01 technical
environmental
managementrelevant to acca qualification paper F5 from june 2011
The new Paper F5 syllabus, which is
effective from June 2011 onwards,
introduces the area of environmental
management accounting for the first
time. It has, so far, been examined
only in Paper P5 but, with its growing
importance, it seemed appropriate to
introduce it at an earlier level. The two
requirements of the Paper F5 syllabus
are as follows:
¤ discuss the issues businesses
face in the management of
environmental costs
¤ describe the different methods a
business may use to account for its
environmental costs.
You should note that the Paper F5
syllabus examines ‘environmental
management accounting’ rather
than ‘environmental accounting’.
Environmental accounting is a broader
term that encompasses the provision
of environment-related information
both externally and internally. It focuses
on reports required for shareholders
and other stakeholders, as well of the
provision of management information.
Environmental management
accounting, on the other hand, is a
subset of environmental accounting.
It focuses on information required
for decision making within the
organisation, although much of the
information it generates could also be
used for external reporting.
students should note that the Paper F5
syllabus examines ‘environmental management
accounting’ rather than ‘environmental
accounting’. Environmental accounting is a
broader term that encompasses the provision
of environment-related information both
externally and internally.
The aim of this article is to give
a general introduction on the area
of environmental management
accounting, followed by a discussion
of the first of the two requirements
listed above. The second of them
has already been covered in a high
level of detail in Shane Johnson’s
article of June 2004 (www.accaglobal.
com/students/student_accountant/
archive/2004/42/1073480), so
I will only provide a summary of
the four main environmental cost
accounting techniques
An introduction to
environmental management
accounting (EMA)
Many of you reading this article
still won’t be entirely clear on what
environmental management accounting
actually is. You will not be alone! There
is no single textbook definition for it,
although there are many long-winded,
jargon ridden ones available. Before
we get into the unavoidable jargon, the
easiest way to approach it in the first
place is to step back and ask ourselves
what management accounting itself
is. Management accounts give us
an analysis of the performance of a
business and are ideally prepared on a
timely basis so that we get up-to-date
management information. They break
down each of our different business
segments (in a larger business) in a
high level of detail. This information is
then used to assess how the business’
historic performance has been and,
moving forward, how it can be improved
in the future.

Performance objectives 12, 13 and 14 are relevant to this exam
accounting
Environmental management
accounting is simply a specialised
part of the management accounts that
focuses on things such as the cost of
energy and water and the disposal
of waste and effluent. It is important
to note at this point that the focus of
environmental management accounting
is not all on purely financial costs. It
includes consideration of matters such
as the costs vs benefits of buying from
suppliers who are more environmentally
aware, or the effect on the public image
of the company from failure to comply
with environmental regulations.
Environmental management
accounting uses some standard
accountancy techniques to identify,
analyse, manage and hopefully reduce
environmental costs in a way that
provides mutual benefit to the company
and the environment, although
sometimes it is only possible to provide
benefit to one of these parties. For
example, activity-based costing may
be used to ascertain more accurately
the costs of washing towels at a
gym. The energy used to power the
washing machine is an environmental
cost; the cost driver is ‘washing’.
Environmental management accounting is
a specialised part of the management accounts
that focuses on the cost of energy and
water and the disposal of waste and effluent.
student accountant issue 15/2010
Studying Paper F5?
Once the costs have been identified
and information accumulated on how
many customers are using the gym, it
may actually be established that some
customers are using more than one
towel on a single visit to the gym. The
gym could drive forward change by
informing customers that they need
to pay for a second towel if they need
one. Given that this approach will be
seen as ‘environmentally-friendly’, most
customers would not argue with its
introduction. Nor would most of them
want to pay for the cost of a second
towel. The costs to be saved by the
company from this new policy would
include both the energy savings from
having to run fewer washing machines
all the time and the staff costs of
those people collecting the towels and
operating the machines. Presumably,
since the towels are being washed less
frequently, they will need to be replaced
by new ones less often as well.
02
In addition to these savings to the
company, however, are the all-important
savings to the environment since
less power and cotton (or whatever
materials the towels are made from)
is now being used, and the scarce
resources of our planet are therefore
being conserved. Lastly, the gym
is also seen as an environmentally
friendly organisation and this, in turn,
may attract more customers and
increase revenues. Just a little bit of
management accounting (and common
sense!) can achieve all these things.
While I always like to minimise the
use of jargon, in order to be fully versed
on what environmental management
accounting is really seen by the
profession as encompassing today, it is
necessary to consider a couple of the
most widely accepted definitions of it.
In 1998, the International Federation
of Accountants (IFAC) originally
defined environmental management
accounting as:
‘The management of environmental
and economic performance through
the development and implementation
of appropriate environment-related
accounting systems and practices.
While this may include reporting
and auditing in some companies,
environmental management
accounting typically involves lifecycle
costing, full cost accounting, benefits
assessment, and strategic planning for
environmental management.’
03 technical

Then, in 2001, The United Nations To summarise then, for the purposes ¤ Environmental prevention costs: the
Division for Sustainable Development of clarifying the coverage of the costs of activities undertaken to
(UNDSD) emphasised their belief that Paper F5 syllabus, my belief is that prevent the production of waste.
environmental management accounting EMA is internally not externally focused ¤ Environmental detection costs:
systems generate information for and the Paper F5 syllabus should, costs incurred to ensure that
internal decision making rather than therefore, focus on information for the organisation complies with
external decision making. This is in line internal decision making only. It regulations and voluntary standards.
with my statement at the beginning should not be concerned with how ¤ Environmental internal failure costs:
of this article that EMA is a subset of environmental information is reported costs incurred from performing
environmental accounting as a whole. to stakeholders, although it could activities that have produced
The UNDSD make what became a include consideration of how such contaminants and waste that
widely accepted distinction between information could be reported internally. have not been discharged into
two types of information: physical For example, Hansen and Mendoza the environment.
information and monetary information. (1999) stated that environmental costs ¤ Environmental external failure
Hence, they broadly defined EMA to be are incurred because of poor quality costs: costs incurred on activities
the identification, collection, analysis controls. Therefore, they advocate the performed after discharging waste
and use of two types of information for use of a periodical environmental cost into the environment.
internal decision making: report that is produced in the format
¤ physical information on the use, flows of a cost of quality report, with each It is clear from the suggested format of
and destinies of energy, water and category of cost being expressed this quality type report that Hansen and
materials (including wastes) as a percentage of sales revenues or Mendoza’s definition of ‘environmental
¤ monetary information on operating costs so that comparisons cost’ is relatively narrow.
environment-related cost, earnings can be made between different periods
and savings. and/or organisations. The categories of Managing environmental costs
costs would be as follows: There are three main reasons why the
This definition was then adopted by an management of environmental costs
international consensus group of over is becoming increasingly important in
30 nations and thus eventually adopted organisations. First, society as a whole
by IFAC in its 2005 international has become more environmentally
guidance document on ‘environmental aware, with people becoming
management accounting’. increasingly aware about the ‘carbon
footprint’ and recycling taking place
now in many countries. A ‘carbon
footprint’ (as defined by the Carbon
the management of environmental costs can Trust) measures the total greenhouse
be a difficult process. This is because first, gas emissions caused directly and
indirectly by a person, organisation,
just as EMA is difficult to define, so too are event or product.
the actual costs involved. Second, having
defined them, some of the costs are difficult
to separate out and identify. Third, the costs
can need to be controlled but this can only
be done if they have been correctly identified.

Companies are finding that they can
increase their appeal to customers
by portraying themselves as
environmentally responsible. Second,
environmental costs are becoming
huge for some companies, particularly
those operating in highly industrialised
sectors such as oil production. In
some cases, these costs can amount
to more than 20% of operating
costs. Such significant costs need
to be managed. Third, regulation is
increasing worldwide at a rapid pace,
with penalties for non-compliance also
increasing accordingly. In the largest
ever seizure related to an environmental
conviction in the UK, a plant hire firm,
John Craxford Plant Hire Ltd, had to
not only pay £85,000 in costs and fines
but also got £1.2m of its assets seized.
This was because it had illegally buried
waste and also breached its waste
and pollution permits. And it’s not
just the companies that need to worry.
Officers of the company and even junior
employees could find themselves facing
criminal prosecution for knowingly
breaching environmental regulations.
But the management of
environmental costs can be a difficult
process. This is because first, just
as EMA is difficult to define, so too
are the actual costs involved. Second,
having defined them, some of the
costs are difficult to separate out and
identify. Third, the costs can need to be
controlled but this can only be done if
they have been correctly identified in
the first place. Each of these issues is
dealt with in turn below.
student accountant issue 15/2010
Much of the information that is needed to
prepare environmental management accounts
could actually be found in a business’
general ledger.
Defining environmental costs
Many organisations vary in their
definition of environmental costs.
It is neither possible nor desirable
to consider all of the great range
of definitions adopted. A useful
cost categorisation, however, is that
provided by the US Environmental
Protection Agency in 1998. They stated
that the definition of environmental
costs depended on how an organisation
intended on using the information. They
made a distinction between four types
of costs:
¤ conventional costs: raw material
and energy costs having
environmental relevance
¤ potentially hidden costs: costs
captured by accounting systems
but then losing their identity in
‘general overheads’
¤ contingent costs: costs to be incurred
at a future date, eg clean up costs
¤ image and relationship costs: costs
that, by their nature, are intangible,
for example, the costs of preparing
environmental reports.
The UNDSD, on the other hand,
described environmental costs as
comprising of:
¤ costs incurred to protect the
environment, eg measures taken to
prevent pollution and
¤ costs of wasted material, capital
and labour, ie inefficiencies in the
production process.
04
Neither of these definitions contradict
each other; they just look at the costs
from slightly different angles. As a
Paper F5 student, you should be aware
that definitions of environmental costs
vary greatly, with some being very
narrow and some being far wider.
Identifying environmental costs
Much of the information that is needed
to prepare environmental management
accounts could actually be found in
a business’ general ledger. A close
review of it should reveal the costs of
materials, utilities and waste disposal,
at the least. The main problem is,
however, that most of the costs will
have to be found within the category
of ‘general overheads’ if they are to be
accurately identified. Identifying them
could be a lengthy process, particularly
in a large organisation. The fact that
environmental costs are often ‘hidden’
in this way makes it difficult for
management to identify opportunities
to cut environmental costs and yet it is
crucial that they do so in a world which
is becoming increasingly regulated
and where scarce resources are
becoming scarcer.
05 technical
It is equally important to allocate
environmental costs to the processes or
products which give rise to them. Only
by doing this can an organisation make
well-informed business decisions.
For example, a pharmaceutical
company may be deciding whether to
continue with the production of one
of its drugs. In order to incorporate
environmental aspects into its decision,
it needs to know exactly how many
products are input into the process
compared to its outputs; how much
waste is created during the process;
how much labour and fuel is used
in making the drug; how much
packaging the drug uses and what
percentage of that is recyclable etc
etc. Only by identifying these costs
and allocating them to the product
can an informed decision be made
about the environmental effects
of  continued production.
In 2003, the UNDSD identified four
management accounting techniques
for the identification and allocation
of environmental costs: input/
outflow analysis, flow cost accounting,
activity based costing and lifecycle
costing. These are referred to later
under ‘different methods of accounting
for environmental costs’.
Controlling
environmental costs
It is only after environmental costs have
been defined, identified and allocated
that a business can begin the task of
trying to control them.
It is only after environmental costs have
been defined, identified and allocated that
a business can begin the task of trying to
control them.
As we have already discussed,
environmental costs will vary greatly
from business to business and, to be
honest, a lot of the environmental
costs that a large, highly industrialised
business will incur will be difficult for
the average person to understand,
since that person won’t have a detailed
knowledge of the industry concerned.
I will therefore use some basic
examples of easy-to-understand
environmental costs when considering
how an organisation may go about
controlling such costs. Let us
consider an organisation whose main
environmental costs are as follows:
¤ waste and effluent disposal
¤ water consumption
¤ energy
¤ transport and travel
¤ consumables and raw materials.
Each of these costs is considered in
turn below.
Waste
There are lots of environmental costs
associated with waste. For example,
the costs of unused raw materials and
disposal; taxes for landfill; fines for
compliance failures such as pollution. It
is possible to identify how much material
is wasted in production by using the
‘mass balance’ approach, whereby the
weight of materials bought is compared
to the product yield. From this process,
potential cost savings may be identified.
In addition to these monetary
costs to the organisation, waste has
environmental costs in terms of lost
land resources (because waste has
been buried) and the generation
of greenhouse gases in the form
of  methane.
Water
You have probably never thought about
it but businesses actually pay for water
twice – first, to buy it and second,
to dispose of it. If savings are to be
made in terms of reduced water bills,
it is important for organisations to
identify where water is used and how
consumption can be decreased.
Energy
Often, energy costs can be reduced
significantly at very little cost.
Environmental management accounts
may help to identify inefficiencies
and wasteful practices and, therefore,
opportunities for cost savings.
Transport and travel
Again, environmental management
accounting can often help to identify
savings in terms of business travel
and transport of goods and materials.
At a simple level, a business can
invest in more fuel-efficient vehicles,
for example.

Consumables and raw materials
These costs are usually easy to identify
and discussions with senior managers
may help to identify where savings can
be made. For example, toner cartridges
for printers could be refilled rather
than replaced.
This should produce a saving both
in terms of the financial cost for the
organisation and a waste saving for
the environment (toner cartridges are
difficult to dispose of and less waste is
created this way).
Accounting for
environmental costs
In the context of Paper F5, when the
syllabus requires you to describe the
different methods of accounting for
environmental costs, it aims to cover
two areas:
¤ Internal reporting of environmental
costs, which has already been
discussed in the introduction.
¤ Management accounting techniques
for the identification and allocation
of environmental costs: the most
appropriate ones for the Paper F5
syllabus are those identified by
the UNDSD, namely input/outflow
analysis, flow cost accounting,
activity-based costing and lifecycle
costing. Since these have been more
than adequately covered by Shane
Johnson’s article in the June 2004
edition of Student Accountant, I have
only covered them briefly here. Much
of Shane’s article goes above and
beyond what is required for Paper F5,
since the purpose of that article was
to cover knowledge required by the
advanced performance management
paper, Paper P5.
student accountant issue 15/2010
Input/outflow analysis
This technique records material inflows
and balances this with outflows on the
basis that, what comes in, must go out.
So, if 100kg of materials have been
bought and only 80kg of materials have
been produced, for example, then the
20kg difference must be accounted for
in some way. It may be, for example,
that 10% of it has been sold as scrap
and 90% of it is waste. By accounting
for outputs in this way, both in terms
of physical quantities and, at the end
of the process, in monetary terms
too, businesses are forced to focus on
environmental costs.
Flow cost accounting
This technique uses not only material
flows but also the organisational
structure. It makes material flows
transparent by looking at the physical
quantities involved, their costs and
their value. It divides the material
flows into three categories: material,
system and delivery and disposal. The
values and costs of each of these three
flows are then calculated. The aim
of flow cost accounting is to reduce
the quantity of materials which, as
well as having a positive effect on the
environment, should have a positive
effect on a business’ total costs in the
long run.
activity-based costing distinguishes between
environment-related costs and
environment‑driven costs hidden on
general overheads.
06
Activity-based costing
ABC allocates internal costs to cost
centres and cost drivers on the
basis of the activities that give rise
to the costs. In an environmental
accounting context, it distinguishes
between environment-related costs,
which can be attributed to joint cost
centres, and environment‑driven
costs, which tend to be hidden on
general overheads.
Lifecycle costing
Within the context of environmental
accounting, lifecycle costing is a
technique which requires the full
environmental consequences,
and, therefore, costs, arising from
production of a product to be taken
account across its whole lifecycle,
literally ‘from cradle to grave’.
Summary
I hope you now have a clearer idea
about exactly what environmental
management accounting is and why
it’s important.
While I have tried to give some
simple, practical examples and
explanations, a certain amount
of  jargon is unavoidable in this subject
area. Enjoy your further reading.
Ann Irons is examiner for Paper F5
01 technical
foreign
risk and its relevant to acca qualification paper F9
Increasingly, many businesses have dealings in foreign
currencies and, unless exchange rates are fixed with respect
to one another, this introduces risk. There are three types
of currency risk as detailed below.
Economic risk. The source of economic risk is the change
in the competitive strength of imports and exports. For
example, if a company is exporting (let’s say from the UK to
a eurozone country) and the euro weakens from say €/£1.1
to €/£1.3 (getting more euros per pound sterling implies that
the euro is less valuable, so weaker) any exports from the UK
will be more expensive when priced in euros. So goods where
the UK price is £100 will cost €130 instead of €110, making
those goods less competitive in the European market.
Similarly, goods imported from Europe will be cheaper in
sterling than they had been, so those goods will have become
more competitive in the UK market. Note that a company
can, therefore, experience economic risk even if it has no
overt dealings with overseas countries. If competing imports
could become cheaper you are suffering risk arising from
currency rate movements.
Doing something to mitigate economic risk can be difficult
– especially for small companies with limited international
dealings. In general, the following approaches might provide
some help:
¤ Try to export or import from more than one currency zone
and hope that the zones don’t all move together, or if they
do, at least to the same extent. For example, over the six
months 14 January 2010 to 14 June 2010 the
€/US$ exchange rate moved from about €/US$0.6867
to €/US$ 0.8164. This meant that the € had weakened
relative to the US$ (or the US$ strengthened relative
to the €) by 19%. This made it less competitive for US
manufacturers to export to a eurozone country. If, in the
same period, the £/US$ exchange rate moved from
£/US$0.6263 to £/US$0.6783, a strengthening of the
US$ relative to £ of only about 8%. Trade from the US to
the UK would not have been so badly affected.
¤ Make your goods in the country you sell them. Although
raw materials might still be imported and affected by
exchange rates, other expenses (such as wages) are
in the local currency and not subject to exchange rate
movements.
Translation risk. This affects companies with foreign
subsidiaries. If the subsidiary is in a country whose
currency weakens, the subsidiary’s assets will be less
valuable in the consolidated accounts. Usually, this
effect is of little real importance to the holding company
because it does not affect its day-to-day cash flows.
However, it would be important if the holding company
wanted to sell the subsidiary and remit the proceeds. It
also becomes important if the subsidiary pays dividends.
However, the term ‘translation risk’ is usually reserved for
consolidation effects.
It can be partially overcome by funding the foreign
subsidiary using a foreign loan. For example, take a US
subsidiary that has been set up by its holding company
providing equity finance. Its statement of financial position
would look something like this:
US$m
Non-current assets 1.5
Current assets 0.5
2.0
Equity 2.0
If the US$ weakens then all the US$2m total assets become
less valuable.
 student accountant issue 15/2010
Performance objectives 15 and 16 are relevant to this exam
currency
management
Translation risk affects companies
with foreign subsidiaries. If the
subsidiary is in a country whose
currency weakens, the subsidiary’s
assets will be less valuable in the
consolidated accounts.
However, if the subsidiary were set up using 50% equity and
50% US$ borrowings, its statement of financial position
would look like this:
US$m
Non-current assets 1.5
Current assets 0.5
2.0
$ Loan 1.0
Equity 1.0
2.0
The holding company’s investment is only US$1m and the
company’s net assets in US$ are only US$1m. If the US$
weakens, only the net US$1m becomes less valuable.
Transaction risk. This arises when a company is importing
or exporting. If the exchange rate moves between agreeing
the contract in a foreign currency and paying or receiving
the cash, the amount of home currency paid or received will
alter, making those future cash flows uncertain. For example,
in June a UK company agrees to sell an export to Australia
for 100,000 Australian $ (A$), payable in three months. The
exchange rate at the date of the contract is A$/£1.80 so the
company is expecting to receive 100,000/1.8 = £55,556. If,
however, the A$ weakened over the three months to become
worth only A$/£2.00, then the amount received would be
worth only £50,000.
02
Studying Paper F9?
Of course, if the A$ strengthened over the three months,
more than £55,556 would be received.
It is important to note that transaction risk management
is not mainly concerned with achieving the most favourable
cash flow: it is mainly aimed at achieving a definite cash flow.
Only then can proper planning be undertaken.
DEALING WITH TRANSACTION RISKS
Assuming that the business does not want to tolerate
exchange rate risks (and that could be a reasonable choice
for small transactions), transaction risk can be treated in the
following ways:
1 Invoice. Arrange for the contract and the invoice to be
in your own currency. This will shift all exchange risk
from you onto the other party. Of course, who bears
the risk will be a matter of negotiation, along with price
and other payment terms. If you are very keen to get a
sale to a foreign customer you might have to invoice in
their currency.
2 Netting. If you owe your Japanese supplier ¥1m, and
another Japanese company owes your Japanese subsidiary
¥1.1m, then by netting off group currency flows your
net exposure is only for ¥0.1m. This will really only work
effectively when there are many sales and purchases
in the foreign currency. It would not be feasible if the
transactions were separated by many months. Bilateral
netting is where two companies in the same group
cooperate as explained above; multilateral netting is where
many companies in the group liaise with the group’s
treasury department to achieve netting where possible.
3 Matching. If you have a sales transaction with one foreign
customer, and then a purchase transaction with another
(but both parties operate with the same foreign currency)
then this can be efficiently dealt with by opening a foreign
currency bank account. For example:
1 November: should receive US$2m from US customer
15 November: must pay US$1.9m to US supplier.
03 technical
Deposit the US$2m in a US$ bank account and simply
pay the supplier from that. That leaves only US$0.1m of
exposure to currency fluctuations.
Usually, for matching to work well, either specific
matches are spotted (as above) or there have to be many
import and export transactions to give opportunities for
matching. Matching would not be feasible if you received
US$2m in November, but didn’t have to pay US$1.9m until
the following May. There aren’t many businesses that can
simply keep money in a foreign currency bank account for
months on end.
4 Leading and lagging. Let’s imagine you are planning to
go to Spain and you believe that the euro will strengthen
against your own currency. It might be wise for you to
change your spending money into euros now. That would
be ‘leading’ because you are changing your money in
advance of when you really need to. Of course, the euro
might weaken and then you’ll want to kick yourself,
but remember: managing transaction risk is not about
maximising your income or minimising your expenditure, it
is about knowing for certain what the transaction will cost
in your own currency.
Let’s say, however, that you believe that the euro is
going to weaken. Then you would not change your money
until the last possible moment. That would be ‘lagging’,
delaying the transaction. Note, however, that this does not
reduce your risk. The euro could suddenly strengthen and
your holiday would turn out to be unexpectedly expensive.
Lagging does not reduce risk because you still do not know
your costs. Lagging is simply taking a gamble that your
hunch about the weakening euro is correct.
5 Forward exchange contracts. A forward exchange contract
is a binding agreement to sell (deliver) or buy an agreed
amount of currency at a specified time in the future at an
agreed exchange rate (the forward rate).
In practice there are various ways in which the
relationship between a current exchange rate (spot rate)
and the forward rate can be described. Sometimes it
is given as an adjustment to be made to the spot rate;
in the Paper F9 exam, for example, the forward rates are
quoted directly.
However, for each spot and forward there is always a
pair of rates given. For example:
Spot €/£ 1.2025 ± 0.03 ie 1.2028
and 1.2022
Three-month forward rate €/£ 1.2020 ± 0.06 ie 1.2026
and 1.2014
One of each pair is used if you are going to change
sterling to euros. So £100 would be changed now for either
€120.28 or €120.22. Guess which rate the bank will give
you! You will always be given the exchange rate which
leaves you less well off, so here you will be given a rate of
1.2022, if changing £ to euros now, or 1.2014 if using a
forward contract. Once you have decided which direction
one rate is for, the other rate is used when converting the
other way. So:
€ to £ £ to €
Spot €/£ 1.2028 - 1.2022
Three month forward rate €/£ 1.2026 - 1.2014
So, let’s assume you are a manufacturer in Italy, exporting
to the UK. You have agreed that the sale is worth
£500,000, to be received in three months, and wish to
hedge (reduce your risk) against currency movements.
In three months you will want to change £ to € and
you can enter a binding agreement with a bank that in
three months you will deliver £500,000 and that the bank
will give you £500,000 x 1.2014 = €600,700 in return.
That rate, and the number of euros you will receive, is
now guaranteed irrespective of what the spot rate is at
the time. Of course if the £ had strengthened against
the € (say to €/£ = 1.5) you might feel aggrieved as
you could have then received €750,000, but income
maximisation is not the point of hedging: its point is to
provide certainty and you can now put €600,700 into your
cash flow forecast with confidence.
 student accountant issue 15/2010
However, there remains here one lingering risk: what
happens if the sale falls through after arranging the
forward contract? We are not necessarily talking about a
bad debt here as you might not have sent the goods, but
you have still entered into a binding contract to deliver
£500,000 to your bank in three months’ time. The bank will
expect you to fulfil that commitment, and so what you might
have to do is get enough € to buy £500,000 using the spot
rate, use this to meet your forward contract, receiving
€600,700 back. This process is known as ‘closing out’, and
you could win or lose on it depending on the spot rate at the
time.
6 Money market hedging. Let’s say that you were a UK
manufacturer exporting to the US and in three months you
are due to receive US$2m. You would suffer no currency
risk if that US$2m could be used then to settle a US$2m
liability; that would be matching the currency inflow and
outflow. However, you don’t have a US$2m liability to
settle then – so create one that can soak up the US$. You
can create a US$ liability by borrowing US$ now and then
repaying that in three months with the US$ receipt. So
the plan is:
Interest on the US$ loan will accrue
for three months
Borrow US$2m
US$ now liability
Convert at
spot rate
£ available US$2m
now from
customer
To work out how many US$ need to be borrowed now, you
need to know US$ interest rates. For example, the US$
three month interest rate might be quoted as:
0.54% – 0.66%
04
It is important to understand that, although this might
be described as a ‘three month rate’ it is always quoted
as an annualised rate. One rate is what you would earn in
interest if the money was on deposit, and the other is the
rate you would pay on a loan. Again, no prizes for guessing
which is which: you will always be charged more than you
earn. On the US$ loan we will be charged 0.66% pa for
three months and the loan has to grow to become US$2m
in that time. So, If X is borrowed now and three months’
interest is added:
X(1 + 0.66%/4) = 2,000,000
X = $1,996,705
This can be changed now from US$ to £ at the current spot
rate, say US$/£ 1.4701, to give £1,358,210.
This amount of sterling is certain: we have it now and
it does not matter what happens to the exchange rate in
the future. Ticking away in the background is the US$ loan
which will amount to US$2m in three months and which
can then be repaid by the US$2m we hope to receive
from our customer. That is the hedging process finished
because exchange rate risk has been eliminated
Why might this somewhat complicated process be
used instead of a simple forward contract? Well, one
advantage is that we have our money now rather than having
to wait three months for it. If we have the money now we
can use it now – or at least place it in a sterling deposit
account for three months. This raises an important issue
when we come to compare amounts received under forward
contracts and money market hedges. If these amounts
are received at different times they cannot be directly
compared, because receiving money earlier is better than
receiving it later. To compare amounts under both methods
we should see what the amount received now would become
if deposited for three months. So, if the sterling three
month deposit rate were 1.2%, then placing £1,358,210 on
deposit for three months would result in:
£1,358,210 (1 + 1.2%/4) = £1,362,285
It is this amount that should be compared to any proceeds
under a forward contract.
05 technical
The example above dealt with hedging the receipt of
an amount of foreign currency in the future. If foreign
currency has to be paid in the future, then what the
company can do is change money into sufficient foreign
currency now and place it on deposit so that it will grow to
become the required amount by the right time. Because
the money is changed now at the spot rate, the transaction
is immune from future changes in the exchange rate.
FURTHER METHODS OF EXCHANGE RISK HEDGING
There are two other methods of exchange risk hedging which
you are required to know about, but you will not be required
solve numerical questions relating to these methods. They
involve the use of derivatives: financial instruments whose
value derives from the value of something else – like an
exchange rate.
1 Currency futures. Simply think of these as items you
can buy and sell on the futures market and whose price
will closely follow the exchange rate. Let’s say that a US
exporter is expecting to receive €5m in three months’ time
and that the current exchange rate is US$/€1.24. Assume
that this rate is also the price of US$/€ futures. The
US exporter will fear that the exchange rate will weaken
over the three months, say to US$/€1.10 (that is fewer
dollars for a euro). If that happened, then the market
price of the future would decline too, to around 1.1. The
exporter could arrange to make a compensating profit
on buying and selling futures: sell now at 1.24 and buy
later at 1.10. Therefore, any loss made on the main the
currency transaction is offset by the profit made on the
futures contract.
This approach allows hedging to be carried
out using a market mechanism rather than entering
into the individually tailored contracts that the
forward contracts and money market hedges require.
However, this mechanism does not offer anything
fundamentally new.
2 Options. Options are radically different. They give the
holder the right, but not the obligation, to buy or sell a
given amount of currency at a fixed exchange rate (the
exercise price) in the future (if you remember, forward
contracts were binding). The right to sell a currency at
a set rate is a put option (think: you ‘put’ something up
for sale); the right to buy the currency at a set rate is a
call option.
Suppose a UK exporter is expecting to be paid US$1m
for a piece of machinery to be delivered in 90 days. If
the £ strengthens against the US$ the UK firm will lose
money, as it will receive fewer £ for the US$1m. However,
if the £ weakens against the US$, then the UK company
will gain additional money. Say that the current rate is
US$/£1.40 and that the exporter will get particularly
concerned if the rate moved beyond US$/£1.50. The
company can buy £ call options at an exercise price of
US$/£ = 1.50, giving it the right to buy £ at US$1.50/£.
If the dollar weakens beyond US$/£1.50, the company
can exercise the option thereby guaranteeing at
least £666,667. If the US$ stays stronger – or even
strengthens to, say, US$/£1.20, the company can let
the option lapse (ignore it) and convert at 1.20, to give
£833,333.
This seems too good to be true as the exporter is
insulated from large losses but can still make gains. But
there’s nothing for nothing in the world of finance and
to buy the options the exporter has to pay an up-front,
non‑returnable premium. Options can be regarded just like
an insurance policy on your house. If your house doesn’t
burn down you don’t call on the insurance, but neither
do you get the premium back. If there is a disaster the
insurance should prevent massive losses.
Options are also useful if you are not sure about a
cash flow. For example, say you are bidding for a contract
with a foreign customer. You don’t know if you will win or
not, so don’t know if you will have foreign earnings, but
want to make sure that your bid price will not be eroded
by currency movements. In those circumstances, an
option can be taken out and used if necessary or ignored
if you do not win the contract or currency movements
are favourable.
Ken Garrett is a freelance author and lecturer
options give the holder the right,
but not the obligation, to buy or
sell a given amount of currency
at a fixed exchange rate (the
exercise price) in the future.
01 technical
revenue
relevant to acca qualification paper P2
This article looks at the contentious current issue
of revenue. This is a key area of development for the
International Accounting Standards Board (IASB) and the
project appears within the examinable documents
of Paper P2, Corporate Reporting.
Revenue development
The concept of revenue and the related IAS (IAS 18) comes
to us from a period in financial reporting when the focus was
on profit. This performance focus was the cornerstone of
financial reporting for roughly 50 years from 1950 to 2000.
You probably know this idea as the concept of matching
and probably know that for many years it was the key to
understanding accounting standards.
Since the IASB took over the development of accounting
standards in 2001, its focus has been on assets and
liabilities. This change of focus left IAS 18 out of step with
the new ideas.
This probably would not have been enough to raise
revenue above some of the other problems that are faced
by the IASB were it not for one salient factor: the US and
its dominance of financial reporting. The US government
highlighted the problems with revenue recognition as
a stumbling block on the road to convergence with
International Financial Reporting Standards (IFRS).
This article uses the vehicle of a question to illustrate
how the subject might be examined. The revenue project
is enormously conceptual and even the big brains on the
IASB find it a challenge. So all I’ll say now is good luck and
here is the question.
Illustrative question: Ramification
Ramification is an engineering company. It has two contracts
nearing completion at its year end. The company has made
certain assumptions related to revenue recognition and
wants to know if these would be acceptable under current
revenue rules. Further the company is aware of a discussion
paper on revenue. The company would like to know what
affect the revenue proposals would have upon the revenue of
Ramification should the proposals be accepted.
Contract X
This is a restoration project. Ramification has been
contracted to restore an old prestigious building in a city
centre. The contract provides that $1m will be payable to
Ramification in two equal instalments of $500,000 each.
The first instalment is payable on completion of work to the
foundations, which is considered to be half the work. The
final instalment is payable on completion of the work to the
visible brickwork, which is considered to be the other half
of the work. The first instalment is due one year from the
current year end (providing the foundation work is complete).
The final instalment is due two years from the current year
end (provided the brickwork is complete).
The contract requires that a surveyor verifies the work
completed. At the year end, the surveyor has reported
that the foundation work is entirely complete and that the
brickwork is nearing completion. He has, therefore, reported
that the whole contract is approximately 90% complete.
Ramification proposes to base revenue for contract X on
the assumption that the contract is a construction contract.
So Ramification proposes to recognise revenue using the
surveyor’s percentage and proposes to ignore the time value
of money. The cost of capital is 10%.
Contract Y
This is a small building contract. Ramification built a small
hut for housing equipment. Ramification agreed a sale price
of $20,000, but also offered a three-month warranty. The
building itself is finished, but the warranty is still open.
The warranty is an offer to rebuild the hut should anything
happen to it within three months from the date of handover.
Handover took place two days before the year end and
nothing has happened so far. There remains almost three full
months before the warranty lapses and nothing is expected
to happen.
Previous similar contracts have been sold at $18,000 for
the hut and $3,000 for the warranty. Therefore Ramification
proposes to recognise $20,000 in revenue and a provision of
$3,000 representing the fair value of the obligation.
Required
(a) Discuss the problems with existing revenue recognition
rules that have led to the issue of the discussion paper
on revenue.
(7 marks)
 student accountant issue 15/2010
Performance objectives 10 and 11 are relevant to this exam
The concept of revenue and the
related IAS (IAS 18) comes to us from
a period in financial reporting
when the focus was on profit.
(b) Discuss the appropriateness of the assumptions utilised
by Ramification in contracts X and Y above. Calculate
the revenue recognised in the current year based on
those assumptions.
(6 marks)
(c) Briefly explain the basis of the proposals put forward by
the discussion paper to create a comprehensive standard
for revenue recognition.
(8 marks)
(d) Explain how the application of the proposals would affect the
revenue recognition of Ramification for contracts X and Y.
(4 marks)
(25 marks)
Answer commentary
The first thing I would advise you, before we get into the
answer proper, is be realistic. In the exam you would have 45
minutes to complete your answer. That includes reading time,
momentary panicking time and thinking time. So do not
think you are going to be able to deliver the perfect answer
that covers all the issues.
It can be daunting to look at past exam answers. The
volume and detail included can lead you to think that this
is what is expected from you in the exam. This is simply
not true. The exam answers are teaching answers. They are
idealised answers that are there to instruct. In order to score
full marks, you do not need a perfect answer. You simply
need a clear concise answer that covers the appropriate
number of key points.
Let us move to requirement (a) to further explain what I
mean. Clearly, if you had time you could write a book about
the problems with existing revenue recognition. Do not try.
Just produce at least seven points as quickly as you can that
address the principal problems.
Do not be afraid of putting down what you really think. The
examiner frequently gives full marks to a narrative answer
that is not the same as his own so long as that answer has
the appropriate number of ideas clearly expressed.
02
Studying Paper P2?
Next I would like to remind you of the marking guide used
extensively throughout Section B. It is one mark for one
relevant point well expressed. It is the marking guide that
is the driver behind the style of answer that you see below.
Each idea is delivered in one or two sentences and capped by
one heading. This is of enormous assistance to your
marker who can now see instantly each point you are trying
to deliver.
My exam answer:
(a) Current revenue recognition
IAS18 distinguishes two types of revenue: ‘At’ revenue is
recognised at the point risks and rewards for transferred
(sale of goods) and ‘Over’ revenue which is recognised
over the period (sale of services).
Intuitive
There is very little else in IAS 18. It is left to the user to
interpret the revenue recognition from there. The great
strength of IAS 18 is that it is intuitive – but that has now
become its weakness.
Distinction
In many sales situations it is obvious whether the
revenue should be recognised ‘At’ or ‘Over’. But in other
situations one revenue stream could be recognised either
‘At’ or ‘Over’.
Example: Film making
A good example is film making. This could be interpreted
as providing a service over a period or it could be
interpreted as delivering intellectual property at a point
in time.
Unbundling
Then IAS 18 has the problem of unbundling. Unbundling
is the process of splitting a compound revenue stream
into its component parts. The IAS requires unbundling
but does not say when or how.
03 technical
Example: Furniture and finance
For example, the bundled sale of furniture with hidden
finance must be unbundled but IAS 18 gives no guidance
to the retailer.
Other IFRS
Another irritation in existing revenue guidance is that
it is mostly in IAS 18 but there are other IFRS that give
(sometime contradictory) guidance:
Industry IFRS
Construction Construction Contracts (IAS 11)
Leasing Leasing (IAS 17)
Insurance Insurance Contracts (IFRS 4)
US
The IASB may have made do with existing IFRS guidance
on revenue had the US not made improved revenue
recognition a condition of convergence.
(b) Introduction
As explained in part (a) above, existing revenue reporting
is intuitive; it is interpretive. The result is that when
revenue becomes more complex, as it does in these two
examples, there are various ways of recognising the
revenue. So I cannot say that the revenue recognition
suggested is right or wrong. I can only comment on
its reasonableness.
Assumption (1) (X) 90%
Restoration is not construction but it is very similar
so I think using construction contract accounting and
therefore 90% is reasonable.
Assumption (2) (X) Time value
Construction contract accounting does ignore
the time value of money so this assumption also
seems reasonable.
Revenue (X)
So based on the above assumptions the revenue
would be:
Revenue = ($1m) 90% = $900k
Assumption (1) (Y) Hut
Ramification has assumed that the sales proceeds
relate exclusively to the hut. Personally, I do not see the
contract this way but the assumption is acceptable. In
fact, this is the existing culture for the recognition of a
sale with a warranty.
Assumption (2) (Y) Provision
Ramification also assumes that the warranty gives rise to
an obligation and not revenue. I suppose this is acceptable.
Revenue (Y)
The assumptions result in the following in the current
financial statement:
Sales = $20k
Provision = $3k
(c) Comprehensive
The first proposal is that new revenue rules should
be comprehensive and, therefore, all industries would be
using the same one rule.
Framework
More importantly the proposal is to create revenue
guidance based on the framework and the key elements
of assets/liabilities.
As explained in part (a), existing
revenue reporting is intuitive; it is
interpretive. The result is that
when revenue becomes more
complex, as it does in these two
examples, there are various ways of
recognising the revenue.
 student accountant issue 15/2010
04

Asset/liability in part (c), Once the supplier has

To paraphrase the framework ‘An asset/liability
is a present right/obligation to a future economic fulfilled the performance
inflow outflow’. obligation, the interlocked liability
Change is removed and the remaining
The IASB are proposing a change from performance asset is revealed and recognised.
reporting to positional reporting.

Contract
The proposal proposes that at the point of contract
signature the supplier has an interlocked asset and
liability. The asset is the right to the cash from the
customer and the liability is the obligation to perform.
Proposed (X) Revenue
The result would be the following revenue:
Asset (revenue) = $500k/1.1 = $455k

Performance obligation Proposed (Y) Revenue explanation

Once the supplier has fulfilled the performance
obligation, the interlocked liability is removed and the
remaining asset is revealed and recognised.
Revenue
At this point the revenue is recognised almost as an
afterthought. Notice that the proposal focuses on the
asset and liability first. Then once the asset is revealed
the revenue is recognised.
Under the proposal this second contract must be
unbundled; that is broke down into its two parts, hut
revenue and warranty revenue. This would be done using
the hut and warranty separate sales figures.
Proposed (Y) Revenue
This is as follows:
Asset (Revenue) = $20,000 (18/18+3) = $17,143

Discounting Conclusion
Because the asset is a right to a cash flow and The above covers the highly conceptual revenue development
timing makes a difference to value, the IASB are project and also gives you an example of how to answer the
proposing discounting. current issues question.

Unbundling Martin Jones is lecturer at the London School of Business

Because a bundled transaction has two performance and Finance
obligations, unbundling becomes compulsory. So the
one sale of two things must be split into two (see Part (d)
proposed (Y) revenue below).

(d) Proposed (X) Revenue explanation

In order to assess the performance of performance
obligations, Ramification would refer to the contract and
the survey. Ramification would see that the foundations
are complete and the brickwork is not. So an asset
of  $500k in year one would be recognised.