104,400.
Selling and Administrative Expenses Budget
The sales budget is often used as the starting point for estimating the selling
and administrative expenses. For example, a budgeted increase in sales may
require more advertising. Below is a selling and administrative expenses
budget for Elite Accessories Inc.(
Detailed supporting schedules are often prepared for major items in the
selling and administrative expenses budget. An advertising expense
schedule for the Marketing Department should include the advertising media
to be used (newspaper, direct mail, television), quantities (column inches,
number of pieces, minutes), and the cost per unit. Effective control results
from assigning responsibility for achieving the budget to department
supervisors.
Budgeted Income Statement
The budgets for sales, cost of goods sold, and selling and administrative
expenses, combined with the data on other income, other expense, and
income tax, are used to prepare the budgeted income statement. Below is a
budgeted income statement for Elite Accessories Inc. The budgeted income
statement summarizes the estimates of all phases of operations. This allows
management to assess the effects of the individual budgets on profits for the
year. If the budgeted net income is too low, management could review and
revise operating plans in an attempt to improve income.
Cash Budget
Managers use balance sheet budgets to plan their firm’s objectives related to
financing, investing, and cash. The cash and capital expenditure budgets for
Elite Accessories Inc. will be used to illustrate balance sheet budgets. The
cash budget is one of the most important elements of the budgeted balance
sheet. The cash budget presents expected cash receipts (inflows) and cash
payments (outflows) for a period of time. Information from the various
operating budgets, including the sales budget, direct materials purchases
budget, and selling and administrative expenses budget, affects the cash
budget. In addition, the capital expenditures budget, dividend policies, and
plans for equity or long-term debt financing affect the cash budget.
In this example, the Elite Accessories Inc.’s monthly cash budget for January,
February, and March 20XX are prepared by developing the estimated cash
receipts and estimated cash payments portion of the cash budget. Estimated
cash receipts are planned additions to cash from sales and other sources,
such as issuing securities or collecting interest. A supporting schedule can be
used to estimate collections from sales.
Elite Accessories Inc. expects to sell 10% of its merchandise for cash. Of the
remaining 90% of sales that were made on account, 60% are expected to be
collected in the month of the sale and the remainder in the next month. This
information is used to prepare Elite Accessories’ schedule of collections from
sales presented below. The cash receipts from sales on account are
determined by adding amounts expected to be collected from credit sales
made in the current period (60%) and the receipts from credit sales made in
the previous period (40%) that would have been accrued as accounts
receivable.
Schedule of Collections from Sales
Estimated cash payments are planned cash expenditures for manufacturing
costs, selling and administrative expenses, capital expenditures, and other
uses such as buying securities or paying interest or dividends. Elite
Accessories estimates $24,000 per month for depreciation expense on
machines, and this amount was included in manufacturing costs. Accounts
payable were related to manufacturing costs, and Elite Accessories expects
to pay 75% manufacturing costs in the month in which they are incurred and
the balance in the next month. Elite Accessories’ cash payments are
determined by adding the amounts paid for the current period’s costs (75%)
and amounts accrued as a liability from costs in the previous period (25%)
that will be paid in the current period. The $24,000 of depreciation must be
excluded from all budgeted amounts, since depreciation is a noncash
expense that should not be included in the cash budget.
To complete the cash budget for Elite Accessories Inc., assume that Elite
Accessories Inc. is expecting the following related cash:
Cash balance on January 1 ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( (
$280,000
Quarterly taxes paid on March 31 ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( (
150,000
Quarterly interest expense paid on January 10( ( ( ( ( ( ( ( ( ( ( (
22,500
Quarterly interest revenue received on March 21 ( ( ( ( ( ( ( ( ( (
24,500
Equipment purchased for cash in February( ( ( ( ( ( ( ( ( ( ( ( ( ( (
274,000
In addition, monthly selling and administrative expenses are paid in the
month incurred and are expected to be: January ($160,000), February
($165,000), and March ($145,000).
The minimum cash balance protects against variations in estimates and for
unexpected needs for cash. For effective cash management, much of the
minimum cash balance should be deposited in income-producing securities
that can be readily converted to cash. U.S. Treasury Bills or Notes are
examples of such securities.
Using the cash budget prepared for Elite Accessories, Inc. that is presented
on the next slide, we can compare the estimated cash balance at the end of
the period with the minimum balance required by operations. Assuming that
the minimum cash balance for Elite Accessories Inc. is $340,000, we can
determine any expected excess or deficiency.
Cash Budget for Elite Accessories Inc.
Capital Expenditures Budget
The capital expenditures budget summarizes plans for acquiring fixed assets.
Such expenditures are necessary as machinery and other fixed assets wear
out, become obsolete, or for other reasons need to be replaced. In addition,
it may be necessary to expand plant facilities when demand for a company's
product increases. The useful life of many fixed assets extends over long
periods of time, and expenditures for fixed assets may vary from year to
year. It is normal to project capital expenditures for a number of periods into
the future in preparing the capital expenditures budget. The exhibit below is
a 5-year capital expenditures budget for Elite Accessories Inc.
The capital expenditures budget should be considered in preparing the other
operating budgets. For example, the estimated depreciation of new
equipment affects the factory overhead cost budget. Plans for financing
capital expenditures may also affect the cash budget.
Budgeted Balance Sheet
The budgeted balance sheet estimates an entity’s financial condition at the
end of the budget period. The budgeted balance sheet assumes that all
operating budgets and financing plans are met. It has a format similar to a
balance sheet based on actual data in the accounts. For this reason, a
budgeted balance sheet for Elite Accessories Inc. is not illustrated.
If the budgeted balance sheet indicates a weakness in financial position, it
may be advisable to revise the financing plans or other plans. For example, a
large amount of long-term debt in relation to stockholders’ equity might
require revising financing plans for capital expenditures. Such revisions
might include issuing equity rather than debt.
Standards
Lesson32of38
Standards are performance goals. Service, merchandising, and
manufacturing businesses may all use standards to evaluate and control
operations. For example, long-haul drivers for the United Parcel Service are
expected to drive a standard distance per day. The Limited’s sales
associates are expected to meet sales standards.
Manufacturers normally use standard costs for each of the three
manufacturing costs: direct materials, direct labor, and factory overhead.
Accounting systems that use standards for these costs are called standard
cost systems. These systems enable management to determine how much a
product should cost (standard cost), how much it actually costs (actual cost),
and the reasons for any difference (cost variances). When actual costs are
compared with standard costs, only the exceptions or variances are reported
for cost control. This reporting by the principle of exceptions allows
management to focus on correcting the variances. Thus, using standard
costs assists management in controlling costs and in motivating employees
to focus on costs.
Setting standards is both an art and a science. The standard-setting process
normally requires the joint efforts of accountants, engineers, and other
management personnel. Setting standards often begins with analyzing past
operations. However, standards are not just an extension of past costs, and
caution must be used in relying on past cost data. For example, inefficiencies
may be contained within past costs. In addition, changes in technology,
machinery, or production methods may diminish the relevance of past costs
for future operations.
Types of Standards
Standards imply an acceptable level of production efficiency. One of the
major objectives in setting standards is to motivate workers. To achieve the
most benefit from standard costing, standards should be attainable.
Standards that are too loose may not motivate employees to perform their
best since the standard level of performance can be reached easily. As a
result, operating performance may be lower than what is possible. Tight,
unrealistic standards may also negatively affect performance. Workers may
become frustrated with an inability to meet standards and may give up
trying to do their best. Ideal standards, also known as theoretical standards,
can be achieved only under perfect operating conditions, such as no idle
time, no machine breakdowns, and no materials spoilage. Although ideal
standards are not widely used because they are often unattainable, a few
firms use ideal standards to motivate changes and improvement. This
approach is termed "Kaizen costing.” Kaizen is a Japanese term meaning
"continuous improvement.”
Most companies use currently attainable standards (sometimes called
normal standards). These standards represent performance that can be
attained with reasonable effort. Attainable standards allow for normal
production difficulties and mistakes, such as materials spoilage and machine
breakdowns. Attainable standards may help motivate employees to become
more focused on costs and more likely to put forth their best efforts.
Issues with Standards
Standard costs should be continuously reviewed and should be revised when
they no longer reflect operating conditions. Inaccurate standards may distort
management decision-making and may weaken management's ability to
plan and control operations.
Standards should not be revised just because they differ from actual costs.
They should be revised only when the standards no longer reflect the
operating conditions they were intended to measure. For example, the direct
labor standard would not be revised simply because workers were unable to
meet properly determined standards. On the other hand, standards should
be revised when prices, product designs, labor rates, or manufacturing
methods change. For example, when aluminum beverage cans were
redesigned to taper slightly at the top of the can, manufacturers reduced the
standard amount of aluminum per can because less aluminum was required
for the top piece of tapered cans.
Standards are used to value inventory and to plan and control costs.
Companies are also using standards to assess performance at lower levels of
the organization, for shorter accounting periods, and for an increasing
number of costs.
Using standards for performance evaluation has been criticized by some. For
example, critics assert that standards limit improvement of operations by
discouraging improvement beyond the standard. Regardless of this criticism,
standards are widely used. Most managers strongly support standard cost
systems and regard standards as critical for running large businesses
efficiently.
Budgetary Performance Evaluation
Lesson33of38
The master budget assists a company in planning, directing, and controlling
performance. The control function includes budgetary performance
evaluation and compares the actual performance against the budget. This
comparison is typically shown in a budget performance report.
(We illustrate budget performance evaluation using Western Rider Inc., a
manufacturer of blue jeans. Western Rider Inc. uses standard manufacturing
costs in its budgets. The standards for direct materials, direct labor, and
factory overhead are separated into two components: (1) a price standard
and (2) a quantity standard. Multiplying these two elements together yields
the standard cost per unit for a given manufacturing cost category, as shown
for style XL jeans.
Manufacturing Costs Standard Price x ( ( Standard Quantity per Pair (= Standard Cost per
Pair of XL Jeans
Direct Materials
Direct Labor
Factory Overhead
$5 per sq. yard
$9 per hour
$6 per hour
1.50 sq. yards
0.80 hour per pair
0.80 hour per pair
$7.50
Total Standard Cost Per Pair $19.50
The standard price and quantity are separated because the means of
controlling them are normally different. For example, the direct materials
price per square yard is controlled by the Purchasing Department, and the
direct materials quantity per pair is controlled by the Production Department.
Budgeted costs at planned volumes are included in the master budget at the
beginning of the period. Standard amounts budgeted for materials
purchases, direct labor, and factory overhead are determined by multiplying
the standard costs per unit by the planned level of production. At the end of
the month, the standard costs per unit are multiplied by the actual
production and compared to the actual costs.
To illustrate, assume that Western Rider produced and sold 5,000 pairs of XL
jeans. It incurred direct materials costs of $40,150, direct labor costs of
$38,500, and factory overhead costs of $22,400. The budget performance
report shown below summarizes the actual costs, the standard amounts for
the actual level of production achieved, and the differences between the two
amounts. These differences are called cost variances. A favorable cost
variance occurs when the actual cost is less than the standard cost (at actual
volumes). An unfavorable variance occurs when the actual cost exceeds the
standard cost (at actual volumes).
WESTERN RIDER INC.
B Performance Report
F the Month Ended June 30, 20XX
Manufacturing Costs Actual
Costs
Standard Costs at Actual Volume
(5,000 pairs of XL jeans)*
Cost Variance -
(Favorable)
Unfavorable
Direct Materials
Direct Labor
Factory Overhead
Total Manufacturing
Costs
$40,150
38,500
( ( 22,400
$101,050
$37,500
36,000
( ( ( 24,000
$97,500
$2,650
2,500
( ( ( (1,600)
$3,550)
*5,000 pairs x $7.50 per pair = $37,500
*5,000 pairs x $7.20 per pair = $36,000
*5,000 pairs x $4.80 per pair = $24,000
Based on the information in the budget performance report, management
can investigate significant differences and take corrective action. In the
exhibit presented above, for example, the direct materials cost variance is
an unfavorable $2,650.(
There are two possible explanations for this variance: (1) the amount of blue
denim used per pair of blue jeans was different than expected, and/or (2) the
purchase price of blue denim was different than expected.
Variance from Standards
Lesson34of38
The total difference between actual costs and standard costs for a period is
normally made up of several variances, some of which can be favorable and
some unfavorable. There can be variances from standards in direct materials
costs, in direct labor costs, and in factory overhead costs. The relationship of
these variances to the total manufacturing cost variance is shown below.
Illustrations and analyses of these variances for Western Rider Inc. are
presented in the following slides.
The example shows the total manufacturing cost variance is made up of
direct materials cost variance, direct labor cost variance, and factory
overhead cost variance.
The Direct Material Cost Variance is influenced by direct materials price
variance and direct materials quantity variance.
The Direct Labor Cost Variance is influenced by direct labor rate variance
and direct labor time variance.
The Factory Overhead Cost Variance is influenced by the variable factory
overhead controllable variance and the fixed factory overhead volume
variance.
Direct Materials Variances for Western Rider
Inc.
What caused Western Rider Inc.’s unfavorable materials variance of $2,650?
The total unfavorable cost variance of $2,650 ($40,150 - $37,500) results
from the combination of an excess price per square yard of $0.50 and using
200 fewer square yards of denim. As illustrated below, these two factors can
be reported as two separate variances: the direct materials price variance
and the direct materials quantity variance.(
Standard Price = $5 per yard
Actual Price = $5.50 per yard
Standard Quantity = 1.5 yards/pair of jeans (7,500 yards for
5,000 pairs)
Actual Quantity = 7,300 yards
S A V
Direct Materials(Price
Variance
7,300 yards × $5 per
yard = $36,500
7,300 yards × $5.50
per yard = $40,150 $3,650 Unfavorable
Direct Materials
Quantity Variance
7,500 yards × $5 per
yard = $37,500
7,300 yards × $5 per
yard = $36,500 $1,000 Favorable
Direct Materials Variances
The direct materials price variance is the difference between the actual price
per unit ($5.50) and the standard price per unit ($5.00), multiplied by the
actual quantity used (7,300 square yards). If the actual price per unit
exceeds the standard price per unit, the variance is unfavorable, as shown
for Western Rider Inc. If the actual price per unit is less than the standard
price per unit, the variance is favorable.
The direct materials quantity variance is the difference between the actual
quantity used (7,300 square yards) and the standard quantity at the actual
production level (7,500 square yards), multiplied by the standard price per
unit ($5.00). If the actual quantity of materials used exceeds the standard
quantity budgeted, the variance is unfavorable. If the actual quantity of
materials used is less than the standard quantity, the variance is favorable.
The direct materials variances can be illustrated by making the three
calculations shown below.
The materials price variance is $40,150 minus $36,500 equals $3,650, which
is unfavorable. The price of materials was higher than expected.
The materials quantity variance is $36,500 minus $37,500 equals negative
$1,000, which is favorable. The materials needed was less than expected.
The total direct materials cost variance is $40,150 - $37,500 which equals
$2,650. Because the direct materials cost was higher than expected, this is
unfavorable.
Reporting Direct Materials Variances
The direct materials quantity variance should be reported to the proper
operating management level for corrective action. For example, an
unfavorable quantity variance could be caused by malfunctioning equipment
that has not been properly maintained or operated. However, unfavorable
materials quantity variances are not always caused by Operating
Departments. For example, the excess materials usage may be caused by
purchasing inferior raw materials. In this case, the Purchasing Department
should be held responsible for the variance.(
The materials price variance should normally be reported to the Purchasing
Department, which may or may not be able to control this variance. If
materials of the same quality could have been purchased from another
supplier at the standard price, the variance was controllable. On the other
hand, if the variance resulted from a market- wide price increase, the
variance may not be controllable.
Direct Labor Variances for Western Rider Inc.
Western Rider Inc.’s direct labor cost variance can also be separated into two
parts. The total unfavorable cost variance $2,500 ($38,500 - $36,000) results
from an excess rate of $1.00 per direct labor hour and using 150 fewer direct
labor hours. These two reasons can be reported as two separate variances.(
Standard Rate = $9 per hour
Actual Price = $10 per hour
Standard Hours = 0.80 hours/pair of jeans (4,000 yards for
5,000 pairs)
Actual Hours = 3,850
S A V
Direct Labor Rate
Variance
3,850 hours × $9 per
hour = $34,650
3,850 hours × $10 per
hour = $38,500 $3,850 Unfavorable
Direct Labor Time
Variance
4,000 hours × $9 per
hour = $36,000
3,850 hours × $9 per
hour = $34,650 $1,350 Favorable
Direct Labor Variances
The direct labor rate variance is the difference between the actual rate per
hour ($10.00) and the standard rate per hour ($9.00), multiplied by the
actual hours worked (3,850 hours). If the actual rate per hour is less than the
standard rate per hour, the variance is favorable. If the actual rate per hour
exceeds the standard rate per hour, the variance is unfavorable.
The direct labor time variance is the difference between the actual hours
worked (3,850 hours) and the standard hours at actual production (4,000
hours), multiplied by the standard rate per hour ($9.00). If the actual hours
worked exceed the standard hours, the variance is unfavorable. If the actual
hours worked are less than the standard hours, the variance is favorable.
The direct labor variances are illustrated by making the three calculations
shown below.
Reporting Direct Labor Variances
Controlling direct labor cost is normally the responsibility of the production
supervisors. To aid them, reports analyzing the cause of any direct labor
variance may be prepared. Differences between standard direct labor hours
and actual direct labor hours can be investigated. For example, a time
variance may be incurred because of the shortage of skilled workers. Such
variances may be uncontrollable unless they are related to high turnover
rates among employees, in which case the cause of the high turnover should
be investigated.
Likewise, differences between the rates paid for direct labor and the
standard rates can be investigated. For example, unfavorable rate variances
may be caused by the improper scheduling and use of workers. In such
cases, highly paid skilled workers might have been used in jobs normally
performed by unskilled, lower-paid workers. In this case, the unfavorable
rate variance should be reported for corrective action to the managers
responsible for scheduling work assignments.
Standards for Non-manufacturing Expenses
Lesson35of38
Standards for Nonmanufacturing Expenses
Using standards for nonmanufacturing expenses such as service, selling, and
administrative expenses is not as common as using standards for
manufacturing costs. This is because many nonmanufacturing expenses do
not directly relate to a unit of output or other measure of activity. For
example, administrative expenses associated with the work of the office
manager are not easily related to a measurable output. In these cases, static
budgets are often used to control nonmanufacturing expenses.(
When nonmanufacturing activities are repetitive and produce a common
output, standards can be applied. In these cases, the use of standards is
similar to that described for a manufactured product. For example, standards
can be applied to the work of customer service personnel who process sales
orders. A standard cost for processing a sales order (the output) could be
developed. The variance between the actual cost of processing a sales order
and the standard cost could then be used to control sales order processing
costs.
Non-financial Performance Measures
Lesson36of38
Many managers supplement financial performance measures, such as
variances from standard, with nonfinancial measures of performance.
Measuring both financial and nonfinancial performance helps employees
consider multiple, and sometimes conflicting, performance objectives. For
example, one company had a machining operation that was measured
according to a direct labor time standard. Employees did their work quickly
in order to create favorable direct labor time variances. Unfortunately, the
fast work resulted in poor quality that, in turn, created difficulty in the
assembly operation. To encourage employees to consider both the speed
and quality of their work, the company decided to use both a labor time
standard and a quality standard.
In the preceding example, nonfinancial performance measures brought
additional perspectives, such as quality of work, to evaluating performance.
Some additional examples of nonfinancial performance measures are as
follows:
Inventory turnover
On-time delivery
Elapsed time between a customer order and product delivery
Customer preference rankings compared to competitors
Response time to a service call
Time to develop new products
Employee satisfaction
Number of customer complaints
Nonfinancial measures can be linked to either the inputs or outputs of an
activity or process. A process is a sequence of activities linked together for
performing a particular task. For example, the procurement process consists
of the "create purchase order" and "select vendor" activities that are
performed in procuring materials.(
To illustrate nonfinancial measures for a single activity, consider the counter
service activity of a fast-food restaurant. The outputs of the counter service
activity include the customer line wait, order accuracy, and service
experience. The inputs that impact these outputs include the number of
employees, level of employee experience and training, reliability of the
french fryer, menu complexity, fountain drink supply, and the like. Note that
the inputs for one activity could be the outputs of another. For example,
fryer reliability is an input to the counter service activity but is an output of
the french frying activity. Moving back, fryer maintenance would be an input
to the french frying activity.(
(
Thus, a chain of inputs and outputs can be developed between a set of
connected activities or processes. The fast-food restaurant can develop a set
of linked nonfinancial performance measures across the chain of inputs and
outputs. The output measures tell management about performance of the
activity, such as keeping the line wait to a minimum. The input measures are
the factors that affect the activity's performance. Thus, if the fast-food
restaurant line wait is too long, input measures might indicate a need for
more training, more employees, or better fryer reliability.
Budgeting Includes
1 Establishing specific goals for the overall entity and its units
2 Executing plans to achieve the goals
3 Periodically comparing actual results with the goals
4 Considering appropriate actions in response
Nonfinancial Performance Measures
Quality of work
Inventory turnover
On-time delivery
Elapsed time between a customer order and product delivery
Customer preference rankings compared to competitors
Response time to a service call
Time to develop new products
Employee satisfaction
Number of customer complaints
