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MANAGEMENT ACCOUNTING - Solutions Manual

TABLE OF CONTENTS

Chapter

1

1-1 – 1-19

 

MANAGEMENT ACCOUNTING: AN OVERVIEW

 

2

Management Accounting and the Business Environment

2-1 –

2-5

3

Understanding of Financial Statements

3-1 – 3-10

4

Financial Statements Analysis – I

4-1 – 4-9

5

Financial Statements Analysis – II

5-1 – 5-38

6

Cash Flow Analysis

6-1 – 6-18

7

Gross Profit Valuation Analysis and Earnings Per Share Determination

7-1 – 7-7

8

Cost Concepts and Classifications

8-1 –

8-17

9

Cost Behavior: Analysis and Use

9-1 – 9-30

  • 10 Job-Order Costing and Process Costing

Systems Design:

10-1 –

10-16

  • 11 Systems Design: Activity-Based Costing and Management

11-1 – 11-15

  • 12 Variable Costing

12-1 – 12-21

  • 13 Cost-Volume-Profit Relationships

13-1 – 13-37

  • 14 Responsibility Accounting and Transfer Pricing

14-1 –

14-26

  • 15 Functional and Activity-Based Budgeting

15-1 –

15-22

  • 16 Standard Costs and Operating Performance Measures

16-1 –

16-17

  • 17 Application of Quantitative Techniques in Planning, Control and Decision Making - I

17-1 – 17-2

  • 18 Application of Quantitative Techniques in Planning, Control and Decision Making – II

18-1 – 18-7

  • 19 Relevant Costs for Decision Making

19-1 –

19-33

  • 20 Capital Budgeting Decisions

20-1 – 20-16

  • 21 Decentralized Operations and Segment Reporting

21-1 –

21-4

  • 22 Business Planning

22-1 – 22-6

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Management Accounting: An Overview

  • 23 Strategic Cost Management; Balanced Scorecard 23-1 –

23-4

  • 24 Advanced Analysis and Appraisal of Performance: Financial

and Nonfinancial

24-1 – 24-12

  • 25 Managing Productivity and Marketing Effectiveness

25-1 –

25-19

  • 26 Executive Performance Measures and Compensation

26-1 –

26-3

  • 27 Managing Accounting in a Changing Environment

27-1 – 27-22

CHAPTER 1 MANAGEMENT ACCOUNTING: AN OVERVIEW

I.

Questions

  • 1. Use of the word “need” in the quoted passage is pejorative. It implies an unlimited level of demand for information. However, rational managers apply a cost-benefit criterion to information and will only want accounting information if its benefits exceed its costs. Accounting information provides benefits by improving decision making and controlling behavior in organizations. In most organizations, accounting information is very prevalent which implies that its benefits exceed its costs. Hence, successful managers will find it in their self-interest to learn how to use accounting information in these organizations. Clearly, this statement is incurred in those firms where accounting information has very limited usefulness (e.g., if the accounting information is often wrong or is not produced in a timely fashion). In these organizations, managers do not find the accounting information to have benefits in excess of its costs, will not use it, do not need to know how to use it, and definitely do not need it.

  • 2. a. Historical costs are of limited use in making planning decisions in a rapidly changing environment. With changing products, processes and prices, the historical costs are inadequate approximations of the opportunity costs of using resources.

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Historical costs may, however, be useful for control purposes, as they provide information about the activities of managers and can be used as performance measures to evaluate managers.

b. The purpose of accounting systems is to provide information for planning purposes and control. Although historical costs are not generally appropriate for planning purposes, additional measures are costly to make. An accounting system should include additional measures if the benefits of improved decision making are greater than the costs of the additional information.

  • 3. Finance and economics textbooks traditionally state that the goal of a profit organization is to maximize shareholder wealth. Managers are frequently presumed to act in the best interest of the shareholder, although recent finance literature recognizes that appropriate incentives are necessary to align manager interests with shareholder interests. The goal, however, are not very clear as to how this is achieved. Most finance textbooks focus on financing decisions and not on the use of assets and dealing with customers. Marketing’s goal of satisfying customers recognizes that customers are the source of revenues for the organization, and therefore the means through which shareholder value is increased. However, customer satisfaction is only valuable insofar as it creates shareholder wealth. The further goal of marketing is to ensure that customer satisfaction is maximized without compromising the organization’s profitability.

  • 4. Yes. Planning is really much more vital than control; that is, superior control is fruitless if faulty plans are being implemented. However, planning and control are so intertwined that it seems artificial to draw rigid lines of separation between them.

  • 5. Yes. The controller has line authority over the personnel in his own department but is a staff executive with respect to the other departments.

  • 6. Line authority is exerted downward over subordinates. Staff authority is the authority to advise but not command others; it is exercised laterally or upward. Functional authority is the right to command action laterally and downward with regard to a specific function or specialty.

  • 7. Cost accounting is the controller’s primary means of implementing the 7- point concept of modern controllership. Cost accounting is intertwined with all seven duties to some extent, but its major focus is on the first three.

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Management Accounting: An Overview

8. Bettina Company President VP, Production VP, Finance VP, Sales Controller Treasurer Assistant Assistant Controller Treasurer
8.
Bettina Company
President
VP, Production
VP, Finance
VP, Sales
Controller
Treasurer
Assistant
Assistant
Controller
Treasurer
Special
Cost
Tax
Internal
General
System &
Studies
Accounting
Manager
Audit
Accounting
EDP
Manager
Manager
Manager
Manager
Manager
Cost
Budget &
Performance
Systems
Standard
Analyst
Analyst
Cost Analyst
Cost Clerk
Payroll
Accounts
Accounts
Billing
General
Clerk
Receivable
Payable
Clerk
Ledger
Clerk
Clerk
Bookkeeper
9.
Management accountants contribute to strategic decisions by providing
information about the sources of competitive advantage and by helping
managers identify and build a company’s resources and capabilities.
  • 10. In most organizations, management accountants perform multiple roles: problem solving (comparative analyses for decision making), scorekeeping (accumulating data and reporting reliable results), and attention directing (helping managers properly focus their attention).

  • 11. Three guidelines that help management accountants increase their value to managers are (a) employ a cost-benefit approach, (b) recognize behavioral as well as technical considerations, and (c) identify different costs for different purposes.

  • 12. Management accounting is an integral part of the controller’s function in an organization. In most organizations, the controller reports to the chief financial officer, who is a key member of the top management team.

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Management Accounting: An Overview

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13.

Management accountants have ethical responsibilities that are related to competence, confidentiality, integrity, and objectivity.

14.

By reporting and interpreting relevant data, the controller exerts a force or influence that impels management toward making better-informed decisions.

The controller of one company described the job as “a business advisor to…help the team develop strategy and focus the team all the way through recommendations and implementation.”

15.

Financial Accounting

Audience:

External:

shareholders,

creditors, tax

authorities

Purpose:

Report on past performance to external parties; basis of contracts with owners and lenders

Timeliness:

Delayed; historical

 

Restrictions:

Regulated; rules driven by generally accepted accounting principles and government authorities

Type of Information:

Financial measurements only

 

Nature of Information:

Objective,

auditable,

reliable,

consistent,

Scope:

precise Highly aggregate; report on entire organization

Managerial Accounting

 

Audience:

Internal: Workers, managers, executives

Purpose:

Inform internal decisions made by employees and managers; feedback and control on operating performance

Timeliness:

Current, future oriented

 

Restrictions:

No regulations; systems and information determined by management to meet strategic and operational needs

Type of Information:

Financial, plus operational and physical measurements on processes, technologies, suppliers customers, and competitors

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Management Accounting: An Overview

Nature of Information:

More

subjective

and

judgmental;

valid,

relevant, accurate

 

Scope:

Disaggregate;

inform

local

decisions

and

actions

  • 16. The competitive environment has changed dramatically. Companies encountered severe competition from overseas companies that offered high-quality products at low prices. Activity-based costing systems are introduced in many manufacturing and service organizations to overcome the inability of traditional cost systems to accurately assign overhead costs. Activity-based management is a viable approach for managers to make decisions based on ABC information. There has been improvement of operational control systems such that information is more current and provided more frequently. The nature of work has changed from controlling to informing. Firms are concerned about continuous improvement, employee empowerment and total quality. Nonfinancial information has become a critical feedback measure. Finally, the focus of many firms is on measuring and managing activities.

  • 17. As measurements are made on operations and, especially, on individuals and groups, the behavior of the individuals and groups are affected. People will react to the measurements being made by focusing on the variables or behavior being measured. In addition, if managers attempt to introduce or redesign cost and performance measurement systems, people familiar with the previous system will resist. Management accountants must understand and anticipate the reactions of individuals to information and measurements. The design and introduction of new measurements and systems must be accompanied with an analysis of the likely reactions to the innovations.

II.

Exercises

Exercise 1

  • a. (1) Problem solving

  • b. (3) Attention-directing

  • c. (1) Problem solving

  • d. (2) Scorekeeping

Exercise 2

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Management Accounting: An Overview

Chapter 1

a.

(4) Marketing

b.

(3) Production

c.

(6) Customer service

d.

(5) Distribution

Exercise 3

a.

(4) Marketing

b.

(3) Production

c.

(5) Distribution

d.

(4) Marketing

e.

(5) Distribution

f.

(3) Production

g.

(1) Research and development

h.

(2) Design

III. Problems

Problem 1 (Problem Solving, Scorekeeping, and Attention Directing)

Because the accountant’s duties are often not sharply defined, some of these answers might be challenged:

  • 1. Scorekeeping

  • 2. Attention directing

  • 3. Scorekeeping

  • 4. Problem solving

  • 5. Attention directing

  • 6. Attention directing

  • 7. Problem solving

  • 8. Scorekeeping (depending on the extent of the report) or attention getting

  • 9. This question is intentionally vague. The give-and-take of the budgetary process usually encompasses all three functions, but it emphasizes scorekeeping the least. The main function is attention directing, but problem solving is also involved.

10. Problem solving

Problem 2 (Management Accounting Information System)

  • 1. b, g, i, m

Inputs:

  • 2. a, d, f, j

Processes:

  • 3. Outputs: e, k, n

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Management Accounting: An Overview

  • 4. System objectives: c, h, l

Problem 3 (Role of Management Accountants)

Planning. The management accountant gains an understanding of the impact on the organization of planned transactions (i.e., analyzing strengths and weaknesses) and economic events, both strategic and tactical, and sets obtainable goals for the organization. The development of budgets is an example of planning.

Controlling. The management accountant ensures the integrity of financial information, monitors performance against budgets and goals, and provides information internally for decision making. Comparing actual performance against budgeted performance and taking corrective action where necessary is an example of controlling. Internal auditing is another example.

Evaluating Performance. The management accountant judges and analyzes the implication of various past and expected events, and then chooses the optimum course of action. The management accountant also translates data and communicates the conclusions. Graphical analysis (such as trend, bar charts, or regression) and reports comparing actual costs with budgeted costs are examples of evaluating performance.

Ensuring Accountability of Resources. The management accountant implements a reporting system closely aligned to organizational goals that contribute to the measurement of the effective use of resources and safeguarding of assets. Internal reporting such as comparison of actual to budget is an example of accountability.

External Reporting. The management accountant prepares reports in accordance with generally accepted accounting principles and then disseminates this information to shareholders, creditors, and regulatory tax agencies. An annual report or a credit application are examples of external reporting.

Problem 4 (Line Versus Staff)

Jamie Reyes is staff. She is in a support role – she prepares reports and helps explain and interpret them. Her role is to help the line managers more effectively carry out their responsibilities.

Stephen Santos is a line manager. He has direct responsibility for producing a garden hose. Clearly, one of the basic objectives for the existence of a

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Management Accounting: An Overview

Chapter 1

manufacturing firm is to make a product.

Thus,

Stephen has

direct

responsibility for a basic objective and therefore holds a line position.

Problem 5 (Professional Ethics and End-of-Year Games)

Requirement 1

The possible motivations for the snack foods division wanting to play end-of- year games include:

  • (a) Management incentives. Yummy Foods may have a division bonus scheme based on one-year reported division earnings. Efforts to front-end revenue into the current year or transfer costs into the next year can increase this bonus.

  • (b) Promotion opportunities and job security. Top management of Yummy Foods likely will view those division managers that deliver high reported earnings growth rates as being the best prospects for promotion. Division managers who deliver “unwelcome surprises” may be viewed as less capable.

  • (c) Retain division autonomy. If top management of Yummy Foods adopts a “management by exception” approach, divisions that report sharp reductions in their earnings growth rates may attract a sizable increase in top management supervision.

Requirement 2

The “Standards of Ethical Conduct…” require management accountants to:

Refrain from either actively or passively subverting the attainment of the organization’s legitimate and ethical objectives, and

Communicate unfavorable as well as favorable information and professional judgment or opinions.

Several of the “end-of-year games” clearly are in conflict with these requirements and should be viewed as unacceptable by Tan:

  • (a) The fiscal year-end should be closed on midnight of December 31. “Extending” the close falsely reports next year’s sales as this year’s sales.

  • (b) Altering shipping dates is falsification of the accounting reports.

  • (c) Advertisements run in December should be charged to the current year. The advertising agency is facilitating falsification of the accounting records.

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The other “end-of-year games” occur in many organizations and may fall into the “gray” to “acceptable” area. However, much depends on the circumstances surrounding each one:

  • (a) If the independent contractor does not do maintenance work in December, there is no transaction regarding maintenance to record. The responsibility for ensuring that packaging equipment is well maintained is that of the plant manager. The division controller probably can do little more than observe the absence of a December maintenance charge.

  • (d) In many organizations, sales are heavily concentrated in the final weeks of the fiscal year-end. If the double bonus is approved by the division marketing manager, the division controller can do little more than observe the extra bonus paid in December.

  • (e) If TV spots are reduced in December, the advertising cost in December will be reduced. There is no record falsification here.

  • (g) Much depends on the means of “persuading” carriers to accept the merchandise. For example, if an under-the-table payment is involved, it is clearly unethical. If, however, the carrier receives no extra consideration and willingly agrees to accept the assignment, the transaction appears ethical.

Each of the (a), (d), (e) and (g) “end-of-year games” may well disadvantage Yummy Foods in the long run. For example, lack of routine maintenance may lead to subsequent equipment failure. The divisional controller is well advised to raise such issues in meetings with the division president. However, if Yummy Foods has a rigid set of line/staff distinctions, the division president is the one who bears primary responsibility for justifying division actions to senior corporate officers.

Requirement 3

If Tan believes that Ryan wants her to engage in unethical behavior, she should first directly raise her concerns with Ryan. If Ryan is unwilling to change his request, Tan should discuss her concerns with the Corporate Controller of Yummy Foods. Tan also may well ask for a transfer from the snack foods division if she perceives Ryan is unwilling to listen to pressure brought by the Corporate Controller, CFO, or even President of Yummy Foods. In the extreme, she may want to resign if the corporate culture of Yummy Foods is to reward division managers who play “end-of-year games” that Tan views as unethical and possibly illegal.

Problem 6

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Management Accounting: An Overview

Chapter 1

James Torres has come up with a scheme that involves a combination of data falsification and smoothing! Not only has he made up the revenue numbers, but also he has had the gall to defer some of them to the next period. Making up such numbers is clearly illegal. Smoothing, in this example is also illegal because the numbers are fictitious.

Problem 7

Clearly the vice-president will lose his or her job if you turn him or her in. Given that this is a major violation of the code of ethics and a violation patent law, the vice-president could go to jail. Your best course of action is to check your information and if the vice-president is definitely involved, go immediately to the VP’s superior (who is probably a senior VP or the company

president). The organization’s attorneys will take over from there.

Problem 8

One option is to do nothing and ignore what you saw, however, this may violate your own code of ethics and your ethical responsibilities under the organization’s code of ethics. Given that you want to do something, it is probably best to start by talking to employees in your organization whose job it is to deal with ethical issues. If no such employees exist or are available, you might start by using a decision model. This model incorporated the following steps:

  • 1. Determine the Facts – What, Who, Where, How

  • 2. Define the Ethical Issue

  • 3. Identify Major Principles, Rule, Values

  • 4. Specify the Alternatives.

  • 5. Compare Values and Alternatives, See if Clear Decision

  • 6. Assess the Consequences.

  • 7. Make Your Decision.

IV. Cases

Case 1 (Financial vs. Managerial Accounting)

Requirement (a)

Other forward looking information desired in addition to the income statement information are

  • 1. Disclosure of the components of financial performance, i.e., nature and source of revenues, various activities, transactions, and other relevant events affecting the company.

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Management Accounting: An Overview

  • 2. Nature and function of the components of income and expenses

Requirement (b)

No. GAAP does not allow capitalization of employee training and advertising costs even if management feels that they increase the value of the company’s brand name. The reasons are uncertainty of the future benefits that may be derived therefrom and difficulty and reliability of their measurement.

Requirement (c)

Detailed information that managers would likely request are analysis of the significant increases in

  • 1. Sales

  • 2. Cost of sales

  • 3. Payroll

  • 4. Stock and option based compensation

  • 5. Advertising and promotion.

Requirement (d)

Nonmonetary measures:

  • 1. Change in number and profile of customers

  • 2. Share in the market

  • 3. Who, what and how many are the competitors

  • 4. Product lines offered by the entity vs. Product lines of competitors

  • 5. Sales promotion and advertising activities

Requirement (e)

  • 1. Competitors

  • 2. Employees

  • 3. Prospective creditors

Case 2 (You get what you measure!)

Requirement (a)

Increase in sales to new customers to sales

Too much emphasis on this ratio may lead the sales manager to spend more time developing business with new customers and disregard the needs of

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Management Accounting: An Overview

Chapter 1

existing customers. It is therefore possible to lose the business of several key accounts.

Requirement (b)

Decrease in cost of goods sold to sales This performance measure could create the following problems:

  • 1. Purchasing goods with poor quality at lower cost and selling them for the same price.

  • 2. Indiscriminately increasing selling price to widen the profit margin without regard to competitor’s current prices.

  • 3. If the entity is manufacturing its own goods, managers could try to economize on costs, i.e., buying poorer quality of materials, employing unskilled workers, etc. thereby causing deterioration of the quality of the finished products.

In

all

of the above situations,

adversely affected.

customer patronage could eventually be

Requirement (c)

Decrease in selling and administrative expense to sales

Cost-cutting is generally advisable for as long as the quality of goods and services are not compromised. Likewise, certain cost-saving measures could demotivate sales people and other employees and could lead to counter- productive activities.

Case 3 (The Roles of Managers and Management Accountants)

  • 1. Managerial accounting, Financial accounting

  • 2. Planning

  • 3. Directing and motivating

  • 4. Feedback

  • 5. Decentralization

  • 6. Line

  • 7. Staff

  • 8. Controller

  • 9. Budgets

    • 10. Performance report

    • 11. Chief Financial Officer

    • 12. Precision; Nonmonetary data

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Management Accounting: An Overview

Case 4 (Ethics in Business)

If cashiers routinely short-changed customers whenever the opportunity presented itself, most of us would be careful to count our change before leaving the counter. Imagine what effect this would have on the line at your favorite fast-food restaurant. How would you like to wait in line while each and every customer laboriously counts out his or her change? Additionally, if you can’t trust the cashiers to give honest change, can you trust the cooks to take the time to follow health precautions such as washing their hands? If you can’t trust anyone at the restaurant would you even want to eat out?

Generally, when we buy goods and services in the free market, we assume we are buying from people who have a certain level of ethical standards. If we could not trust people to maintain those standards, we would be reluctant to buy. The net result of widespread dishonesty would be a shrunken economy with a lower growth rate and fewer goods and services for sale at a lower overall level of quality.

Case 5 (Ethics and the Manager)

Requirement 1

Failure to report the obsolete nature of the inventory would violate the Standards of Ethical Conduct as follows:

Competence

Perform duties in accordance with relevant technical standards.

Prepare complete reports using reliable information.

By failing to write down the value of the obsolete inventory, Perez would not be preparing a complete report using reliable information. In addition, generally accepted accounting principles (GAAP) require the write-down of obsolete inventory.

Integrity

Avoid conflicts of interest.

 

Refrain

from activities that

prejudice the

ability to

perform

duties

ethically. Refrain from subverting the legitimate goals of the organization.

Refrain from discrediting the profession.

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Chapter 1

Members of the management team, of which Perez is a part, are responsible for both operations and recording the results of operations. Since the team will benefit from a bonus, increasing earnings by ignoring the obsolete inventory is clearly a conflict of interest. Perez would also be concealing unfavorable information and subverting the goals of the organization. Furthermore, such behavior is a discredit to the profession.

Objectivity

Communicate information fairly and objectively.

Disclose all relevant information.

Hiding the obsolete inventory impairs the objectivity and relevance of financial statements.

Requirement 2

As discussed above, the ethical course of action would be for Perez to insist on writing down the obsolete inventory. This would not, however, be an easy thing to do. Apart from adversely affecting her own compensation, the ethical action may anger her colleagues and make her very unpopular. Taking the ethical action would require considerable courage and self-assurance.

Case 6 (Preparing an Organization Chart)

Requirement 1

See the organization chart on page 17.

Requirement 2

Line positions would include the university president, academic vice-president, the deans of the four colleges, and the dean of the law school. In addition, the department heads (as well as the faculty) would be in line positions. The reason is that their positions are directly related to the basic purpose of the university, which is education. (Line positions are shaded on the organization chart.)

All other positions on the organization chart are staff positions. The reason is that these positions are indirectly related to the educational process, and exist only to provide service or support to the line positions.

Requirement 3

All positions would have need for accounting information of some type.

For

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Management Accounting: An Overview

example, the manager of central purchasing would need to know the level of current inventories and budgeted allowances in various areas before doing any purchasing; the vice president for admissions and records would need to know the status of scholarship funds as students are admitted to the university; the dean of the business college would need to know his/her budget allowances in various areas, as well as information on cost per student credit hour; and so forth.

Case 7 (Ethics in Business)

Requirement 1

No, Santos did not act in an ethical manner. In complying with the president’s instructions to omit liabilities from the company’s financial statements he was in direct violation of the IMA’s Standards of Ethical Conduct for Management Accountants. He violated both the “Integrity” and “Objectivity” guidelines on this code of ethical conduct. The fact that the president ordered the omission of the liabilities is immaterial.

Requirement 2

No, Santos’ actions can’t be justified. In dealing with similar situations, the Securities and Exchange Commission (SEC) has consistently ruled that “… corporate officers…cannot escape culpability by asserting that they acted as ‘good soldiers’ and cannot rely upon the fact that the violative conduct may have been condoned or ordered by their corporate superiors.” (Quoted from:

Gerald H. Lander, Michael T. Cronin, and Alan Reinstein, “In Defense of the Management Accountant,” Management Accounting, May, 1990, p. 55) Thus, Santos not only acted unethically, but he could be held legally liable if insolvency occurs and litigation is brought against the company by creditors or others. It is important that students understand this point early in the course, since it is widely assumed that “good soldiers” are justified by the fact that they are just following orders. In the case at hand, Santos should have resigned rather than become a party to the fraudulent misrepresentation of the company’s financial statements.

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Case 6

Requirement 1 President Vice Vice Vice Vice Academic Vice President, President, President, President President, Physical Auxiliary
Requirement 1
President
Vice
Vice
Vice
Vice
Academic Vice
President,
President,
President,
President
President,
Physical
Auxiliary
Admissions &
Financial
Plant
Services
Records
Services
(Controller)
Manager,
Manager,
Manager,
Manager,
Manager,
Manager,
Manager, Plant
Grounds &
Central
University
University
Computer
Accounting
&
Custodial
Purchasing
Press
Bookstore
Services
& Finance
Maintenance
Services
Dean,
Dean, Business
Dean,
Dean,
Dean,
Engineering &
Humanities
Fine Arts
Law School
Quantitative
(Departments)
(Departments)
(Departments)
(Departments)

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MANAGEMENT ACCOUNTING - Solutions Manual

Case 8 (Ethics in Business)

Requirement 1

Andres Romero has an ethical responsibility to take some action in the matter of PhilChem, Inc. and the dumping of toxic wastes. The Standards of Ethical Conduct for Management Accountants specifies that management accountants should not condone the commission of acts by their organization that violate the standards of ethical conduct. The specific standards that apply are as follows.

Competence. Management accountants have a responsibility to perform their professional duties in accordance with relevant laws and regulations. Confidentiality. Management accountants must refrain from disclosing confidential information unless legally obligated to do so. However, Andres Romero may have a legal responsibility to take some action. Integrity. Management accountants have a responsibility to:

  • - refrain from either actively or passively subverting the attainment of the organization’s legitimate and ethical objectives.

  • - communicate favorable as well as unfavorable information and professional judgments or opinions. • Objectivity. Management accountants must fully disclose all relevant information that could reasonably be expected to influence an intended user’s understanding of the reports, comments, and recommendations.

Requirement 2

The Standards of Ethical Conduct for Management Accountants indicates that the first alternative being considered by Andres Romero, seeking the advice of his boss, is appropriate. To resolve an ethical conflict, the first step is to discuss the problem with the immediate superior, unless it appears that this individual is involved in the conflict. In this case, it does not appear that Romero’s boss is involved.

Communication of confidential information to anyone outside the company is inappropriate unless there is a legal obligation to do so, in which case Romero should contact the proper authorities. Contacting a member of the Board of Directors would be an inappropriate action at this time. Romero should report the conflict to successively higher levels within the organization and turn only to the Board of Directors if the problem is not resolved at lower levels.

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Cost Concepts and Classifications

Chapter 8

Requirement 3

Andres Romero should follow the established policies of the organization bearing on the resolution of such conflict. If these policies do not resolve the ethical conflict, Romero should report the problem to successively higher levels of management up to the Board of Directors until it is satisfactorily resolved. There is no requirement for Romero to inform his immediate superior of this action because the superior is involved in the conflict. If the conflict is not resolved after exhausting all courses of internal review, Romero may have no other recourse than to resign from the organization and submit an informative memorandum to an appropriate member of the organization.

  • V. Multiple Choice Questions

(CMA Unofficial Solution, adapted)

  • 1. 21.

D

11.

D

B

31.

D

41.

A

51.

B

  • 2. 22.

D

12.

D

B

32.

C

42.

C

52.

B

  • 3. 23.

D

13.

D

A

33.

D

43.

D

53.

A

A

  • 4. 24.

B

14.

A

34.

B

44.

B

54.

C

A

  • 5. 25.

D

15.

B

35.

D

45.

C

55.

D

  • 6. 26.

16.

A

A

C

36.

B

46.

B

56.

C

  • 7. 27.

B

17.

D

B

37.

C

47.

A

57.

C

A

  • 8. 28.

D

18.

D

38.

B

48.

B

58.

C

  • 9. 29.

D

19.

D

B

39.

A

49.

C

59.

A

10.

A

20.

D

30.

C

40.

A

50.

D

60.

B

CHAPTER 2

MANAGEMENT ACCOUNTING AND THE BUSINESS ENVIRONMENT

  • I. Questions

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Chapter 8

Cost Concepts and Classifications

  • 1. Managerial accounting information often brings to the attention of managers important issues that need their managerial experience and skills. In many cases, managerial-accounting information will not answer the question or solve the problem, but rather make management aware that the issue or problem exists. In this sense, managerial accounting sometimes is said to serve an attention-directing role.

  • 2. Non-value-added costs are the costs of activities that can be eliminated with no deterioration of product quality, performance, or perceived value.

  • 3. Managers rely on many information systems in addition to managerial- accounting information. Examples of other information systems include economic analysis and forecasting, marketing research, legal research and analysis, and technical information provided by engineers and production specialists.

  • 4. Becoming the low-cost

producer

in

an

industry

requires

a

clear

understanding by management of the costs incurred in its production process. Reports and analysis of these costs are a primary function of managerial accounting.

  • 5. Some activities in the value chain of a manufacturer of cotton shirts are as follows:

    • (a) Growing and harvesting cotton

    • (b) Transporting raw materials

    • (c) Designing shirts

    • (d) Weaving cotton material

    • (e) Manufacturing shirts

    • (f) Transporting shirts to retailers

    • (g) Advertising cotton shirts

Some activities in the value chain of an airline are as follows:

  • (a) Making reservations and ticketing

  • (b) Designing the route network

  • (c) Scheduling

  • (d) Purchasing aircraft

  • (e) Maintaining aircraft

  • (f) Running airport operations, including handling baggage

  • (g) Serving food and beverages in flight

  • (h) Flying passengers and cargo

8-20

Cost Concepts and Classifications

Chapter 8

  • 6. Strategic cost management is the process of understanding and managing, to the organization’s advantage, the cost relationships among the activities in an organization’s value chain.

  • 7. If customers who provide a company with the most profits are attracted, satisfied, and retained, profits will increase as a result.

  • 8. A value chain is a sequence of business functions whose objective is to provide a product to a customer or provide an intermediate good or service in a larger value chain. These business functions include R&D, design, production, marketing, distribution, and customer service. An organization can become more effective by focusing on whether each link in the chain adds value from the customer’s perspective and furthers the organization’s objectives.

  • 9. Organizations are under continuous pressure to reduce the cost of the products or services they sell to their customers.

Cost:

Quality:

Customers are expecting higher levels of quality and are less tolerant of low quality than in the past.

Time: Time has many components: the time taken to develop and bring new products to market; the speed at which an organization responds to customer requests; and the reliability with which promised delivery dates are met. Organizations are under pressure to complete activities faster and to meet promised delivery dates more reliably than in the past in order to increase customer satisfaction. Innovation: There is now heightened recognition that a continuing flow of innovative products or services is a prerequisite for the ongoing success of most organizations.

  • 10. Managers make planning decisions and control decisions. Planning decisions include deciding on organization goals, predicting results under various alternative ways of achieving those goals, and then deciding how to attain the desired goals. Control decisions include taking actions to implement the planning decisions and deciding on performance evaluation and feedback that will help future decision making.

  • 11. Four themes for managers to attain success are customer focus, value- chain and supply-chain analysis, key success factors, and continuous improvement and benchmarking.

8-21

Chapter 8

Cost Concepts and Classifications

  • 12. Companies add value through R&D; design of products, services, or processes; production; marketing; distribution; and customer service. Managers in all business functions of the value chain are customers of management accounting information.

  • 13. This phrase means that people will direct their attention to work primarily on those tasks that management monitors and measures. Employees may not pay as much attention (or no attention) to tasks that are not measured. Often management will reward people based on how well they perform relative to a specific measure. As an example, in a manufacturing organization, if people are measured and rewarded based on the number of outputs per hour, regardless of quality, employees will focus their attention on producing as many units of output as possible. A negative consequence is that the quality of output may suffer.

  • 14. Some of these new measures are quality, speed to market, cycle time, flexibility, complexity and productivity.

  • 15. Customer satisfaction is often thought to be a qualitative measure of performance as one cannot directly observe “satisfaction.” However, using attitude surveys and psychological measurements, customer satisfaction can be measured in quantitative terms. For instance, people who design surveys often employ attitude scales that ask questions in which customers respond on a 1 to 5 scale. These values can be summed and averaged to determine satisfaction scores.

16.

Stakeholders

Contribution Requirements

Employees

Effort, skills,

Rewards, interesting

information

jobs, economic security, proper treatment

Partners

Goods, services,

Financial rewards

information

commensurate with the risk taken

Owners

Capital

Financial rewards

Community

Allows the organization to operate

Conformance to laws, good corporate

8-22

Cost Concepts and Classifications

Chapter 8

and does not oppose its operation

citizenship and, perhaps, leadership

17. Competitive

benchmarking

is

an

organization’s

search

for,

and

implementation of, the best way to do something as practiced in other organizations.

Continuous improvement is the relentless search to (1) document, understand, and improve the activities that the organization undertakes to meet its customers’ requirement, (2) eliminate processing activities that do not add product features that customers value, and (3) improve the performance of activities that increase customer value or satisfaction.

18. A value-added activity is an activity that, if eliminated, would reduce the product’s service to the customer in the long run.

An activity that cannot be classified as value-added is a nonvalue-added activity:

  • a. Value-added

  • b. Nonvalue-added

  • c. Nonvalue-added

  • d. Value-added

  • e. Nonvalue-added

  • f. Nonvalue-added

  • g. Value-added

  • h. Value-added

  • i. Nonvalue-added

  • j. Value-added

19. Just-in-time means making a good or service only when the customer, internal or external, requires it. Just-in-time requires a product layout with a continuous flow (no delays) once production starts. It means that setup costs must be reduced substantially to eliminate the need to produce in batches, and it means that processing systems must be reliable. Just-in- time production is based on the elimination of all nonvalue-added activities to reduce cost and time. It is an approach to improvement that is continuous and involves employee empowerment and involvement.

20. Managerial accounting is concerned with providing information to managers for use within the organization. Financial accounting is con- cerned with providing information to stockholders, creditors, and others outside of the organization.

8-23

Chapter 8

Cost Concepts and Classifications

21. A strategy is a game plan that enables a company to attract customers by distinguishing itself from competitors. The focal point of a company’s strategy should be its target customers.

II.

Multiple Choice Questions

 
  • 11. 21.

B

A

31.

B

A

  • 12. 22.

B

32.

C

  • 13. 23.

D

C

33.

C

A

  • 14. 24.

D

  • 15. 25.

D

A

A

  • 16. 26.

A

C

  • 17. 27.

B

  • 18. 28.

B

C

  • 19. 29.

D

B

20.

B

30.

A

 

CHAPTER 3

 

UNDERSTANDING FINANCIAL STATEMENTS

I.

Questions

  • 1. A financial statement is a means of communicating information about an enterprise in financial (i.e., peso) terms. It represents information that the accountant believes is a true and fair representation of the financial activity of the enterprise.

  • 2. Every financial statement relates to time in one way or another. A statement of financial position, or balance sheet, represent a “picture” of the enterprise at a point in time (e.g., the end of a month or year). An income statement and a statement of cash flows, on the other hand, cover activity that took place over a period of time (e.g., a month or year).

  • 3. a.

Creditors are interested in financial statements to assist them in evaluating the ability of a business to repay its debts. No one wants

8-24

Cost Concepts and Classifications

Chapter 8

to extend credit to a company that is unable to meet its obligations as they come due.

  • b. Potential investors use financial statements in selecting among alternative investment opportunities. They are interested in investing in companies in which the value of their investment will increase as a result of future profitable operations.

  • c. Labor unions are interested in financial statements because the financial position of a company and its profits are important factors in the company’s ability to pay higher wages and to employ more people.

  • 4. Business transactions affect a company’s financial position, and as a result they change the statement of financial position or balance sheet. The other financial statements – the income statement and the statement of cash flows – are detailed expansions of certain aspects of the statement of financial position and help explain how the company’s position changed over time.

  • 5. The cost principle indicates that many assets are included in the financial records, and therefore, in the statement of financial position, at their original cost to the reporting enterprise. This principle affects accounting for assets in several ways, one of which is that the amount of most assets is not adjusted periodically for changes in the market value of the assets. Instead, cost is retained as the basic method of accounting, regardless of changes in the market value of those assets.

  • 6. The going concern assumption states that in the absence of evidence to the contrary (i.e., bankruptcy proceedings), an enterprise is expected to continue to operate in the foreseeable future. This means, for example, that it will continue to use the assets it has in its financial statements for the purpose for which they were acquired.

  • 7. The three categories and the information included in each are: Operating activities – Cash provided by and used in revenue and expense transactions. Investing activities – Cash provided by and used as a result of investments in assets, such as machinery, equipment, land, and buildings. Financial activities – Cash provided by and used in debt and equity financing, such as borrowing and repaying loans, and investments from and dividends paid to the enterprise’s owners.

8-25

Chapter 8

Cost Concepts and Classifications

  • 8. Adequate disclosure refers to the requirement that financial statements, including accompanying notes, must include information necessary for reasonably informed users of financial statements to understand the company’s financial activities. This requirement is often met, in part, by the addition of notes to the financial statements. Financial statement notes include both quantitative and qualitative information that is not included in the body of the financial statements.

  • 9. A strong income statement is one that has significantly more pesos of revenue than expenses, resulting in net income that is a relatively high percentage of the revenue figure. A trend of relatively high income numbers over time signals a particularly strong income situation.

    • 10. A strong statement of cash flows is one that shows significant amounts of cash generated from operating activities. This means that the enterprise is generating cash from its ongoing activities and is not required to rely on continuous debt and equity financing, or the sale of its major assets.

    • 11. The purpose of classifications in financial statements is to develop useful subtotals, which help users analyze the statements. The most commonly used classifications are: In a balance sheet: current assets, plant and equipment, other assets, current liabilities, long-term liabilities and equity. In a multiple-step income statement: revenue, cost of goods sold, operating expenses, and nonoperating items. The operating expense section often includes subclassifications for selling expenses and for general and administrative expenses. In a statement of cash flows: operating activities, investing activities, and financing activities.

    • 12. In classified financial statements, similar items are grouped together to produce subtotals which may assist users in their analyses. Comparative financial statements show financial statements for two or more time periods in side-by-side columns. Consolidated statements include not only the financial statement amounts for the company itself but also for any subsidiary companies that it owns. The financial statements of large corporations often possess all three of these characteristics.

    • 13. In a multiple-step income statement, different categories of expenses are deducted from revenue in a series of steps, thus resulting in various subtotals, such as gross profit and operating income. In a single-step

8-26

Cost Concepts and Classifications

Chapter 8

income statement, all expenses are combined and deducted from total revenue in a single step. Both formats result in the same amount of net income.

II.

Matching Type

 

1.

 
  • 1. d

3.

a

5.

e

7.

f

9.

c

  • 2. j

g

4.

6.

h

8.

b

10. i

 
 

2.

 
  • 1. d

3.

i

5.

m

7.

h

9.

f

11. b

13. e

  • 2. g

a

4.

 

6.

c

8.

n

10. k

 

12. j

14. l

 

3.

 
  • a. F

c.

F

e.

I

g.

F

I.

I

k.

F

  • b. I

d.

I

f.

F

h.

F

j.

F

l.

I

III. Problems

Problem 1 (Preparing a Balance Sheet – A Second Problem)

Requirement (a)

Assets

SM Farms Balance Sheet September 30, 2005

Liabilities and Equity

Cash

Liabilities:

 

P 16,710

Accounts receivable

22,365

Notes

payable

 

P530,000

Land

Accounts

payable

 

550,000

77,095

Barns and sheds

78,300

Property

taxes

payable

 

9,135

Citrus trees

76,650

Wages

payable

 

1,820

Livestock

120,780

 

Total

liabilities

P618,050

8-27

Chapter 8

Cost Concepts and Classifications

Irrigation system

20,125

Equity:

Farm machinery

42,970

Share

capital

 

250,000

Fences & gates

33,570

Retained

earnings*

 

93,420

Total

Total

 

P961,470

P961,470

* Total assets, P961,470, minus total liabilities, P618,050,

P250,000.

less share capital,

Requirement (b)

The loss of an asset, Barns and Sheds, from a typhoon would cause a decrease in total assets. When total assets are decreased, the balance sheet total of

liabilities and equity must also decrease. Since there is no change in liabilities as a result of the destruction of an asset, the decrease on the right-hand side of the balance sheet must be in the retained earnings account. The amount of the decrease in Barns and Sheds, in the equity, and in both balance sheet totals, is

P23,800.

Problem 2 (Preparing a Balance Sheet and Cash Flow Statement; Effects of Business Transactions)

Requirement (a)

Assets

The Tasty Bakery Balance Sheet August 1, 2005

Liabilities and Equity

Cash

Liabilities:

P

6,940

Accounts receivable

11,260

Notes

payable

 

P

74,900

Supplies

7,000

Accounts

payable

 

16,200

Land

Salaries

payable

 

67,000

8,900

Building

84,000

 

Total

liabilities

P100,000

Equipment and fixtures

Equity:

44,500

8-28

Cost Concepts and Classifications

Chapter 8

 

Share

capital

 

80,000

 

Retained

earnings

 

40,700

Total

Total

P220,700

P220,700

Requirement (b)

 

The Tasty Bakery Balance Sheet August 3, 2005

Assets

Liabilities and Equity

Cash

Liabilities:

P 14,490

Accounts receivable

11,260

Notes

payable

 

P

74,900

Supplies

8,250

Accounts

payable

 

7,200

Land

Salaries

payable

 

67,000

8,900

Building

84,000

 

Total

liabilities

P 91,000

Equipment and fixtures

Equity:

51,700

 

Share

capital

 

105,000

 

Retained

earnings

 

40,700

Total

Total

P236,700

P236,700

The Tasty Bakery Statement of Cash Flows For the Period August 1 - 3, 2005

8-29

Chapter 8

Cost Concepts and Classifications

Cash flows from operating activities:

Cash

payment

of

P(16,200

accounts payable

)

Cash

purchase

of

(1,250)

supplies

Cash

used

in

P(17,450

operating activities

)

Cash flows from investing activities:

 

None

Cash flows from financing activities:

 

Sale of share capital

 

P25,000

Increase in cash

P 7,550

Cash balance, August 1,

 

6,940

2005

Cash balance, August 3,

 

P14,490

2005

Requirement (c)

The Tasty Bakery is in a stronger financial position on August 3 than it was on August 1.

On August 1, the highly liquid assets (cash and accounts receivable) total only P18,200, but the company has P25,100 in debts due in the near future (accounts payable plus salaries payable).

On August 3, after additional infusion of cash from the sale of stock, the liquid assets total P25,750, and debts due in the near future amount to P16,100.

Note to Instructor: The analysis of financial position strength in requirement (c) is based solely upon the balance sheets at August 1 and August 3. Hopefully, students will raise many legitimate issues regarding necessity of information about operations, rate at which cash flows into the business, etc. In this problem, the improvement in financial position results solely from the sale of share capital.

8-30

Cost Concepts and Classifications

Chapter 8

Problem

3

(Preparing

Financial

Statements;

Effects

of

Business

Transactions)

 

Requirement (a)

 

The First Malt Shop Balance Sheet September 30, 2005

 
 

Assets

Liabilities and Equity

Cash

 

Liabilities:

 
 

P 7,400

Accounts receivable

1,250

Notes

payable*

 

P

70,000

Supplies

 

3,440

Accounts

payable

 

8,500

Land

 
 

55,000

Total

liabilities

 

P 78,500

Building

 

45,500

Equity:

 
 

Share

capital

 

50,000

Furniture & fixtures

20,000

Retained

earnings

 

4,090

Total

 

Total

 

P132,590

P132,590

* Total assets, P132,590, less equity, P54,090, less accounts payable, P8,500, equals notes payable.

Requirement (b)

Assets

The First Malt Shop Balance Sheet October 6, 2005

Liabilities and Equity

Cash

Liabilities:

 

P 29,400

Accounts receivable

1,250

Notes

payable

 

P

70,000

Supplies

4,440

Accounts

payable

8-31

Chapter 8

Cost Concepts and Classifications

 

18,000

Land

 

55,000

Total

liabilities

 

P 88,000

Building

 

45,500

Equity:

 

Share

capital

 

80,000

Furniture & fixtures

38,000

Retained

earnings

 

5,590

Total

Total

 

P173,590

 

P173,590

The First Malt Shop Income Statement For the Period October 1-6, 2005

 

Revenues

 

P 5,500

Expenses

(4,000)

Net income

P 1,500

The First Malt Shop Statement of Cash Flows For the Period October 1-6, 2005

 

Cash

flows

from

operating

activities:

 
 

Cash

received

from

P5,500

revenues Cash paid for expenses

(4,000

)

Cash paid for accounts

(8,500

payable

)

Cash paid for supplies

(1,0

00)

Cash used in operating activities

 

P(8,000)

8-32

Cost Concepts and Classifications

Chapter 8

Cash

flows

from

investing

activities:

 
 

None

Cash

flows

from

financing

activities:

 

Cash received from sale of share capital

P30,000

Increase in cash

P

22,000

Cash balance, October 1, 2005

7,400

Cash balance, October 6, 2005

P29,400

Requirement (c)

The First Malt Shop is in a stronger financial position on October 6 than on September 30. On September 30, the company had highly liquid assets (cash and accounts receivable) of P8,650, which barely exceeded the P8,500 in liabilities (accounts payable) due in the near future. On October 6, after the additional investment of cash by shareholders, the company’s cash alone exceeded its short-term obligations.

Problem

4

(Preparing

a

Balance

Sheet;

Discussion

of

Accounting

Principles)

Requirement (1)

 
 

Fil-Cinema Scripts Balance Sheet November 30, 2005

 
 

Assets

Liabilities and Equity

Cash

Liabilities:

 

P

3,940

Notes receivable

 

2,200

Notes

payable

 

P

73,500

Accounts receivable

 

2,450

Accounts

payable

8-33

Chapter 8

Cost Concepts and Classifications

 

32,700

Land

 

39,000

Total

liabilities

 

P106,200

Building

54,320

Equity:

 

Share

capital

 

5,000

Office furniture*

12,825

Retained

earnings

 

3,535

Total

Total

 

P114,735

P114,735

* P8,850 + P6,500 – P2,525.

Requirement (2)

(1) The cash in Cruz’s personal savings account is not an asset of the business entity Fil-Cinema Scripts and should not appear in the balance sheet of the business. The money on deposit in the business bank account (P3,400) and in the company safe (P540) constitute cash owned by the business. Thus, the cash owned by the business at November 30 totals

P3,940.

(2) The years-old IOU does not qualify as a business asset for two reasons. First, it does not belong to the business entity. Second, it appears to be uncollectible. A receivable that cannot be collected is not viewed as an asset, as it represents no future economic benefit.

(3) The total amount to be included in “Office furniture” for the rug is P9,400, the total cost, regardless of whether this amount was paid in cash. Consequently, “Office furniture” should be increased by P6,500. The P6,500 liability arising from the purchase of the rug came into existence prior to the balance sheet date and must be added to the “Notes payable” amount. (4) The computer is no longer owned by Hollywood Scripts and therefore cannot be included in the assets. To do so would cause an overstatement of both assets and equity. The “Office furniture” amount must be reduced by P2,525.

(5) The P22,400 described as “Other assets” is not an asset, because there is no valid legal claim or any reasonable expectation of recovering the income taxes paid. Also, the payment of income taxes by Cruz was not a business transaction by Fil-Cinema Scripts. If a refund were obtained

8-34

Cost Concepts and Classifications

Chapter 8

from the government, it business entity.

would come to Cruz

personally, not to the

(6) The proper valuation for the land is its historical cost of P39,000, the amount established by the transaction in which the land was purchased. Although the land may have a current fair value in excess of its cost, the offer by the friend to buy the land if Cruz would move the building appears to be mere conversation rather than solid, verifiable evidence of the fair value of the land. The “cost principle,” although less than perfect, produces far more reliable financial statements than would result if owners could “pull figures out of the air” in recording asset values.

(7) The accounts payable should be limited to the debts of the business, P32,700, and should not include Cruz’s personal liabilities.

IV. Multiple Choice Questions

  • 21. 21.

D

31.

B

B

31.

B

C

  • 22. 22.

D

32.

C

32.

D

  • 23. 23.

D

33.

D

A

33.

D

A

  • 24. 24.

B

34.

B

34.

D

A

  • 25. 25.

35.

D

A

35.

C

  • 26. 26.

B

a.

D

36.

A

A

A

  • 27. 27.

D

17.

B

37.

A

C

  • 28. 28.

18.

B

B

38.

C

C

  • 29. 29.

B

19.

D

  • 30. 30.

20.

C

C

C

CHAPTER 4

FINANCIAL STATEMENTS ANALYSIS - I

I.

Questions

  • 1. The objective of financial statements analysis is to determine the extent of a firm’s success in attaining its financial goals, namely:

    • a. To earn maximum profit

8-35

Chapter 8

Cost Concepts and Classifications

  • b. To maintain solvency

  • c. To attain stability

  • 2. Some of the indications of satisfactory short-term solvency or working capital position of a business firm are:

    • 1. Favorable credit position

    • 2. Satisfactory proportion of cash to the requirements of the current volume

    • 3. Ability to pay current debts in the regular course of business

    • 4. Ability to extend more credit to customers

    • 5. Ability to replenish inventory promptly

  • 3. These tests are:

    • 1. Improvement in the financial position

    • 2. Well-balanced financial structure between borrowed funds and equity

    • 3. Effective employment of borrowed funds and equity

    • 4. Ability to declare satisfactory amount of dividends to shareholders

    • 5. Ability to withstand adverse business conditions

    • 6. Ability to engage in research and development in an attempt to provide new products or improve old products, methods or processes

  • 4. Some indicators of managerial efficiency are:

    • 1. Ability to earn a reasonable return on its investment of borrowed funds and equity

    • 2. Ability to control operating costs within reasonable limits

    • 3. No overinvestment in fixed assets, receivables and inventories

  • 5. The techniques used in Financial Statement Analysis are:

    • I. Vertical analysis which shows the relationships of the items in the same year: also referred to as “static measure.”

      • a. Financial ratios

      • b. Common-size statements

  • II.

    Horizontal analysis which shows the changes or tendencies of an item for 2 or more years; also referred to as “dynamic measure.”

    8-36

    Cost Concepts and Classifications

    Chapter 8

    • a. Comparative statements - showing changes in absolute amount and percentages

    • b. Trend percentages

    III. Use of special reports or statements

    • a. Statements of Changes in Financial Position

    • b. Gross Profit / Net Income Variation Analysis

    • 6. Refer to page 133 of the textbook.

    • 7. Horizontal analysis involves the comparison of items on financial statements between years. Analysis of comparative financial statements or the increase/decrease method of analysis and trend percentages are the two techniques that may be applied under horizontal analysis. Vertical analysis involves the study of items on a single statement for a single year, such as the analysis of an income statement for some given

    year.

    Common-size statement and financial ratios are techniques used in

    vertical analysis.

    • 8. Trends can indicate whether a situation is improving, remaining the same or deteriorating. They can also give insight to the probable future course of events in a firm.

    • 9. Trend percentages represent the expression of several years’ financial data in percentage form in terms of a base year.

      • 10. Refer to page 133 of the textbook.

      • 11. Observation of trends is useful primarily in determining whether a situation is improving, worsening, or remaining constant. By comparing current data with similar data of prior periods we gain insight into the direction in which future results are likely to move. Some other standards of comparison include comparison with other similar companies, comparison with industry standards, and comparison with previous years’ information. By comparing analytical data for one company with some independent yardstick, the analyst hopes to determine how the position of the company in question compares with some standard of performance.

      • 12. Trend percentages are used to show the increase or decrease in a financial statement amount over a period of years by comparing the amount in each

    8-37

    Chapter 8

    Cost Concepts and Classifications

    year with the base-year amount. A component percentage is the percentage relationship between some financial amount and a total of which it is a part.

    Measuring the change in sales over a period of several years would call for use of trend percentages. The sales in the base year are assigned a weight of 100%. The percentage for each later year is computed by dividing that year’s sales by the sales in the base year.

    • 13. Expenses (including the cost of goods sold) have been increasing at an even faster rate than net sales. Thus Premiere is apparently having difficulty in effectively controlling its expenses.

    • 14. A corporate net income of P1 million would be unreasonably low for a large corporation, with, say, P100 million in sales, P50 million in assets, and P40 million in equity. A return of only P1 million for a company of this size would suggest that the owners could do much better by investing in insured bank savings accounts or in government bonds which would be virtually risk-free and would pay a higher return. On the other hand, a profit of P1 million would be unreasonably high for a corporation which had sales of only P5 million, assets of, say, P3 million, and equity of perhaps one-half million pesos. In other words, the net income of a corporation must be judged in relation to the scale of operations and the amount invested.

    II.

    True or False

    1.

    2.

    True

    False

    III. Problems

    3.

    4.

    True

    True

    5.

    6.

    False

    False

    7.

    8.

    True

    False

    Problem 1 (Percentage Changes)

    9.

    True

    10. True

    • a. Accounts receivable decreased 16% (P24,000 decrease P150,000 = 16% decrease).

    • b. Marketable securities decreased 100% (P250,000 decrease P250,000 = 100% decrease).

    • c. A percentage change cannot be calculated because retained earnings showed a negative amount (a deficit) in the base year and a positive amount in the following year.

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    Cost Concepts and Classifications

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    • d. A percentage change cannot be calculated because of the zero amount of notes receivable in 2005, the base year.

    • e. Notes payable increased 7 ½% (P60,000 increase P800,000 = 7 ½% increase).

    • f. Cash increased 3% (P2,400 increase P80,000 = 3% increase).

    • g. Sales increased 10% (P90,000 increase P900,000 = 10% increase).

    Problem 2 (Computing and Interpreting Rates of Change)

    Requirement (a)

    Computation of percentage changes:

    • 1. Net sales increased 10% (P200,000 increase).

    increase P2,000,000 = 10%

    • 2. Total expenses increased 11% (P198,000 increase P1,800,000 = 11% increase).

    Requirement (b)

    • 1. Total expenses grew faster than net sales. Net income cannot also have grown faster than net sales, or the sum of the parts would exceed the size of the whole.

    • 2. Net income must represent a smaller percentage of net sales in 2006 than it did in 2005. Again, the reason is that the expenses have grown at a faster rate than net sales. Thus, total expenses represent a larger percentage of total sales in 2006 than in 2005, and net income must represent a smaller percentage.

    Problem 3 (Financial Statement Analysis using Comparative Statements or Increase-Decrease Method)

    Requirement 1

    XYZ Corporation Balance Sheet As of December 31

     

    Change

    Peso

    %

     

    2005

    2006

    Assets

    Cash and equivalents

    14,000

    16,000

    2,000

    14.29%

    Receivables

    28,800

    55,600

    26,800

    93.06%

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    Chapter 8

    Cost Concepts and Classifications

    Inventories

    54,000

    85,600

    31,600

    58.52%

    Prepayments and others

    4,800

    7,400

    2,600

    54.17%

    Total current assets Property, plant & equipment - net

    101,600

    164,600

    63,000

    62.01%

    of dep.

    30,200

    73,400

    43,200

    143.05%

    Total assets

    131,800

    238,000

    106,200

    80.58%

    Liabilities and Equity

    Notes payable to banks

    10,000

    54,000

    44,000

    440.00%

    Accounts payable

    31,600

    55,400

    23,800

    73.32%

    Accrued liabilities

    4,200

    6,800

    2,600

    61.90%

    Income taxes payable

    5,800

    7,000

    1,200

    20.69%

    Total current liabilities

    51,600

    123,200

    71,600

    138.76%

    Share capital

    44,600

    44,600

    0

    0.00%

    Retained earnings

    35,600

    70,200

    34,600

    97.19%

    Total equity

    80,200

    114,800

    34,600

    43.14%

    Total liabilities and equity

    131,800

    238,000

    106,200

    80.58%

    XYZ Corporation Income Statement Years ended December 31 (P thousands)

     

    Change

    Peso

    %

     

    2005

    2006

    Net sales

    266,400

    424,000

    157,600

    59.16%

    Cost of goods sold

    191,400

    314,600

    123,200

    64.37%

    Gross profit Selling, general and administrative

    75,000

    109,400

    34,400

    45.87%

    expenses

    35,500

    58,400

    22,900

    64.51%

    Income before income taxes

    39,500

    51,000

    11,500

    29.11%

    Income taxes

    12,300

    16,400

    4,100

    33.33%

    Net income

    27,200

    34,600

    7,400

    27.21%

    Requirement 2

    Short-term financial position

    Current

    • 1. while

    Assets

    increased by 62.01%

    Unfavorable

    Current

    Liabilities

    increased by 138.76%

    Quick

    • 2. while

    Assets

    increased by 62.40%

    Unfavorable

    Current

    Liabilities

    increased by 138.76%

    • 3. while

    Net

    Sales

    increased by 59.16%

    Unfavorable

    Accounts

    Receivable

    increased by 93.06%

     

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    Cost Concepts and Classifications

    Chapter 8

    4.

    Cost of

    Inventories

     

    Goods

    Sold

    increased by 64.37%

    while

    increased by 58.52%

     

    Favorable

    Leverage

     

    5.

    Total

    Total

    Assets

    increased by 80.58%

    while

    Liabilities

    increased by 138.76%

     

    Unfavorable

    6.

    Total

    Total

    Liabilities

    increased by 138.76%

    while

    Equity

    increased by 43.14%

     

    Unfavorable

    Profitability

     

    7.

    Net

    increased by 59.16%

    while

    Cost of

    increased by 64.37%

    Sales

    Goods

    Sold

     

    Unfavorable

     

    8.

    Net

    Selling,

    Sales

    increased by 59.16%

    while

    General &

    increased by 64.51%

     

    Administrative

    Expenses

     

    Unfavorable

    9.

    Net

    Net

    Sales

    increased by 59.16%

    while

    Income

    increased by 27.21%

     

    Unfavorable

    10. Net

     

    Total

     

    Income

    increased by 27.21%

    while

    Assets

    increased by 80.58%

     

    Unfavorable

    Problem 4 (Trend Percentages)

    Requirement (1)

    The trend percentages are:

     

    Year 5

    Year 4

    Year 3

    Year 2

    Year 1

    Sales

    125.0

    120.0

    110.0

    105.0

    100.0

    Cash

    80.0

    90.0

    105.0

    110.0

    100.0

    Accounts receivable

    140.0

    124.0

    108.0

    104.0

    100.0

    Inventory

    112.0

    110.0

    102.0

    108.0

    100.0

    Total current assets

    118.8

    113.1

    104.1

    106.9

    100.0

    Current liabilities

    130.0

    106.0

    108.0

    110.0

    100.0

    Requirement (2)

    8-41

    Chapter 8

    Cost Concepts and Classifications

    Sales:

    The sales are increasing at a steady rate, with a particularly strong gain in Year 4.

    Assets: Cash declined from Year 3 through Year 5. This may have been due to the growth in both inventories and accounts receivable. In particular, the accounts receivable grew far faster than sales in Year 5. The decline in cash may reflect delays in collecting receivables. This is a matter for management to investigate further.

    Liabilities:

    The current liabilities jumped up in Year 5. This was probably due to the buildup in accounts receivable in that the company doesn’t have the cash needed to pay bills as they come due.

    Problem 5 (Use of Trend Percentages)

    a.

    • 1. An unfavorable tendency could be observed in Receivables in relation to Net Sales from 2003 – 2005 because receivables had been increasing at a much faster rate than Net Sales. This could indicate inefficiency in the collection of receivables or simply poor company credit policy. The situation however, improved in 2006 and 2007 when sales started to move up at a faster rate than accounts receivable. This would indicate improvement in the credit and collection policy or more cash sales were being generated.

    • 2. Unfavorable tendency in inventory persisted from 2003 to 2007 because it had been going up at a much faster rate than Net Sales. If this continues, the company will end up with over-investment in inventory because the buying rate is faster than the selling price.

    • 3. Favorable tendencies could be noted in Fixed Assets in relation to Net Sales because inspite of the minimal additions to fixed assets made by the company from 2003 through 2007, sales had been increasing at a very encouraging rate.

    • 4. Net Income had likewise been increasing at a much faster rate than net sales. This is favorable because this would indicate that the company had been successfully controlling the increases in Cost of Sales and Operating Expenses.

    b.

    Review computations of the Trend Percentages.

    It will be noted that the

    Trend Percentages in Total Noncurrent Liabilities and Equity from 2005

    8-42

    Cost Concepts and Classifications

    Chapter 8

    to 2007 were interchanged. Correction should be made first before interpretation is done.

    • 1. The upward tendency in current assets had been accompanied by an upward trend in current liabilities. It could be noted that current assets had been moving up at a much faster rate than current liabilities. This is favorable because the margin of safety of the short- term creditors is widened.

    • 2. Favorable tendencies could also be observed in noncurrent assets which had been increasing and which increases had been accompanied by downward trend in noncurrent liabilities. This would mean better security on the part of creditors and stronger financial position.

    • 3. There is an unfavorable tendency in Net Sales in relation to non- current assets. Sales had not been increasing at the same rate as the increases in fixed assets. This could indicate that more investments are made in noncurrent assets without considering whether or not they could sell the additional units of product they are producing.

    • c. The unfavorable trend in net income could be attributed to the following tendencies:

      • 1. Higher rates of increases in cost of sales as compared to sales.

      • 2. Higher rates of increases in selling, general and administrative expenses in relation to net sales.

      • 3. Higher rates of increases in other financial expenses than the rates of increases in net sales

    IV. Multiple Choice Questions

    • 31. D

    36.

    A, C, D

    • 32. A

    37.

    B*

    • 33. A

    38.

    D

    • 34. B

    • 35. D

    • 36. C

    • 37. C

    • 38. A

    • 39. D

    • 40. C

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    Chapter 8

    Cost Concepts and Classifications

    * (P400,000 – P160,000) P160,000 = 150%

    CHAPTER 5

    FINANCIAL STATEMENTS ANALYSIS - II

    I.

    Questions

    • 1. By looking at trends, an analyst hopes to get some idea of whether a situation is improving, remaining the same, or deteriorating. Such analyses can provide insight into what is likely to happen in the future. Rather than looking at trends, an analyst may compare one company to another or to industry averages using common-size financial statements.

    • 2. Ratios highlight relationships, movements, and trends that are very difficult to perceive looking at the raw underlying data standing alone. Also, ratios make financial data easier to grasp by putting the data into perspective. As to the limitation in the use of ratios, refer to page 129.

    • 3. Price-earnings ratios are determined by how investors see a firm’s future prospects. Current reported earnings are generally considered to be useful only so far as they can assist investors in judging what will happen in the future. For this reason, two firms might have the same current earnings, but one might have a much higher price-earnings ratio if investors view it to have superior future prospects. In some cases, firms with very small current earnings enjoy very high price-earnings ratios. This is simply because investors view these firms as having very favorable prospects for earnings in future years. By definition, a stock with current earnings of P4 and a price-earnings ratio of 20 would be selling for P80 per share.

    • 4. A manager’s financing responsibilities relate to the acquisition of assets for use in his or her company. The acquisition of assets can be financed in a number of ways, including through issue of ordinary shares, through issue of preference shares, through issue of long-term debt, through leasing, etc. A manager’s operating responsibilities relate to how these assets are used once they have been acquired. The return on total assets ratio is designed to measure how well a manager is discharging his or her

    8-44

    Cost Concepts and Classifications

    Chapter 8

    operating responsibilities.

    It does this by looking at a company’s income

    before any consideration is given as to how the income will be distributed

    among capital resources, i.e., before interest deductions.

    • 5. Financial leverage, as the term is used in business practice, means obtaining funds from investment sources that require a fixed annual rate of return, in the hope of enhancing the well-being of the ordinary shareholders. If the assets in which these funds are invested earn at a rate greater that the return required by the suppliers of the funds, then leverage is positive in the sense that the excess accrues to the benefit of the ordinary shareholders. If the return on assets is less than the return required by the suppliers of the funds, then leverage is negative in the sense that part of the earnings from the assets provided by the ordinary shareholders will have to go to make up the deficiency.

    • 6. How a shareholder would feel would depend in large part on the stability of the firm and its industry. If the firm is in an industry that experiences wide fluctuations in earnings, then shareholders might be very pleased that no interest-paying debt exists in the firm’s capital structure. In hard times, interest payments might be very difficult to meet, or earnings might be so poor that negative leverage would result.

    • 7. No, the stock is not necessarily overpriced. Book value represents the cumulative effects on the balance sheet of past activities evaluated using historical prices. The market value of the stock reflects investors’ beliefs about the company’s future earning prospects. For most companies market value exceeds book value because investors anticipate future growth in earnings.

    • 8. A company in a rapidly growing technological industry probably would have many opportunities to invest its earnings at a high rate of return; thus, one would expect it to have a low dividend payout ratio.

    • 9. It is more difficult to obtain positive financial leverage from preference shares than from long-term debt due to the fact that interest on long-term debt is tax deductible, whereas dividends paid on preference shares are not tax deductible.

    10. The current ratio would probably be highest during January, when both current assets and current liabilities are at a minimum. During peak operating periods, current liabilities generally include short-term borrowings that are used to temporarily finance inventories and

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    Chapter 8

    Cost Concepts and Classifications

    receivables. As the peak periods end, these short-term borrowings are paid off, thereby enhancing the current ratio.

    • 11. A 2-to-1 current ratio might not be adequate for several reasons. First, the composition of the current assets may be heavily weighted toward slow- turning inventory, or the inventory may consist of large amounts of obsolete goods. Second, the receivables may be large and of doubtful collectibility, or the receivables may be turning very slowly due to poor collection procedures.

    • 12. Expenses (including the cost of goods sold) have been increasing at an even faster rate than net sales. Thus Sunday is apparently having difficulty in effectively controlling its expenses.

    • 13. If the company’s earnings are very low, they may become almost insignificant in relation to stock price. While this means that the p/e ratio becomes very high, it does not necessarily mean that investors are optimistic. In fact, they may be valuing the company at its liquidation value rather than a value based upon expected future earnings.

    • 14. From the viewpoint of the company’s shareholders, this situation represents a favorable use of leverage. It is probable that little interest, if any, is paid for the use of funds supplied by current creditors, and only 11% interest is being paid to long-term bondholders. Together these two sources supply 40% of the total assets. Since the firm earns an average return of 16% on all assets, the amount by which the return on 40% of the assets exceeds the fixed-interest requirements on liabilities will accrue to the residual equity holders – the ordinary shareholders – raising the return on equity.

    • 15. The length of operating cycle of the two companies cannot be determined from the fact the one company’s current ratio is higher. The operating cycle depends on the relationships between receivables and sales, and between inventories and cost of goods sold. The company with the higher current ratio might have either small amounts of receivables and inventories, or large sales and cost of sales, either of which would tend to produce a relatively short operating cycle.

    • 16. The investor is calculating the rate of return by dividing the dividend by

    the purchase price of the investment (P5

    P50

    =

    10%).

    A more

    meaningful figure for rate of return on investment is determined by

    relating dividends to current market price, since the investor at the present

    time is faced with the alternative of selling the stock for P100

    and

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    Cost Concepts and Classifications

    Chapter 8

    investing the proceeds elsewhere or keeping the investment. A decision to retain the stock constitutes, in effect, a decision to continue to invest P100 in it, at a return of 5%. It is true that in a historical sense the investor is earning 10% on the original investment, but this is interesting history rather than useful decision-making information.

    17. A corporate net income of P1 million would be unreasonably low for a large corporation, with, say, P100 million in sales, P50 million in assets, and P40 million in equity. A return of only P1 million for a company of this size would suggest that the owners could do much better by investing in insured bank savings accounts or in government bonds which would be virtually risk-free and would pay a higher return.

    On the other hand, a profit of P1 million would be unreasonably high for a corporation which had sales of only P5 million, assets of, say, P3 million, and equity of perhaps one-half million pesos. In other words, the net income of a corporation must be judged in relation to the scale of operations and the amount invested.

    II.

    True or False

     

    1.

    True

    3.

    True

    5.

    True

    7.

    True

    9.

    False

    2.

    True

    4.

    False

    6.

    True

    8.

    True

    10. False

    III. Problems

     
     

    Problem 1 (Common Size Income Statements)

     

    Common size income statements for 2005 and 2006:

     

    2006

    2005

     

    Sales.................................................

     

    100%

    100%

    Cost of goods sold.............................

    66

    67

    Gross profit.......................................

    34%

    33%

    Operating expenses...........................

    28

    29

    Net income........................................

    6%

    4%

    The changes from 2005 to 2006 are all favorable. Sales increased and the gross profit per peso of sales also increased. These two factors led to a substantial increase in gross profit. Although operating expenses increased in peso amount, the operating expenses per peso of sales decreased from 29 cents to 28 cents. The combination of these three favorable factors caused net income to rise from 4 cents to 6 cents out of each peso of sales.

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    Chapter 8

    Cost Concepts and Classifications

    Problem 2 (Measures of Liquidity)

    Requirement (a)

    Current assets:

    Cash

    Notes payable

    P 47,600

    Marketable securities

    175,040

    Accounts receivable

    230,540

    Inventory

    179,600

    Unexpired insurance

    4,500

    Total current assets

    P637,280

    Current liabilities:

    P 70,000

    Accounts payable

    125,430

    Salaries payable

    7,570

    Income taxes payable

    14,600

    Unearned revenue

    10,000

    Total current liabilities

    P227,600

    Requirement (b)

    The current ratio is 2.8 to 1. It is computed by dividing the current assets of P637,280 by the current liabilities of P227,600. The amount of working capital is P409,680, computed by subtracting the current liabilities of P227,600 from the current assets of P637,280.

    The company appears to be in a strong position as to short-run debt-paying ability. It has almost three pesos of current assets for each peso of current liabilities. Even if some losses should be sustained in the sale of the merchandise on hand or in the collection of the accounts receivable, it appears probable that the company would still be able to pay its debts as they fall due in the near future. Of course, additional information, such as the credit terms on the accounts receivable, would be helpful in a careful evaluation of the company’s current position.

    Problem 3 (Common-Size Income Statement)

    Requirement 1

     

    2006

    2005