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MN7006/D

Accounting for
Managers

The cover and text of this study module


are printed on recycled board and paper
Module MN7006/D
Accounting for Managers
Edition 22

First published in Great Britain by


Learning Resources
292 High St, Cheltenham, GL50 3HQ
England

Ó University of Leicester 2009

All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or
transmitted in any form or by any means, electronic, mechanical, photocopying, recording or
otherwise, without the prior written consent of the University of Leicester.
ACCOUNTING FOR MANAGERS

Contents
Preface
This study book ii

Section 1
Perspectives on Accounting
What is accounting? 3
Financial and management accounting 5
The emergence of accounting 6
Separation of ownership from control 7
Theoretical perspectives 8

Section 2
Principal Financial Statements
Introduction 14
The nature of profit 14
The nature of cash 15
The matching concept 15
The three main financial statements 17
The double entry system 18
Accounting conventions 21

Financial Accounting Case Study Part I


Introducing Next plc
Commercial context 27
Ten year historical financial summary 28
Extracts from the latest Annual Report 29
Summarised balance sheet 32
Fixed assets and depreciation 33
Section 3
Interpreting Financial Statements
Introductory principles of interpretation 37
Approach to interpretation 38
Illustrative interpretation 40
Illustrative ratio analysis 43

Financial Accounting Case Study Part II


Next's Accounts: Interpretation and Ratio Analysis
Principal financial statements 53
Share capital 56
Dividends 56
Debt capital 56
Segmental analysis for 2006 57
Cashflow statement 58

Section 4
Regulation and Governance
Introductory context 63
The nature of regulation 64
International Financial Reporting Standards (IFRS) 66
Corporate governance 66
Contrasting national approaches 70
Supplementary statements 71

Financial Accounting Case Study Part III


Next plc: Impact of Governance and International
Accounting Standards
New regulatory regime 77
Corporate governance 78
Corporate Social Responsibility (CSR) 83

Section 5
Capital Markets and Shareholder Value
Role of financial markets 90
Shareholder return 91
Cost of capital 94
Value-based measures 95

Financial Accounting Case Study Part IV


Next plc: Share Prices and Share Options
Importance of a market perspective 101
Directors’ remuneration policy 103
Employees share ownership trust 104
Section 6
Strategic Investment Decisions
Management accounting revisited 109
Decision theory 110
Decision relevance 112
Characteristics of decisions 112
Strategic management accounting 113
Investment appraisal 114

Management Accounting Case Study Part I


Context: Dynamic Demand
Introductory extracts from
www. dynamicdemand.co.uk 121
Megawot: strategic decisions 123

Section 7
Marketing Decisions
Simple notions of product profitability 129
Cost, volume and pricing 131
Life cycle analysis 133
Target costing 135
Market pricing 135

Management Accounting Case Study Part II


Pearl: Pricing Decisions

Section 8
Operating Decisions
Resources 147
Accounting for resources 150
Advanced manufacturing environments 151
Service environments 154

Management Accounting Case Study Part III


Pearl: Operating Decisions

Section 9
Budgeting Decisions
What are budgets for? 165
Control theory 166
Budget preparation 167
The master budget 169
Budgetary control 170
Criticisms of budgeting 172
Management Accounting Case Study Part IV
Pearl: Budgeting

Section 10
Performance Management
Dimensions of performance 183
Balanced scorecard 184
Divisional performance management 186
Return on investment (ROI) 188
Residual income (RI) 190
Performance review 191

Management Accounting Case Study Part V


Pearl: Performance Measurement

Appendix A
Solutions to Tutorial Exercises
Section 4 201
Section 5 202

Appendix B
Outline Solutions to Case Exercises
Section 2 – Introducing Next plc 207
Section 3 – Next’s Accounts 210
Section 4 – Next and the Impact of Governance
and International Accounting Standards 215
Section 5 – Next Share Prices and Share Options 220
Section 6 – Dynamic Demand 222
Section 7 – Pearl’s Pricing Decisions 223
Section 8 – Pearl’s Operating Decisions 226
Section 9 – Pearl’s Budgeting 228
Section 10 – Pearl’s Performance Measurement 230
ACCOUNTING FOR MANAGERS

Preface
This study book provides the core learning material for those studying the
module Accounting for Managers with the University of Leicester School of
Management.

Accounting for Managers is designed for managers and not for aspiring
accountants. Managers need to interpret, not prepare, accounts. They need to:

· know their way around published and internal accounting reports,

· understand the meaning of accounting terms and parameters,

· be able to call upon appropriate financial information for a variety of


business decision contexts,

· recognise the conventions under which accountants prepare data


and the consequential limitation of the information they provide,
and

· be aware of the bigger, wider and deeper setting within which


accounting data and financial imperatives are but a part.

This module combines this pragmatic capability to understand accounting


information with a critical perspective on the theories of its provision in
business and society. In practical terms, the module equips students with
information appraisal techniques and cognition of its relevance for decision
making and performance assessment.

The module specifies the following learning objectives; that, at the end of
this course, students will be able to:

· adequately interpret the meaning of a published set of accounts,

Accounting for Managers i


· critically question the parameters under which accounting
information has been provided and recognise the implications of this
process and its content,

· call for accounting data appropriate in different decision making


contexts,

· understand the relevance and limitations of accounting data in


context.

This study book


To assist you in developing a thorough understanding of the subject, this study
book combines explanatory settings and case material with directed readings.
Many of these are from the textbook, Accounting for Managers, 3rd edition,
written by Paul Collier and published by Wiley in 2009. This book is for
post-graduate students and “non-financial managers [...] who need a better
understanding of the role of accounting and how it affects their organization
and business unit”. You should find it very readable as practical examples are
used to illuminate theories and models.

This study book is organised into ten sections and you may find it helpful to
review your understanding against the learning objectives given at the start of
each section. Each section uses directed readings and questions, drawn both
from Collier and other sources – use the questions to assist your learning by
providing feedback on progress. References for further reading are provided
on Blackboard – these may take the form of texts, journal articles, and
internet sites of accounting institutions – but also follow up the references
provided in the Collier text.

You should note that most quoted companies now post their annual reports on
their websites and so there is a rich, contemporary source of accounting
information readily available to you. Indeed, one of the two case studies – Next
plc, which weaves a thread through Sections 2 to 5 of the study book – is drawn
from the internet and so can be supplemented and updated to form an
ever-changing story. This case covers financial accounting and reporting
whilst the other, a fictionalised business start-up, covers the management
accounting topics of Sections 6 to 10.

Journal articles offer an invaluable bridge between contemporary


developments in the practical accounting world and academic thought. Using
them enriches your knowledge and enhances the quality of your work. Most
will be available electronically from the University of Leicester’s library
search engines, in particular, EBSCO.

ii Accounting for Managers


Many articles are referenced in this study book, but the following journals are
recommended to keep pace with contemporary writing:

Accounting and Business Research

Accounting, Auditing and Accountability

Management Accounting Research

Corporate Governance

Together, the dedicated material and the textbook reading offer an insightful
guide through the subject matter, relating conceptual perspectives to the real
world.

Enjoy the learning experience!

Accounting for Managers iii


MN7006/D

SECTION 1

Perspectives on
Accounting
Section 1

Perspectives on Accounting

Learning Objectives

After studying this section you should:

· be able to define accounting and explain why there is a


difference between the reporting requirements of management
and external users,

· have an appreciation of how modern accounting developed,


and

· recognise that there are many theoretical interpretations of the


role and purpose of accounting.

What is accounting?
The American Accounting Association defined accounting in 1966 as:

“The process of identifying, measuring and communicating economic


information to permit informed judgements by users of this
information.”

Let’s see what we can take from this definition. “Identifying” and “measuring”
requires the collection of appropriate data from primary sources and the

Accounting for Managers 3


recording of that data in some rational manner for subsequent quantitative
analysis. The definition uses the word “economic”, but while accounts are
expressed in monetary terms, accounting can use non-financial data to
generate useful information. To be useful, this meaningful data is
‘communicated’ to recipients – often in the form of formal, routine reports – so
that they are able to judge the progress of an organisation toward its aims and
to make informed decisions.

The definition mentions ‘users’ as recipients of this information, but who


might they be? They include any employee – directors, managers and other
workers – within an organisation and stakeholders outside the organisation.
For internal users, this means that the extent and content of accounting
information is tailored to the user’s scope of responsibility. For external users,
accounting information is revealed for commercial or societal interest: to
declare taxes; to reveal solvency to suppliers and profitability to investors; to
demonstrate corporate citizenship. Much of the content of published
accounting reports is governed by law, regulation, standards and audit to
‘assure’ the validity and accuracy of the information released.

The definition asserts the purpose of accounting information to be the making


of “informed judgements”. Typically these judgements will relate to decisions
about resource allocation and the following are illustrative of the multitude of
such decisions:

· a Board of a company agreeing a change in strategy,

· a production manager prioritising the schedule of process time based


on product profitability,

· an HRM manager considering a redundancy package,

· a supplier assessing the extent of credit to grant, or

· a shareholder reviewing an investment portfolio.

All of these are resource allocation decisions – human, infrastructure,


material, and financial resources – and are made using accounting
information.

Collier states on the first page of his introduction,

“Business is not about accounting [...] accounting [...] is the financial


representation of business activity.”

As business leaders, your interest in accounting stems from the model it


provides of the activities you manage and the information it provides on the
financial consequences of past administration, current decisions and future

4 Accounting for Managers


plans. As a strategic manager, you will face both external accounting reports
(e.g. to assess a competitor’s performance) and internal information (e.g. to
make a one-off decision). You need to be equipped with the ability to call for,
interpret, and critically review the data provided.

Financial and management accounting


Accounting is commonly sub-divided into two categories.

Financial accounting is the comprehensive recording of transactions and


their accurate analysis to provide the monetary database for the preparation
of published accounts. Specific classifications, principles of analysis, and
reporting formats are heavily regulated by statute, international accounting
and reporting standards. Financial accounting is therefore the root of
financial reporting and together they form the subject of Sections 2 through 4
of this study book.

Management accounting is, by contrast, highly customised to serve the


organisation in which it operates. The American Institute of Management
Accountants offers a (rather complex) definition,

“A value adding continuous process of planning, designing, measuring


and operating non-financial and financial information systems that
guides management action, motivates behavior, and supports and
creates the cultural values necessary to achieve an organization’s
strategic, tactical and operating objectives.”

Thus, not being regulated, the benefit of management accounting information


should exceed the cost of its provision. It includes non-financial information
and, particularly at the strategic level, incorporates qualitative information
(i.e. comment, opinion or anecdote) where numeric ‘facts’ are not available.
This may occur when sourcing sensitive external data on, say, competitors,
customer taste, or government policy. The definition also refers to behavioural
and cultural aspects of management information – so internal accounting
systems are designed to reflect and promote the specific ethos and aims of the
organisation. Illustrations of this ‘designer information’ are provided in
Sections 6 through 10 of this study book.

The distinction between financial and management accounting arises from


the different historical purposes for which they were designed.

Accounting for Managers 5


The emergence of accounting
The ‘keeping of account’ was undertaken by ancient civilisations, but modern
book-keeping and its principle of double-entry (see later) was first formally
documented by a Franciscan monk called Pacioli in Venice in 1494 [Note 1].
Venice was a major trading community and merchants needed to keep track of
amounts bought or sold and money owed, lent or borrowed.

The essence of financial accounting is to represent these transactions in books


of account where the value of each transaction is market based. For example,

A merchant buys some cotton, turns it into thread, and sells it.
Another merchant buys the thread, dyes it, and sells it to a third
who makes cloth and sells it to a clothing manufacturer who sells
the finished garment. Four individual processes give rise to five
transactions – all made in the market – at prices determined by
the market. If the value of a sale exceeds the value of the related
purchase, a profit is made. In other words, the activity or process
that is undertaken on a particular item is value adding.

Those transactions, when entered into a set of accounts, represent a sale, a


cost, money received or money owed, and money paid out or money owing and
identify the product and person involved. All of these transactions – as you will
see later – can be represented in three primary accounting statements:

· the profit & loss account (or ‘income statement’ in US terminology),

· the cashflow statement, and

· the balance sheet.

In contrast to the market transactions which form the basis for financial
accounting, the origin of management accounting lay in the industrial
revolution of the late 18th Century. Here, individual processes, previously
carried out in the market, were combined under one ‘roof’,

A single company employed yarn makers, dyers, weavers,


clothing designers and tailors. The market transactions are limited
to the procurement of the cotton and the sale of clothing. Market
prices therefore can only reflect the original raw material and
the finished garment: the several processes are not evident from the

[1] Pacioli, L. (1494), Everything about Arithmetic, Geometry, and Proportion


included a section on the observed practice of Venetian merchants.

6 Accounting for Managers


financial accounts. Significantly, this meant that owner-managers
could not tell the extent to which each process contributed to the
overall creation of profit. By documenting internal processes and
attributing costs to each of these, a comparison with external
prices could be made, and the problem eased. Cost accounting
had been introduced.

This has since evolved into management accounting where a wider range of
techniques have been designed to meet the requirements of complex
organisational forms in different sectors of the economy. Financial planning,
performance measurement, control and decision making are all supported by
this development.

Separation of ownership from control


The industrial revolution is also responsible for another significant
development in accounting: the formalisation of published reports. The
capital investment required in factories or distribution fleets was beyond the
scope of all but a few wealthy individuals. Funds could be borrowed from a
bank, but the riskiness of the proposition would have discouraged many
lenders. Partnerships could be formed, as they had in preceding times to
finance such ventures, but the scale of personal liability required for extensive
mechanisation discouraged such combinations. Limiting liability (to the
amount of capital provided) had however been available since the inception of
global shipping companies in the 17th Century. Risk capital could be sourced
from wealthy investors and invested in industrial enterprises of which they
had no practical knowledge. Experienced managers could be employed to run
the business on their behalf. The ownership of business became separated
from the financial control of that business. Owners therefore desired to
monitor the performance of the managers they had engaged and regular
accounting reports were demanded.

To ensure the accuracy of the accounts, professional accountants were trained


[Note 2] and reports were independently audited. Over time, standard
formats for these accounting reports were introduced and standard principles
and conventions adopted in their compilation.

The aim of these practices – to ensure the proper conduct of the affairs of the
company by its Board of Directors – remains true to this day. Financial

[2] The oldest professional accounting body – which became the Institute of
Chartered Accountants of England and Wales – was formed in 1870.

Accounting for Managers 7


propriety has been an issue of contemporary concern following scandals
involving large European and American companies since the turn of the
millenium. The financial reporting requirements of companies, covered in
Section 3 of this study book, are therefore complemented by International
Accounting Standards and corporate governance arrangements, covered in
Section 4.

Theoretical perspectives
You could be excused for thinking that the theory of accounting might be
limited to arithmetic equations representing its renowned double entries.
However, you should now have become aware that accounting operates in a
historical, political, economic, social and organisational setting. Thus, the
regulation, purpose, and use of accounting information add dynamics to its
purely technical function which give rise to many theoretical positions. Collier
summarises these theories in Chapter 5 and explores them further in each
subsequent chapter in his book as they relate to specific applications of
accounting practice.

Accounting might rationally be regarded as a neutral observer of economic


activity, providing an objectively verifiable assessment of performance in
relation to an organisation’s aims. Accounting systems thus use feed-forward
and feed-back loops to support planning and control and are cybernetic in that
they are self-organising. Indeed, their design may be contingent on the
volatility of the external environment: the extent of competition, pace of
change in technology, and the stability of the economy are influential.

This value-free consideration of the role of accounting is challenged within the


organisation where managers may pursue self-interest or make sub-optimal
decisions because incomplete data limits their comprehension. The
‘rational-economic’ perspective is also challenged on the grounds that
accounting is used as a means to convey or reflect organisational values and
beliefs, and that control is exerted through its impact on culture. The
possession of information reflects power and so accounting endorses the
autonomy and responsibility of individuals within an organisation.
Managerial priorities, attitudes and performance are driven by targets and
therefore accounting parameters are not value-neutral – they influence
managerial action.

Just as notions of power and behaviour affect or reflect accounting practice


within an organisation, so can such humanistic considerations be observed in
its external relations. Accounting is, after all, a social construction: it is not
the product of natural laws or physical science – we decide how to account for
our activities and to whom we account. Traditionally associated with profit,

8 Accounting for Managers


there is strong pressure to account for a ‘triple bottom-line’: a score for
investors, for the environment, and for social responsibility. Is the purpose of
published accounts merely a way for shareholders to monitor the performance
of their agents? Or is the Board of Directors accountable to a wider senate as
stakeholder theory would morally or pragmatically assert? In most countries,
statute requires directors to observe a duty of care in the interests of the
company, but what are the interests of the company?

Companies are the workhorse of an economy, providing a means of income to


its population. Politically then, the relationship of business to society,
economy, and government is highly important, and accounting is a public
report of that relation. Critical theorists seek change in these relations, and
those of a Marxist persuasion argue that society is controlled – and the
workforce exploited – by an alliance between the state and big business. Power
– and selective use of information conveys power – means that accounting can
be used a mechanism to justify and legitimise actions of the elite in society.
Marx would argue that there is a historical determinism about the evolution of
capitalism from its roots in the industrial revolution to the global reach of
today’s multinationals. Nation states, which define the boundaries of legal
jurisdiction, are competing for inward investment on the one hand and
variously coalescing to regulate markets and business activities on the other.
The wide yet recent adoption of International Accounting Standards and codes
of corporate governance are examples of this. Yet plural forms of capitalism
remain across the globe.

The shareholder-centric form of Anglo-American capitalism contrasts with


continental European practice (where equity capital has less historic
relevance), South Africa’s (post-apartheid) inclusive stakeholder variety, and
centralist versions in China and Russia. Theorists of political economy argue
that the polity of a nation influences the structure of its markets and the form
of accounting. Anglo-American practice is liberal, Franco-German practice
bureaucratic, developing countries are heavily influenced by colonial legacies,
whilst Communist governments used accounting as the specific channel for
resource allocation and reward. Institutional theorists include the role of
professions as a deterministic structure in the design, content, and role of
accounts. They specify the body of knowledge, the form of training, and award
the qualification and thus influence the mindset of practitioners. The
globalising professional bodies are US, UK or Commonwealth in origin as
many countries have limited recognition of accountants. In continental
Europe and Japan for example, management accounting is not formally
recognised as a distinct profession and thus the practice of accounting is less
linked to the financial accounts than to engineering, operations and
marketing. Fortunately, this has made management accounting open to
influence from a variety of disciplines.

This theoretical perspective is not a review of the many theories pertinent to


accounting. It uses selected illustrations, deliberately without reference, to

Accounting for Managers 9


demonstrate the plurality of thought and to invite a more critical response
from the reader. To take from this brief introduction an appreciation that
accounting is not just an impartial computational framework but that it is
both a product of and an influence upon power and behaviour is enough for the
moment.

Blackboard

Now check Blackboard for the details of your directed and other reading for this
section. You are expected to do all of the directed reading before carrying on.

Concluding Comments

This section provides the context for your subsequent studies. It defines the twin
branches of accounting and gives a theoretical and empirical perspective on
their emergence. Do not be concerned if you don’t fully grasp the theoretical
positions yet: their relevance will become clearer as you work through the
directed readings on Blackboard and as you examine accounting applications
in the rest of the study book.

As an exercise to test your understanding, list the differences between financial


and management accounting.

10 Accounting for Managers


MN7006/D

SECTION 2

Principal Financial
Statements
Section 2

Principal Financial Statements

Learning Objectives

This section provides you with the basic building blocks of account
formulation which will later enable you to critically interpret accounting
information. After studying this section and its readings, you should:

· understand the purpose and content of a balance sheet,


cashflow statement, and profit & loss account,

· be able to explain the concept of accrual and distinguish


between cashflow and profit, and

· understand how assets and liabilities are formed and


extinguished.

At the end of this section, the first case study – Next plc – is introduced.
Your learning can be applied to this reality and reinforced by undertaking
the exercises. The Next case material will be supplemented at the end of
Sections 3, 4 and 5 so that you can develop a comprehensive
competence in financial analysis.

Accounting for Managers 13


Introduction
The principal financial statements were introduced in the previous section.
Here we explore the purpose of each, their content, and the conventions by
which they are compiled. We start with profit, then differentiate it from cash,
before moving onto capital and the asset and liabilities that make up a balance
sheet.

The nature of profit


Profit is the economic surplus on a business transaction:

· a product is sold at a greater price than that at which it was bought,

· a service is provided at a price greater than the cost of the time


involved in its provision,

· a manufacture is sold at a value greater than the cost of procuring


and transforming the raw materials used to create it.

Profit is the value of the sold output of a business less the cost of the related
input. Accountants attribute costs in various ways to the sales to which they
relate – including those that are not immediately or directly spent (e.g. the use
of plant and machinery and allocation of administrative resource).

Accountants routinely assess profit over a period of time: a month; a year.


They therefore have to first attribute sales to the period in which they occur
and use the transaction date to do so. This is the date when the supply of a
product or service is made and is usually the same date as that on a receipt (for
a ‘cash’ purchase) or an invoice where credit is granted. If a service or supply
occurs over an extended period (e.g. electricity distribution or the construction
of a road), then the attribution of sales to accounting periods becomes more
complex, however, the formula remains,

Profit = Sales – Costs of sales

Sales are often termed ‘turnover’ or ‘income’ (in the US) and costs may be
referred to as ‘expenses’. This can be confusing, especially when we encounter
cash-based terms such as receipts, payments, and expenditure. In common
parlance, these are often used interchangeably but, in interpreting accounting
reports, recognition of the correct terminology is important.

14 Accounting for Managers


The nature of cash
Profit is not the same thing as cash. Cash is money in tangible or electronic
form. It is received – adding to the balance in a till or bank account – or paid
out – reducing the amount of funds available. As students, we are all too
familiar with the fluctuations in our bank accounts and the struggle to remain
above the overdraft limit. So it is with business – should an organisation
breach a bank facility or other financing commitment, funds are withdrawn,
they are insolvent and face bankruptcy. In the short-term, businesses must
have sufficient cash, not profit, to survive; in the medium-term, profitability is
essential to sustaining a business because, as we shall see, it is through profit
that cash is generated.

Cashflow is the net movement in the cash balance over an accounting period.
‘Net’ in that it is the cash in (which is termed ‘receipts’) less cash out (termed
‘payments’). Thus, the formulae are,

Cashflow = Receipts – Payments

Closing Cash Balance = Opening Cash Balance + Cashflow

The matching concept


You should understand by now that profits are not cashflows because receipts
are adjusted to determine sales and costs are matched to sales. Accountants
undertake this match by an ‘accrual’ process that recognises differences
between sales and receipts, and costs and payments as assets and liabilities in
the balance sheet (see later).

Accrual refers to the displacement in time between the transaction date and
the cashflow date. An example best illustrates this. In June, a business
purchases 100 widgets from a supplier for $400 cash. It sells widgets for $10
each and 70 are sold on a month’s credit to a customer in July; in August the
remaining widgets are sold for cash. Transactions occur in all three months,
but cash flows out in June and in August and profit is recognised in July and
August because the $4 cost per widget is set against sales in those months.
These events are shown in Figure 2.1. Note that profit and cashflow are the
same over the quarter, but that the phasing is shifted. The differences are due
to the following:

· in June, the cash payment has been used to buy stock (an asset),

Accounting for Managers 15


· in July, 70/100ths of this asset ($280) has been used to provide sales
of $700 and generate the profit of $420. The $700 owing to the
business is a debtor (an asset),

· in August, the remaining $120 of stock is exhausted to provide cash


sales of $300 (thus the profit of $180) whilst the remaining cash
inflow results from July’s sales on credit.

June July August Total


Cashflow -400 1,000 600
Profit 420 180 600

1,000
Profit

750 Cashflow

500

250

-250

-500
June July August Total

Figure 2.1 Matching profit and cashflow.

At the end of August, there is no stock left, nor any amounts owed or owing.
The assets are now represented by a cash balance of $600, complemented as
we see by profits of $600.

The accrual concept means that accountants assess supplies or services that
have been received but not yet invoiced (as a liability), receipts in advance of
work done on a contract (also a liability), and prepayments for supplies of
services like rent (as an asset) in the calculation of profit.

A similar matching process operates in the longer term where assets are
bought that have economic lives of many years. For example: a distribution
company’s trucks, a manufacturing company’s machinery, a shop’s fixtures
and fittings, a software house’s office equipment. All of these ‘fixed assets’
provide commercial benefit over several years – that is they generate sales – so
that it is inappropriate to charge the full cost of these assets against profits in
the year of their purchase. Instead, accountants spread the cost over their
estimated lives and ‘depreciate’ the value of the asset as it ages.

In the case of an ‘intangible asset’ such as a patent, the charge to profit is


called ‘amortisation’. An example demonstrates the result. A delivery van is

16 Accounting for Managers


bought for $20,000 and is expected to have a productive life of 4 years, at which
time it will be sold for $4,000. The depreciation on the vehicle is expected to be
$16,000, or $4,000 per year (see Figure 2.2). This annual cost contrasts
dramatically with cashflows which occur at the beginning and end of its life.
The difference between the two figures is the depreciated value of the asset:
$16,000 at the end of the first year; $12,000 at the end of the second; $8,000 at
the end of the third; zero at the end of the fourth. Over the four years, however,
the depreciation cost is the same as the cash outflow.

Year 1 Year 2 Year 3 Year 4


Cashflow -20,000 4,000
Profit -4,000 -4,000 -4,000 -4,000

5,000

-5,000

-10,000

-15,000 Profit
Cashflow
-20,000

Year 1 Year 2 Year 3 Year 4

Figure 2.2 Matching depreciation and cashflow.

The three main financial statements


From any set of accounts, three reports can be prepared and these form the
core of all published annual accounts (see the Next plc case material at the end
of this section). You have already met the subject of two of them – profit (loss)
and cashflow – whilst the third statement concerns assets, liabilities, and
capital.

The balance sheet:

· a statement of assets and amounts owed externally,

· as at a specified date,

· represents the book value of a business, and its ‘shareholders funds’.

Accounting for Managers 17


The profit & loss account (‘income statement’ in the US):

· statement of sales and related cost,

· over a period ending in the balance sheet date,

· ‘bottom-line’ is the profit retained and added to ‘shareholders funds’.

The cashflow statement:

· statement of receipts and payments,

· over a period ending in the balance sheet date,

· represents the net cash movement on the balance sheet.

These three statements form the focus of your studies into financial
accounting and their format and content will be explored in this and the next
section.

The double entry system


As you may be aware, all the entries in a set of accounts are equal and opposite
so that any given transaction can be represented by two entries: a debit and a
credit. The balance on every account is summarised onto a ‘balance sheet’ – a
sheet that balances all the net debits with the net credits. The summarisation
is classified into three (or arguably five) types of account:

· assets – things expected to yield future economic benefit:

- includes cash if in surplus [Note 3],

- includes amounts owed to the business.

· liabilities – amounts owed by the business to external entities:

- includes cash if in overdraft [Note 3].

[3] CASH: receipts are a debit; payments are a credit.

18 Accounting for Managers


· capital – aggregate investment in the business by shareholders:

- includes accumulated profit [Note 4].

Assets are shown as debit entries, whilst liabilities and capital are credits. In a
balance sheet,

Capital = Assets – Liabilities

CASHFLOW STATEMENT

Receipts Payments

BALANCE SHEET

Cash Overdraft
Current
Liabilities
Current Debtors Creditors
Assets

Stock Long-term Liabilities

Fixed Assets Share Capital

Capital
Reserves and
Reserves

Loss Retained Profit

PROFIT & LOSS ACCOUNT

Costs Sales

Debits (DR) Credits (CR)

Figure 2.3 The relationship between capital and assets/liabilities, and profit and cashflow.

The relationship between capital and assets/liabilities, and profit and


cashflow, is depicted in Figure 2.3. Debit entries and balances are shown on
the left-hand side, whist credits are on the right. Debit entries in the balance
sheet comprise fixed and current assets. Fixed assets are better thought of as
long-term assets like buildings and equipment, with the book value of the
latter falling over time (CR) as depreciation is charged to the profit/loss

[4] PROFIT: sales are a credit; costs are a debit.

Accounting for Managers 19


account (DR). New fixed assets (DR) will be bought (CR to Cash) or leased (CR
to Long-term Liabilities). Current assets include stocks of raw materials and
finished goods and, for manufacturing businesses, work-in-progress. Stocks
rise (DR) when they are acquired (CR to Cash or Creditors) or made (CR to
Costs of Sale). Debtors exist wherever customers are granted credit, rising
when sales are credited and falling when invoices are settled (DR to Cash).
The amount of cash available is shown as an asset (DR), unless the bank
account is overdrawn in which case it becomes a liability (CR). Other Current
Liabilities include Creditors and any accrued debts of the business which are
extinguished (DR) when paid during the course of the next year (CR to Cash).

Net Assets = Fixed Assets + Current Assets – Current Liabilities

Net Assets = Capital Employed

Capital Employed = Long-term Liabilities + Capital and Reserves

The net assets of a business are funded by capital – ‘debt’ and ‘equity’. Loans
are a common example of debt capital and form a CR in ‘Long-term Liabilities’
when arranged (DR to Cash), falling as they are repaid until they become a
Current Liability. Note that the interest paid to service the loan does not affect
the amount outstanding: it is a DR to Costs and a CR to Cash. Capital and
Reserves represent the invested funds of the shareholder (DR to Cash when
shares are issued) and are supplemented by profit retained by the business
(CR balance on the profit & loss account). Reserves vary in composition, but a
common situation arises from an upward revaluation (CR to Reserves) of Land
and Buildings (DR to Fixed Assets).

Balance Sheet Cash a/c Profit & Loss a/c

June DR Stock $400 CR Payments $400

July DR Debtors $700 CR Sales $700


CR Stock $280 DR Costs $280

August DR Receipts $300 CR Sales $300


CR Stock $120 DR Costs $120
CR Debtors $700 DR Receipts $700

Closing Balance Stock $nil DR $600 CR $600


Debtors $nil
Cash DR $600
Cap & Res CR $600

Figure 2.4 Illustrating double entry using the three financial statements.

20 Accounting for Managers


This is a rather shallow exposition of the constituent parts of a balance sheet,
but is sufficient as an introduction. Any transaction can be represented by
double entries involving Asset, Liability, Capital, Cash or Profit & Loss
accounts. We can demonstrate this by using the data in the earlier widget
example (see Figure 2.4).

Accounting conventions
Accounts are kept and financial reports produced using certain rules that
accountants are trained to apply and professionally maintain. These rules
have become formalised into quality standards which are now internationally
adopted (see Section 4). For now, we will limit consideration to a simple
interpretation of the most important ones.

A business’ accounts separate the affairs of the business from that of its owner.
The owner’s interest is recorded as capital and reserves – a liability from the
perspective of the business. Accounts are largely prepared from third-party
transactions which have already occurred – an obvious observation in respect
of the cashflow statement. What is significant, however, is that both the
calculation of profit and (most) assets and liabilities in the balance sheet is
based upon ‘historic costs’ and not realisable value. This means that net asset
value is an eclectic collection of cost over the past and does not represent the
market value of a business (see Section 5 for a discussion of this).

Financial accounting observes four principles. An awareness of these principles


and conventions helps you to recognise the scope for subjectivity in the financial
reports so that you are better able to critically review accounting information.

Going concern

This is the presumption that there is no known impediment to the business


continuing to trade in the future – fundamentally, that there is no risk of
insolvency. This means that asset values justify their potential to generate
commercial return. The liquidation value of a business is likely to be much less
than even its historic cost as many of its assets are specific and have limited
alternative utility – in particular, the value of stock and fixed assets other
than property would be heavily ‘written-down’ (i.e. reduced).

Accruals

This practice has already been employed earlier in this section. Some small
businesses, public sector and non-for-profit organisations will prepare

Accounting for Managers 21


accounts on a cash basis alone. As we have seen, the calculation of profit
through the accrual process provides a better picture of viability, but the
‘smoothing’ of cashflow that profit represents can give rise to manipulation
and abuse.

Comparability

When accounts are published, figures for the previous year are required. To be
consistent, it is important that the same accounting policies have been used
and, if changed, explanation provided and the comparative figures adjusted.
You should note that this does not overcome the effect of inflation, and caution
is necessary in economies where the purchasing power of money is falling
rapidly.

Reliability

Accountants should be prudent in their assessment of profit and the value of


assets. Profits can only be declared when sales are made, but if future losses
on a contract are predicted, they must be recognised immediately. The
potential for customers not settling their accounts should give rise to a
provision for bad debts and stock value should be similarly written down if it is
thought to be obsolete. This is largely judgemental and is normally the subject
of discussion with a company’s auditors.

Blackboard

Now check Blackboard for the details of your directed and other reading for this
section. You are expected to do all of the directed reading before carrying on.

Concluding Comments

Please work through the directed reading as outlined on Blackboard. At the end
of this section (with its accompanying readings), you should be reasonably
familiar with the principles of double entry and the preparation of the balance
sheet. Attempt the questions that have been selected on Blackboard and check
your answers against the solutions. This will provide a useful check on your

22 Accounting for Managers


progress toward the Learning Objectives set out in the introduction to this
section. Congratulate yourself!

Finally, read through the initial case material on Next plc – get a sense of its
business context and an outline feel for what the accounting numbers are
telling you. There are some simple exercises for you to follow, but formal
analysis will follow in Section 3.

Accounting for Managers 23


MN7006/D

FINANCIAL ACCOUNTING

CASE STUDY PART I

Introducing Next plc


Financial Accounting Case Study Part I

Introducing Next plc


At the conclusion of this and the next three sections, you will be given factual
information on this group of companies. Each addition to the case material
will relate to the knowledge content of the section concerned and contain
exercises that will reinforce your ‘textbook’ knowledge with a real-world
scenario. Outline solutions to these exercises are provided in Appendix B.

Inevitably, not all the content will be understandable with or explained by the
study book: for example, pension and employee share ownership
arrangements. The data has been simplified where practicable and the
exercises you are asked to undertake will relate to the ontology covered in the
section and reading. You are encouraged to examine the full accounting
information on Next plc by visiting
http://order.next.co.uk/aboutnext/CompanyResults/index.asp
and downloading the Annual Report.

Commercial context
Next plc is a multi-national clothing retailer, headquartered near Leicester in
the UK. The company was originally called J. Hepworth & Sons, established in
1864. The Next brand was launched in 1982 and the company’s name was
changed in 1986. The group has grown dramatically, though not consistently,
over the last 24 years and now has a turnover in excess of £3 billion. Its
principal business (Next Retail) is conducted through over 550 outlets,
including 100 foreign franchise stores, a significant mail order business (Next
Directory), and a growing call-centre operation that developed out of the mail
order operation. Next’s core business remains clothing, but diversification is
evident into home, jewellery, flowers, electrical devices, and financial services.
Next plc has eight wholly owned subsidiaries, including a garment
manufacturer in Sri Lanka and a buying operation in Hong Kong. Next

Accounting for Managers 27


subsidiaries also have non-controlling equity interests in two further retailing
and home shopping companies.

Ten year historical financial summary


Table 2.1 is compiled from data contained in the ‘Five Year History’ data
provided by Next plc in their Annual Report for 2001, 2004, and 2006. Data for
2005 and 2006 is prepared under International Financial Reporting
Standards (see Section 4), those for prior years under UK national standards.

Sales, Trading After-tax Dividends, Retained Shareholders’ Shares


(£m) Profits, Profits, (£m) Profits, Funds, (£m) Purchased
(£m) (£m) (£m) for
Cancellation

1997 947 146 118 (56) 63 421

1998 1177 173 137 (67) 70 490

1999 1239 158 124 (69) 55 543

2000 1425 187 140 (76) 64 607 –

2001 1589 214 158 (74) 84 500 37m

2002 1872 259 190 (89) 101 547 6m

2003 2203 302 211 (86) 125 275 44m

2004 2516 376 250 (89) 156 155 22m

2005 2859 443 305 (104) 201 277 4m

2006 3106 471 314 (105) 209 256 15m

Table 2.1 Next plc ten year financial summary.

The figures shown in the final column are shares bought back by Next plc from
their own shareholders. This means that the company pays market prices for
their shares. The shares are shown in the balance sheet at their historic issue
price. There were 246 million shares in circulation at the end of 2006, 90
million less than five years earlier.

28 Accounting for Managers


Extracts from the latest Annual Report
These are taken from the Chief Executive’s Review (pp.4–8).

Next Retail

“In the year we increased our net selling space by 980,000 square feet to
4,300,000 square feet. Despite difficult trading conditions we are
forecasting that the sales performance of our portfolio of new stores will
be in line with their appraised target, giving payback of the net capital
invested in 18 months.

“The table below shows how the profile of our stores and space has
changed over the last three years:

Store Size, (square feet) Number of Stores % of Selling Space

2006 2005 2004 2006 2005 2004

less than 5,000 133 152 166 9% 14% 18%

5,000–10,000 132 112 99 23% 25% 26%

10,000–15,000 99 61 45 28% 22% 19%

15,000–20,000 35 29 25 14% 15% 15%

greater than 20,000 40 30 23 26% 24% 22%

Total 439 384 358

“We currently expect to increase net selling space by around 450,000


square feet in the year ahead.

Next Directory

“NEXT Directory had a good year with sales up 13.7% and profits up
18.5%. Sales continue to benefit from increased use of the Internet,
whilst improved gross margins and tight control of costs moved profit
ahead faster than sales.

“Significant economies of scale were made over central overheads with


Directory catalogue production, marketing and call centre costs all
declining as a percentage of sales.

“The number of active customers grew by 11% to 2.1 million as at


January 2006.

Accounting for Managers 29


Product development

“Fashion is moving faster and we have reorganised our buying cycle to


deliver new product more often. New ranges will now be introduced into
stores every six weeks. The effects of the new buying process will begin
to be seen in April this year.

“Going forward we need to be more focused in controlling the number of


different styles in our ranges. We need fewer styles with more
colour-ways of the better selling lines, which have been understocked
from the start of this season. We expect to make further progress
through the course of the year.

Business development

“This year we will be conducting a number of trials to extend and add to


the NEXT brand. These products will, if successful, add to our business
in the years ahead and provide new avenues of growth as our core
product areas approach maturity.

“In particular we will aim to leverage our two million Directory home
shopping customer base. To this end we are trialling an electrical
brochure (NEXTelectric) with 300,000 customers and if this is
successful we can rapidly roll it out to the rest of the customer base in
the Autumn.

Next franchise

“Our overseas franchise operation continues to grow, with sales


increasing by 17% and profit by 30% to £7.9m. At the year end there
were 96 franchise stores compared with 80 the previous year. The
Middle East continues to be our largest region with 41 stores. Our
partner in Japan has 25 stores.

“During the year franchise stores were opened in Gibraltar, Hungary


and Turkey. We anticipate that at least 20 new franchise stores will be
opened during the coming year, including several in Russia.

Ventura

“Several existing contracts were renewed during the year and three
significant new customers have been added to the client list. Ventura
employs in excess of 7,000 people and its UK call centres are operating
close to full capacity. Its call centre in Pune, India opened during the
year and handles business on behalf of NEXT Directory and two other
clients.

30 Accounting for Managers


Other activities

“Other Activities include profits from our Property Management


Division, Choice (an associated company which operates fourteen
discount stores) and Cotton Traders (an associated company which
sells its own brand products).

Outlook

“We believe the competitive and economic environment will remain


very challenging in the year ahead. Whilst we think we have the
opportunity to make improvements to some of our ranges, we are still
budgeting on the basis of negative like-for-like retail sales for the year.
We will focus on the following activities:

· Improving our core product offer, in particular simplifying


some of our ranges to deliver better stock availability and
clearer in-store merchandising.

· Growing top line sales through the addition of profitable new


space in NEXT Retail.

· Adding more customers and product ranges to NEXT


Directory.

· Defending the bottom line through the continued


management of costs and improving gross margin.

· Developing new product areas.”

Accounting for Managers 31


Summarised balance sheet
Next's balance sheet may be summarised as follows:

January 2006 January 2005


(£m) (£m)

Fixed Assets 562 486

Current assets

Stock of finished goods 311 289

Trade and other receivables 415 349

Prepayments 85 76

Other financial assets 31 25

Cash 70 72

912 811

Current liabilities

Bank overdrafts (31) (22)

Unsecured bank loans (100) –

Creditors and other liabilities due within a year (625) (566)

(756) (588)

Non-current liabilities

Corporate bond (298) (300)

Pension obligations & other liabilities (164) (132)

(462) (432)

256 277

Share capital 25 26

Retained earnings 1,751 1,778

Other reserves (1,520) (1,527)

Shareholders’ funds 256 277

“The financial statements have been prepared on the historical cost


basis except for certain financial instruments, pension assets and
liabilities and share based payment liabilities which are measured at
fair value.”

(Annual Report, p. 36)

32 Accounting for Managers


Fixed assets and depreciation
The fixed asset figures in the balance sheet primarily comprise property, plant
and equipment. These are analysed in Note 9 to the accounts, a simplified
version of which is given below, and their calculation is governed by
accounting policies (page 36),

“Property, plant and equipment are stated at cost less accumulated


depreciation and any provision for impairment in value. Depreciation is
provided to write down the cost of fixed assets to their estimated
residual values, based on current prices at the balance sheet date, over
their remaining useful lives by equal annual instalments.

“The depreciation rates generally applicable are summarised as


follows:

Freehold and long leasehold buildings 2.0%

Plant, shop fronts and retail fittings in the high street 16.7%–50.0%
retailing business

All other plant, fixtures, fittings, IT assets and vehicles 6.7%–50.0%

Leasehold improvements over the period of the lease”

Note 9 to the accounts (simplified) Freehold Leasehold Plant and Total


Property Property Fittings (£m)
(£m) (£m) (£m)

Cost as at January 2005 76 11 643 730


Additions – – 179 179
Disposals (5) – (20) (25)

Cost as at January 2006 71 11 802 884

Depreciation as at January 2005 9 2 295 306


Charged against profits for the year – – 81 81
On disposals (1) – (16) (17)

Depreciation as at January 2006 8 2 360 370

Carrying amount as at January 2006 63 9 442 514

Carrying amount as at January 2005 68 9 347 424

Accounting for Managers 33


Exercises

Now try these exercises. Outline solutions are given in Appendix B.

(2a) Review the data in the ten-year history. What does this tell you about
the financial performance of Next plc over the last decade?

(2b) Calculate the capital employed as at January 2006 using the formulae
given in Section 2 and the balance sheet data for Next plc. Is it rising?

(2c) What does the ‘shareholders’ funds’ figure in the balance sheet mean?

(2d) Is there something strange about the capital and reserves?

(2e) What can you determine from the balance sheet about the cash
position of Next plc over the course of the year?

(2f) Why are prepayments shown under ‘current assets’ in the balance
sheet?

(2g) Why are pension obligations shown under non-current liabilities in the
balance sheet?

(2h) Using data in Note 9 to the 2006 Annual Accounts, calculate the
average life over which depreciation is charged on plant and fittings
and the average age of those fixed assets.

(2i) What do you deduce about the rate of fixed asset replacement in view
of the strategic growth of the company?

(2j) What is the likely impact of the historical cost convention on the
reported value of freehold property?

(2k) In view of the above, what is your view of Next plc’s balance sheet and
its reported shareholders funds?

34 Accounting for Managers


MN7006/D

SECTION 3

Interpreting Financial
Statements
Section 3

Interpreting Financial Statements

Learning Objectives

This section addresses the first objective in the Module Outline: to


adequately interpret the meaning of a published set of accounts.

After studying this section and its reading, you should:

· feel confident to review a published set of accounts and


understand its core content,

· appreciate how cashflow can be assessed using


receipts/payments and funds flow approaches, and

· be able to perform and interpret calculations to benchmark


corporate performance over time.

Introductory principles of interpretation


Reviewing a published set of accounts can be daunting. They may contain
complex terms, unknown financial instruments, confusing accounting
policies, and enough notes to the accounts to fell a forest. However, they
usually adopt a familiar format – especially following the introduction of
international reporting standards – and so we can gain an adequate grasp of

Accounting for Managers 37


their meaning. The case material from Next plc will provide an opportunity to
test your skills, but first they will be developed on simpler examples.

Interpretation requires purpose: without purpose, you flounder in a sea of


data. Is the object to assess the potential for investment; the prospect of
acquisition? Is it to forecast growth, to judge credit worthiness, or the
possibility of insolvency? Over what timescale is the evaluation? Solvency is
an immediate consideration, profitability longer-term in nature.

Interpretation requires a perspective: who wants to know? Each stakeholder –


creditor, supplier, shareholder, employee, community – has different interests
that embrace profit, risk, security, and social responsibility.

Interpretation requires benchmarks, not absolutes. Have things got better or


worse? Check the figures for the previous year, they may suggest a trend. Is
there competitive advantage? Compare performance with leading competitors
or the industry average. Important also are shareholder expectations, as
management must generate returns on productive investment greater than
those available on financial markets. How else do you judge whether a 15%
annual return is good? It might be good in a stable sector of a low inflation
economy, but is it adequate for off-shore mineral exploration?

Approach to interpretation
There is a procedure which you can follow as you begin to analyse a set of
accounts. It comprises five simple and fundamental tasks.

Before you examine any of the numbers,


consider the context

In which sector does this business operate? Is it labour or capital intensive?


Are most costs likely to be fixed? Is the sector growing or declining, volatile
and subject to economic conditions? What is the current state of the economy,
the level of inflation, and base interest rate? Which economy is it in: is the
business international, geographically diversified, vulnerable to currency
depreciation, or oil price appreciation? Are there economic, political,
ecological, or technological events or developments that would affect the
business?

Context provides the stage upon which the accounting numbers perform.

38 Accounting for Managers


Do a quick review of absolutes and trends
in the main financial statements

How big is this business; its turnover, its assets base? Is the ‘top-line’ (sales)
growing? Calculate the percentage change on last year – roughly! Does this
rate of change repeat itself throughout the profit & loss account to the
‘bottom-line’? Note any major inconsistencies – these can be investigated
later. What’s happening with cash? Is the business cash generative? Has the
asset base expanded or contracted in keeping with the change in sales? Has
new capital been introduced or retired?

Does your quick analysis make any sense? Does this look like a business that
is managing growth well? Is it profitable? Is it under stress – from a lack of
cash? Now you can move to formal analysis that will help confirm your initial
view.

Undertake a formal but specific ratio analysis

By calculating, comparing and analysing certain ratios from the profit & loss
account and the balance sheet, you can evaluate the profitability, efficiency,
liquidity, or riskiness of a business, and judge whether it is an attractive
investment. The perspective from which you are performing an analysis
determines the relevance of various ratios, so it is important to be selective in
your choice. An investor will be interested in risk and profitability, a bank in
liquidity and the asset backing for a loan (‘balance sheet strength’), a creditor
in liquidity, an employee in profitability and efficiency. The calculated ratio is
not important in itself, but whether it has improved or deteriorated since last
year, or is better or worse than a benchmark figure. The meanings of these
ratios will be explained and demonstrated later. Their limitations will then
become apparent.

Investigate inconsistent results or oddities

Where potentially related ratios show converse changes (e.g. a growth in sales,
but a fall in debtors), the effect of management intervention is indicated (e.g. a
change in credit policy or rigorous chasing of customer debt). Explore this and
other inconsistencies or omissions that become apparent in the data in the
three financial statements or through ratio analysis. Where you are working
with a published set of accounts, this is where recourse to Notes to the
Accounts helps. You should also recognise that these Notes provide further
analysis on individual aspects, for example:

· the sales and profitability of business segments,

Accounting for Managers 39


· the composition and age of assets,

· the form, cost, and term of loans and other debt capital,

· the gains or losses made on acquisitions and disposals,

· the contingent liabilities not included in the balance sheet.

The Chairman’s Statement and Report of the Directors also provide a rich
source of information (e.g. remuneration) and tell you much about context.

Interpret your research and analysis

Describing the context, summating the data, and calculating the ratios is not
enough. It is the objective and critical interpretation of your synthesis and
analysis that is important. Such a commentary forms the basis for judging
performance – for stakeholders – and the taking of decisions.

Illustrative interpretation
Table 3.1 provides some data for NARC Ltd. Other than that NARC is
evidently a medium-sized company, no context is included, so we start with a
quick review of the abbreviated financial statements.

Turnover has fallen by 10% in the year and this percentage change gives the
benchmark for further prior-year comparison. Since cost of sales has reduced
by the roughly the same proportion, gross margins appear unaffected and
mean that management have not responded to the fall in demand by discount
pricing. Operating profit has been cut by 20% because of depreciation – a
pre-defined, though notional, fixed cost. Intriguingly, earnings have risen by a
third because of the dramatic reduction in interest costs – is this because base
rates have fallen or because loans have been repaid? Reference to balance
sheet ‘debt’ suggests the latter. Dividends – a discretionary payment proposed
by the Board of NARC – have been increased, a sign of confidence to the
shareholders despite the sales collapse.

The balance sheet reveals a major contraction (over 50%) in the fixed asset
base of the company including its land and buildings. These could have given
rise to major gains on disposal, though none are evident so perhaps this is a
sale that has been forced upon the Board by lenders. This is possible given the
reduction in debt, but the remaining £1.2m is not shown as ‘current’ liabilities
(indicating that none is due for repayment within the next year). Whatever the
case, it is commendable that management generated the sales that they did

40 Accounting for Managers


2002, 2001, 2002, 2001,
£000s £000s £000s £000s

Profit & Loss Account Balance Sheet


for year ending … as at 31 Dec …

Sales 5000 5555 Land & Buildings 600 1200

Cost of Sales (2000) (2200) Machinery etc @ cost 4500 5000

Depreciation (1000) (1055) Less acc’ depreciation (3600) (3000)

Other Costs (1600) (1800) Fixed Assets 1500 3200


(net book value)

Operating Profit 400 500 Stock 400 500

Interest Payable (100) (270) Debtors 500 500

Corporation Tax (100) (80) Cash 200 –

Profits after Tax 200 150 Current Assets 1100 1000


(earnings)

Dividends (100) (90) Bank Overdraft – (300)

Retained Profit for the 100 60 Creditors (300) (500)


Year

Current Liabilities (300) (800)

Cashflow Statement 2002, 2001, Capital Employed 2300 3400


for the year ended … £000s £000s

Receipts 5000 5250 Long-term Debt (1200) (2400)

Payments (4500) (5400) 1100 1000

Net Cashflow 500 (150) Ordinary Share Capital 100 100


(2m shares)

Opening Cash Balance (300) (150) Reserves 500 500

Closing Cash Balance 200 (300) Acc’ Retained Profit 500 400

Shareholders’ Funds 1100 1000

Table 3.1 Summarised annual accounts for NARC ltd (Not A Real Company).

out of this reduced infrastructure facility. Stock has fallen 20% which either
indicates that buying decisions have been improving, or that stock has
remained on the shelf for less time. Debtors have stayed the same. Creditors,
in contrast, have dropped 60%, and reveal restrictions on credit granted to
NARC by its suppliers or a more liberal payment policy by the management.
Despite this, the cash position has dramatically improved – from overdraft to
surplus. Capital and reserves are stable, with no share capital issued or

Accounting for Managers 41


retired, and shareholders’ funds have simply risen 10% from the ‘bottom-line’
of the profit & loss account.

The cashflow statement shows receipts in 2002 to be the same as sales (there
being no change in debtors), and you should note that the movement reflects
the change in the balance sheet position over the year. Unlike the other two,
the cashflow statement does not adopt the format – called ‘fundsflow’ – used
in reported accounts, it concurs with the simple ‘cashbook’ form that you met
in Section 2. You will recall from this section that all double entries can be
represented in the three principal financial statements. So it should be no
surprise that, given two of the three statements – and sufficient notes to the
accounts – we can construct the third.

£000s Notes

Operating Profit 400

Add back depreciation charge 1000 this is a non-cash cost

Decrease in stock 100 thus releasing cash equal to 500 – 400

Decrease in creditors (200) a source of funding equal to 500 – 300

Cash generated from operations 1300

Capital expenditure less disposals 700 the movement in the gross book value of
fixed assets equal to
1200 + 5000 – (600 + 4500) – 400,
difference between change in depreciation &
the charge

Interest, dividend, & taxation (300) assuming amounts payable are paid giving
100 + 100 +100

Repayment of debt finance (1200) 2400 – 1200

Net Cashflow (this is the same as the 500


earlier cashflow statement showing
receipts and payments)

Table 3.2 NARC's fundsflow statement for 2002.

Though somewhat a distraction, a ‘fundsflow’ statement for NARC will now be


formulated (as seen in Table 3.2). This is a useful exercise as it clearly
demonstrates the difference between profit and cash. In NARC’s case, it
makes clear that whilst the disposal of fixed assets has funded the repayment
of debt, it has continued to invest in new machinery. It also shows that cash
generated from operations is not just a result of profitability, but the effective
management of current assets and liabilities relating to those operations.
Stock and debtors (less creditors) are collectively the ‘working capital’ of a
business, and growth usually causes an increase in the requirement, draining

42 Accounting for Managers


cash. In NARC’s case, there is a net increase in working capital of £100,000
because of the more rapid payment of supplier invoices. This format is much
more informative because it shows what funds have been raised (or repaid) in
a period and how they have been used.

Illustrative ratio analysis


In the following sub-section, commonly used accounting ratios are
explained, defined and demonstrated. A commentary on their application to
NARC ltd is given under each of the five areas specified earlier in the third
part of the approach to interpretation.

Profitability

Gross margin

(Sales - Cost of Sales)


Gross Margin = ´ 100%
Sales

Gross margin relates sales to its directly attributable purchased and process
costs and provides an indication of the mark-up in selling price. It is therefore
particularly important in retail.

Net margin

Operating Profit
Net Margin = ´ 100%
Sales

Net margin is calculated after all operating costs have been taken into
account, but before taxation and the costs of servicing finance.

Return on capital employed (ROCE)

Operating Profit
ROCE = ´ 100%
Net Assets

ROCE can also be termed RONA (return on net assets) and is a popular
measure of return. It relates profit to the historic investment in the asset base
used to generate that profit.

Accounting for Managers 43


In conclusion, as Table 3.3 shows, the return on funds invested in NARC has
improved despite falling sales. Management have successfully held selling
prices or maintained a comparably profitable portfolio of products.

2002 2001
results for comparison

Gross Margin (5000 - 2000 ) 60% 60%


=
5000

Net Margin 400 8% 9%


=
5000

Return on Capital Employed 400 17% 15%


=
2300

Table 3.3 NARC's profitability for 2001 and 2002.

Efficiency

Asset turnover

Sales
Asset Turnover =
Total Assets

This ratio indicates how hard assets are being worked and is especially
important for capital intensive industries. When used together with net
margin, it sharply demonstrates how ROCE can be improved by reducing the
asset base (as in NARC). Margins can improve by raising selling price and this
can damage sales, which reduces asset turnover and has the opposite effect on
ROCE. Note then that,

Profit Sales
ROCE = ´
Sales Assets

Stock turnover

Cost of Sales
Stock Turnover =
Stock

This ratio shows how often stock ‘turns over’ in a year by relating the amount
in stock to the amount used in production or sold in retail. It requires a
balanced judgement between having too little in stock and missing sales
opportunities, and having too much and so tying up funds for working capital
and risking obsolescence.

44 Accounting for Managers


In conclusion, as Table 3.4 shows, by cutting capacity and doubling its
utilisation, the management of NARC have improved ROCE by more efficient
use of stock and infrastructure.

2002 2001
results for comparison

Asset Turnover 5000 2.2 x 1.6 x


=
2300

Fixed Asset Turnover 5000 3.3 x 1.7 x


=
1500

Stock Turnover 2000 5.0 x 4.4 x


=
400

Table 3.4 NARC's efficiency for 2001 and 2002.

Liquidity

Settlement period

Debtors
Settlement Period = ´ 365 days
Sales

This is a measure of credit granted to customers. The more liberal the policy or
ineffective the debt progression, the more funds are tied up in working capital.
Similar calculations (see NARC) can be made for the credit taken from
suppliers, a flexible and much abused form of funding.

Current ratio

Current Assets
Current Ratio =
Current Liabilities

This is a simple – and simplistic – measure of a business’ ability to meet its


immediate liabilities. The reality is highly affected by context, and an
appropriate level is best gauged by comparison within the industry sector.

Acid test

Monetary Current Assets


Acid Test =
Current Liabilities

Accounting for Managers 45


By excluding stock, which is not quickly convertible into money (especially in
manufacturing), this is a slightly more realistic parameter of liquidity, but
still suffers many of the faults of the current ratio.

In conclusion, as Table 3.5 shows, NARC has dramatically improved its


liquidity by creating a cash surplus and paying its suppliers more promptly.

2002 2001
results for comparison

Credit Taken 300 55 days 83 days


´ 365 =
2000

Current Ratio 1100 3.7 x 1.3 x


=
300

Acid Test 700 2.3 x 0.6 x


=
300

Table 3.5 NARC's liquidity for 2001 and 2002.

Risk

Gearing

Debt
Gearing =
Debt + Equity

Where ‘debt’ is equivalent to long-term liabilities and ‘equity’ to shareholders’


funds.

Risk is the degree of volatility in profits. Risk is higher where sales are
cyclical and there is a substantial fixed cost base as changes are multiplied (or
‘geared’) on the bottom-line. Debt finance is ‘fixed’ in that interest payments
must be met, but dividends are discretionary, therefore a high gearing conveys
high financial risk. Where shares are quoted, market values provide a much
more realistic indication of this risk than do the book values in a balance
sheet.

Interest cover

Profit Before Interest and Tax


Interest Cover =
Interest

46 Accounting for Managers


This indicates the ability to meet interest payments – the higher the ratio, the
greater the cushion against the geared effect of a fall in sales on profits.

Dividend cover

Profits after Tax


Dividend Cover =
Dividends

This is similar in concept to interest cover, except that dividends are paid out
of earnings.

2002 2001
results for comparison

Gearing 1200 52% 77%


=
(1200 + 1100 )

Interest Cover 400 4.0 x 1.8 x


=
100

Dividend Cover 200 2.0 x 1.7 x


=
100

Table 3.6 NARC's financial risk for 2001 and 2002.

In conclusion, as Table 3.6 shows, the repayment of debt, whether forced by


the lenders or initiated by NARC’s management, has led to a major
improvement in all three ratios and reduction in financial risk.

Investor

Note: quoted companies use measures of investor risk and return that are
based upon the market price of the share – price/earnings ratio, earnings and
dividend yield – these are explored in Section 5.

Return on equity (ROE)

Profit after Tax


Return on Equity =
Shareholders' Funds

This is a comparable measure to ROCE except that ROE relates the profit
attributable to shareholders to the book value of their investment, whereas
ROCE does not distinguish between the form of capital used to fund the asset
base which generates profits, and hence uses the profit figure before interest
and dividends have been deducted.

Accounting for Managers 47


Earnings per share (EPS)

This is the major measure reported in published accounts and ensures that
injections of equity are adequately reflected in increased profit. It cannot be
used for inter-firm comparison.

In conclusion, as Table 3.7 shows, NARC has improved shareholder return by


reducing its gearing and raising its earnings. This may well have been the
motive behind the capacity reduction in the first place. If so, it demonstrates a
shrewd financial strategy on the part of management.

2002 2001
results for comparison

Return on Equity 200 18% 15%


=
1100

Earnings per Share £200,000 10p 7.5p


=
2,000,000

Table 3.7 NARC's investor return for 2001 and 2002.

Limitations of ratio analysis

Ratios produce a simplistic picture of reality and mean little without


knowledge of the underlying figures and business context. Many are
inaccurate in absolute terms and require comparison. Where that comparison
is with peer companies, differences in definitions and accounting policy can
undermine the analysis.

Blackboard

Now check Blackboard for the details of your directed and other reading for this
section. You are expected to do all of the directed reading before carrying on.

48 Accounting for Managers


Concluding Comments

Competent interpretation comes with practice. The directed readings and


exercises available on Blackboard will ask that you work through several
examples. As you do so, consider how context affects your interpretation. Also,
you will see how a financial commentary can demonstrate interpretative
competence with little recourse to the numbers. This is good practice – try to get
to a position where you can explain what is happening, rather than leaving the
numbers to ‘speak for themselves’.

Finally, undertake the exercise related to the case material from Next plc,
remembering to use the retail context and the company’s financial aims to
interpret the rather surprising results.

Accounting for Managers 49


MN7006/D

FINANCIAL ACCOUNTING

CASE STUDY PART II

Next’s Accounts:
Interpretation and Ratio
Analysis
Financial Accounting Case Study Part II

Next's Accounts: Interpretation


and Ratio Analysis

Principal financial statements


The following tables and notes are drawn from the 2006 Annual Report. The
data has been rationalised (for example, Table 3.8) and, in some cases,
adjusted in the interests of simplicity and comprehension: none of the
adjustments made are believed to make a material difference to the meaning
of the accounts. The Balance Sheet, first introduced in Part I of the case study
is reproduced here in expanded form (Table 3.9) in order that you can conduct
a comprehensive ratio analysis. The cashflow statement is provided later on in
full.

Accounting for Managers 53


2006, 2005,
£ million £ million

Revenue (Sales) 3106 2859

Cost of goods sold 2014 1830

Depreciation 81 69

Lease rentals 141 127

Other expenses 399 390

Total operating costs (2635) (2416)

Operating profit 471 443

Interest on loans & overdrafts (22) (19)

Profit before taxation 449 424

Taxation (136) (119)

Profits after tax (Earnings) 313 305

Table 3.8 Next's profit & loss account. (Sources: Income Statement and Notes 2, 3 and 5 to the
Annual Accounts, 2006.)

54 Accounting for Managers


January 2006, January 2005,
£ million £ million
Non-current Assets
Property, plant & equipment 514 424
Intangibles and other non-current assets 48 62
562 486
Current Assets
Stock of finished goods 311 289
Trade and customer debtors 415 349
Prepayments 85 76
Other financial assets 31 25
Cash 70 72
912 811
Current Liabilities
Bank overdrafts 31 22
Unsecured bank loans 100
Trade payables 173 157
Tax and social security liability 62 53
Other creditors and accruals 328 292
Other liabilities due within a year 62 64
(756) (588)
Non-current Liabilities
Corporate bond 298 300
Pension obligations 116 93
Provision for costs of exiting unwanted 10 10
leases
Other liabilities 38 29
(462) (432)
256 277
Equity
Share capital 25 26
Employee share ownership trust reserve 89 93
Retained earnings 1751 1778
Other reserves (1609) (1620)
Shareholders’ funds 256 277

Table 3.9 Next's balance sheet.

Accounting for Managers 55


Share capital
Authorised ordinary shares of £0.10 each as at January 2006:
400,500,000 (2005: 400,500,000)

Allocated, called up and fully paid £0.10 shares as at January 2006:


246,100,000 (2005: 261,103,000)

During the year Next plc purchased for cancellation 9,060,984 of its own
ordinary shares in the open market at a cost of £126.9m, and a further
5,950,000 under off-market contingent purchase contracts at a cost of £90.6m.
The cost of these purchases was set against retained profits for the year (and
not other reserves as in earlier years). On 30 April 2005, Next plc issued 8,031
ordinary shares for a cash consideration of £0.1m (source: Notes 26 and 27 to
the accounts).

Dividends
Accounting entries related to dividend distributions are shown in Table 3.10.

Declared for 2006, Paid in 2006, Liability at


charged against cashflow January 2006,
profits balance sheet

Final dividend for 2005 71

Interim dividend for 2006 34 34

Final dividend for 2006 71 71

Table 3.10 Next's dividend distribution (source: Note 7 to the accounts).

Debt capital
As at January 2006, the amount of the outstanding liability was £401m
(source: Notes 18, 21, 32 and 33 to the accounts), comprising:

· £100m in an unsecured bank loan – committed borrowing facilities


at January 2006 were £450m expiring between 2 and 5 years’ time,
of which £100m was drawn down.

56 Accounting for Managers


· £298m in corporate bonds, repayable in 2013.

· £3m in finance leases – operating lease commitments as at January


2006 amounted to £1,915m. These are not shown as liabilities in the
balance sheet (nor required to be under International Accounting
Standards) as they are similar to rental agreements. The leases
cover vehicles, equipment, warehouses, office equipment, and retail
stores.

Segmental analysis for 2006


This is a divisional and geographical analysis of key figures in the annual
accounts required by International Accounting Standard. It is shown in Table
3.11.

External Internal Total Operating Capital Assets,


revenue, revenue, revenue, profit, expenditure, £m
£m £m £m £m £m
Sector Analysis
NEXT Retail 2217 2217 320 164 2905
NEXT Directory 685 685 106 1 1121
NEXT Sourcing 9 668 677 33 3 206
Ventura 149 5 154 14 11 112
Other 46 131 177 (2) – 7272
Eliminations (804) (804) (10,142)
Total 3106 – 3106 471 179 1474
Geographical
Analysis
United Kingdom 2974 155 1385
Rest of Europe 102 not 16 31
Middle East 20 available 1 4
Asia 10 7 54
Total 3106 179 1474

Table 3.11 Next's segmental analysis for 2006 (source: Note 1 to the accounts).

Accounting for Managers 57


Cashflow statement
Table 3.12 shows Next's cashflow statement. Minor flows have been omitted
for the sake of brevity, clarity, and comprehension.

Cash Cash
inflows, outflows,
£m £m
Cashflows from operating activities
Profit before interest 471
Depreciation 81
Share option charge 8
Increase in inventories 22
Increase in trade and other receivables 76
Increase in trade and other payables 63
Pension contributions less income statement 12
charge
Corporation taxes paid 113
623 223 400
Cashflows from investing activities
Proceeds from sale of property, plant and 8
equipment
Acquisition of property, plant and equipment 178
8 178 (170)
Cashflows from financing activities
Repurchase of own shares 218
Proceeds/(repayment) of unsecured bank loans 100
Interest paid & received 1 21
Dividends paid 104
Net cash from financing activities 101 343 (242)
Net decrease in cash and cash equivalents (12)
Opening cash and cash equivalents 50
Closing cash and cash equivalents (balance sheet) 38

Table 3.12 Next's cashflow statement Year to January 2006 (source: consolidated cashflow
statement).

58 Accounting for Managers


Exercises

Now try these exercises. Outline solutions are given in Appendix B.

(3a) Quickly review the three principal statements using the approach to
interpretation suggested in this section, starting with the profit & loss
account, then moving onto the cashflow statement and balance sheet.
Note any inconsistencies.

(3b) Conduct an analysis of profitability and efficiency on the segmental


data (Table 3.11) from Note 1 to the accounts using ratios. Interpret
your results and comment on any other insight that the data provides.

(3c) Calculate the following measures for 2005 and 2006 for Next plc:

· debtor settlement period,

· acid test,

· gearing,

· interest cover,

· return on equity,

· earnings per share.

What do the results suggest about the liquidity, risk and investor
performance of Next plc?

Accounting for Managers 59


MN7006/D

SECTION 4

Regulation and
Governance
Section 4

Regulation and Governance

Learning Objectives

This section continues to address the first objective in the Module


Outline – to adequately interpret the meaning of a published set of
accounts – but the emphasis is upon the second – to critically question
the parameters under which accounting information has been provided.

After studying this section and its readings, you should:

· recognise the need for, and nature of, the regulation of


financial reports and the role of external audit, and

· understand the principles of good governance, the


responsibility of the Board, and the need for risk management
and internal audit.

Introductory context
The regulation of accounting reports and the wider issue of corporate
governance are of immense contemporary interest: the former to practicing
accountants, the latter in Boardrooms.

Accounting for Managers 63


The two are related since the current flurry of activity involving both is a
response to the failure of audit to check fraudulent accounting and/or abuse of
power by executive directors. There is not necessarily a widespread lack of
ethical behaviour, but high profile corporate failures have required political
action to restore the legitimacy of business in relation to its society. We are all
very aware of the failure of Enron and the imploding of Arthur Andersen, but
these followed scandals at WorldCom and Global Crossing. Nor are such
scandals unique to the US – Ahold of the Netherlands Vivendi of France,
Parmalat of Italy, and Sumitomo of Japan are examples gathered from around
the world – or to the recent past – Maxwell Communications (of the UK) and
BCCI (originally of Pakistan) both fell into disrepute in the early 1990s.

There has always been a thin line between ‘creative accounting’ (see Collier,
Chapter 7) and fraudulent disclosure, as there has between tax avoidance and
tax evasion.

Even with a limited knowledge of accounting, one can appreciate that the
concepts of accrual and prudence, and the need for judgement in the full
attribution of costs, provide scope for ‘smoothing’ profits between years.
External transactions, ostensibly with third parties, can also be used to
advance sales and source funds that are ‘off balance sheet’. Regulation has
become necessary because the exercise of expertise essential to measuring and
reporting organisational performance in accounting terms can go beyond a fair
assessment to one that is designed to mislead.

The nature of regulation


Regulation involves some specification of accounting convention and process
or the content and form of public disclosure. The approach to this has varied
dramatically between countries: some have formal statutes, others rely upon
common law; some have their own professional bodies, others ‘import’
systems; some define classifications and procedure, others rely upon more
generalised principle. Differences in national approach are often historically
determined: the form of the legal system, any colonial influence, the
importance of equity markets, the degree of alignment between taxation and
accounting returns, and the influence of the accounting or auditing
professions being amongst the determining factors.

For example, in Germany the content of accounting reports is codified in law


and the resultant profit used to assess corporation tax, so, whilst keeping within
the rigid rules, German companies seek to suppress profits. In addition, the
German economy is heavily populated with family-owned companies and there
is a greater reliance upon debt finance provided by commercial banks who have
a presence on supervisory boards. The agency relation is weaker and the

64 Accounting for Managers


consequent need for external reporting much less than in Anglo-American
forms of capitalism. There, equity finance is much higher relative to gross
domestic product and banks are held at arms length. Transparency of financial
performance is more significant, and companies seek to impress shareholders
and equity markets by reporting enhanced profits.

Between the UK and the US, there are significant differences over the
valuation of land, buildings, stock and writing off of goodwill on acquisition
and research and development expenditure. The US enforces historic cost
derived from independently conducted transactions rigorously and its
accounting standards specify appropriate treatment of those transactions and
other business situations.

In the UK, accounting standards are more liberally defined and follow the
principle of ‘substance over form’. This means that the intention behind a
transaction is more important that its mechanics. If a transaction is designed
to conceal a liability, it can fail audit scrutiny in the UK because the intention
is to deceive, whereas in the US it may withstand audit scrutiny because it is
technically valid (e.g. the ‘round-trip’ trades of US energy companies).
However, the greater latitude over measurement in the UK can give rise to
higher profit declarations. The UK requirement is that reported accounts
portray a ‘true and fair view’, whilst the US expects a ‘fair’ presentation.

Reported earnings
for 2004, $bn

UK accounting standards 15.8

US GAAP 17.1

IFRS 17.1

Replacement Cost Accounting 15.2


(an optional disclosure under IFRS)

Table 4.1 BP’s earnings for 2004 according to various reporting standards.

Table 4.1 shows data from BP plc. Profits attributable to shareholders under
UK standards are $1.3bn different to those under US rules, but are we to
believe that $15.8bn is the ‘true’ figure when BP’s executives prefer to adjust
historic costs for inflation and declare $15.2bn? Auditors have a convention
termed ‘materiality’ that the disclosed figures are not materially different to
those that could be otherwise argued as correct under the prevailing
accounting standards. They define a percentage range for reported levels of
sales, profit, and net assets within which they will tolerate sampling errors
and discretionary points. There is no absolute truth.

Accounting for Managers 65


International Financial Reporting
Standards (IFRS)
For as long as national differences remain in company law and regulatory
authority, cross-border interpretation is full of difficulty. Foreign trade and
investment is inhibited by opaque, unreliable and incomparable data. The
harmonisation of national accounting standards and reporting formats has
thus been pursued in the interests of global economy. From 2005, the
European Union mandated compliance for listed companies in member states
with the requirements of the International Accounting Standards Board. By
2010, convergence is planned between US GAAP [Note 5] and the IFRS
providing the platform for a global standard – note that BP’s earnings under
both regimes was the same in 2004, but $1.6bn divergent the following year.

Currently, there are some 40 IFRS covering issues ranging from the
presentation of statements, to the treatment of particular items like
intangible assets, to specific sectors like agriculture. It is unnecessary for you
to know these standards. It is necessary to be aware under which company law
and standards a published set of accounts have been prepared – especially if
you become a director. With quoted companies, there will normally be
supplementary disclosures – in content and frequency – required by the
governing body of the exchange on which the shares are listed. This could be a
self-regulatory body such as the Stock Exchange Council for London market,
but in many countries it is a government ministry. Internationally, these
regulators are represented on IOSCO [Note 6] which supports efforts to ensure
the integrity of financial markets and enhance their efficiency. It works closely
with the IASB and IFAC [Note 7] to improve disclosure and harmonise
accounting standards.

Corporate governance
In step with accounting regulation, corporate governance has developed on a
national basis, sometimes in statutory form but more commonly through codes
of conduct. Developments have often been triggered by high-profile corporate

[5] Generally Accepted Accounting Practice.

[6] International Organisation of Securities Commissions.

[7] International Federation of Accountants.

66 Accounting for Managers


misdemeanours, but their root lies in the fiduciary duties of directors defined
in company law. These obviously vary, but are rarely expounded beyond acting
in the company’s interest, observing a duty of care, and not mis-appropriating
assets or otherwise deceptively benefiting from position. The lack of positive
ethical guidance in these provisions has been addressed by codes of
governance which go well beyond the observance of individual propriety.

At an international level, the main body that has contributed to this issue is
the OECD [Note 8] – 30 countries ‘sharing a commitment to democratic
government and the market economy’. In its Principles of Corporate
Governance, first issued in 1999, it effectively provides a definition,

“The corporate governance framework should ensure the strategic guidance


of the company, the effective monitoring of management by the board, and
the board’s accountability to the company and its shareholders.”

The dual position of the Board in holding management to account, and being
held to account by the owners, is a demonstration of agency and shows the
relevance of corporate governance to the subject of this study book. The use of
independent non-executive directors is an important component in policing
the executive members of the Board. Paragraph E1 in the OECD guidelines
(see Figure 4.1) indicates their role on three committees (paragraph E2):

· nomination (the appointment of Board members, paragraph D3),

· remuneration (the performance-related pay of Executive members,


paragraph D4),

· audit (the liaison with auditors and review of financial and risk controls).

Most national systems (see later) require exclusive or majority representation


of non-executive directors on these committees – although the position of the
Chairman of the Board (as a non-executive) is controversial in the US.

The role of the audit committee is particularly significant in view of the


accounting scandals already mentioned. These resulted from failure of
internal controls, abuse of executive position, and/or false external reporting.
Such failings are potentially inter-related. True and fair financial reports
require integrity of financial accounting systems (paragraph D7), and these
should be reviewed by internal and external audit. Assuming their technical
competence, both these functions need unfettered access and reporting of their
findings, a capacity that can be undermined by a chief finance officer (CFO) as
employer and client, respectively.

[8] Organisation of Economic Co-operation and Development.

Accounting for Managers 67


Section VI: The Responsibilities of the Board
A. Board members should act on a fully informed basis, in good faith, with due diligence
and care, and in the best interest of the company and its shareholders
B. Where board decisions may affect different shareholder groups differently, the board
should treat all shareholders fairly
C. The Board should apply high ethical standards. It should take into account the interests of
stakeholders
D. The board should fulfil certain key functions, including:
1. Reviewing and guiding corporate strategy, major plans of action, risk policy, annual
budgets and business plans; setting performance objectives; monitoring
implementation and corporate performance; and overseeing major capital
expenditures, acquisitions and divestitures
2. Monitoring the effectiveness of the company’s governance practices and making
changes as needed
3. Selecting, compensating, monitoring and, when necessary, replacing key executives
and overseeing succession planning
4. Aligning key executive and board remuneration with the longer term interests of the
company and its shareholders
5. Ensuring a formal and transparent board nomination and election process
6. Monitoring and managing potential conflicts of interest of management, board
members and shareholders, including misuse of corporate assets and abuse in
related party transactions
7. Ensuring the integrity of the corporation’s accounting and reporting systems,
including the independent audit, and that appropriate systems of control are in
place, in particular, systems of risk management, financial and operational control,
and compliance with the law and relevant standards
8. Overseeing the process of disclosure and communications
E. The board should be able to exercise objective independent judgement on corporate
affairs
1. Boards should consider assigning a sufficient number of non-executive board
members capable of exercising independent judgement to tasks where there is a
conflict on interest. Examples of such key responsibilities are ensuring the integrity
of financial and non-financial reporting, the review of related party transactions,
nomination of board members and key executives, and board remuneration
2. When committees of the board are established, their mandate, composition and
working procedures should be well defined and disclosed by the board
3. Board members should be able to commit themselves effectively to their
responsibilities
F. In order to fulfill their responsibilities, board members should have access to accurate,
relevant and timely information

Figure 4.1 Extract from OECD Principles


(see http://www.oecd.org/dataoecd/32/18/31557724.pdf).

The audit committee thus provides an independent point of reference.


Recalling that the Board is responsible for ‘strategic guidance’, appropriate
objectives and plans have to be in place (paragraph D1). One of these
objectives will be financial in nature (e.g. to increase earnings per share), and

68 Accounting for Managers


the imperative of achieving shareholder returns has driven a number of
Boards into risky strategies.

The OECD principles make significant reference to the need for risk
management (paragraphs D1 and D7), and the audit committee has a number
of responsibilities in this respect. Risks are not just linked to the integrity of
financial reporting, but include all business exposures from the strategic to
the operational, from environmental to internal process. Thus there is a need
to define the Board’s attitude toward risk, monitor extant and emerging
exposures, incorporate risk evaluation and mitigation into decision making,
ensure the effectiveness of internal controls, and maintain systems that
provide adequate information for planning, control, internal audit and review.
This approach to risk management is set out in the widely-adopted COSO
[Note 9] framework, depicted in Figure 4.2.

1 Control Environment

2 Risk Assessment 3 Control Action

5 Monitoring

4 Control Information

Figure 4.2 The COSO framework.

Control information contains financial accounting data used in corporate


reporting but, because it embraces wider strategic and operational control, it
also contains management accounting data used for internal reporting.
Sections 6 through 10 of this study book explore this further, but the link
between governance and management accounting is evident from the OECD’s
paragraph D1. This explicitly refers to annual budgets (covered in Section 9),
corporate performance (see Section 10) and capital expenditure (see Section
6).

[9] Committee of the Sponsoring Organisations to the Treadway Commission, 1992.

Accounting for Managers 69


The role of accounting and auditing is broadening in response to the
contemporary concern with risk management. Accounting has to provide
historic reports of stewardship with integrity and provide predictive
mechanisms and contingent controls in respect of the future. Internal audit
(the ‘monitoring’ step in the COSO framework) is developing into risk
management, whilst external auditors are reviewing compliance with the
corporate governance regime as well as accounting regulation. The practical
impact of this is explored by examining the governance regimes that apply in
the UK and the US.

Contrasting national approaches


The UK Combined Code is a self-regulatory framework consisting of principles
of good governance and a code of best practice that have been informed by
some seven reviews over the last eleven years. The requirements of this code
apply only to quoted companies, and are flexibly drawn in that companies that
wish to demur from its provisions may do so if they explain the reason for
non-compliance. The Code is divided into four sections:

· Directors – addresses the role, composition, and information needs of


the Board. Stresses separation of the position of CEO from that of
Chairman, who is responsible for an annual performance evaluation
of the Board itself.

· remuneration – independent decision based on market rates and


performance related.

· accountability and audit – balanced assessment of company’s


position and prospects. Affirmation of going-concern. Sound system
of internal control. Transparent and proper arrangements with
auditors.

· relations with shareholders – dialogue encouraged with institutional


shareholders.

The US approach is conferred in law through the Sarbanes-Oxley Act (SOX). It


not only applies to companies listed on American exchanges, but to many
foreign firms that have a registration with the Securities and Exchange
Commission. Sections of the Act include:

· 201, auditor independence – an accountancy practice cannot provide


both audit and consultancy to the same client. Audit partners must
be rotated every five years. Auditor cannot become CFO of a client
within a year.

70 Accounting for Managers


· 301, independent audit committee – may only comprise
non-executives, one of whom must be a financial expert.

· 302, personal liability of CEO/CFO – must certify ‘appropriateness


of financial statements and disclosures and that (they) fairly
present, in material respects, the operations and financial condition
of the issuer’. They must disclose any material weakness in controls
to auditors and the audit committee.

· 404, internal control report – directors’ statement of its effectiveness


with attestation by auditor.

· 409, real-time disclosure of material changes.

· 80X, document destruction illegal and ‘whistle-blowers’ protected.

Both regimes encourage use of the COSO framework, but there is a more
rigorous test of the effectiveness of internal controls to manage risk and
prevent fraud under the US system. The leading position of a CEO in
American business culture has prevented the role separation seen under the
British code and remains a potential weakness given the intimidation evident
at Enron and WorldCom. In the US and UK regimes the shareholder is
pre-eminent, but the OECD recognises that some countries accept a wider
responsibility to stakeholders [Note 10].

Supplementary statements
Whilst not mandated, many companies portray the ethical relation of business
in society by incorporating sections on social and environmental responsibility
in their annual report. This may be rhetorical, but the current concern about
health, safety, community, human rights, organic food, recycling and climate
change means that stakeholder and ecological interest is no longer seen by
corporations as minimising negative effects (e.g. consumer boycotts, pollution
fines, or industrial injury claims). They recognise that substantial sections of
their markets will seek to buy ethical products.

Recommendations and guidelines exist on programmes of action and forms of


reporting, including the Global Reporting Initiative (based in the

[10] Of all national systems, the South African code most emphasises stakeholder
interests as the country strongly pursues social justice alongside economic
development.

Accounting for Managers 71


Netherlands), Environmental Accounting Project (US), International
Standards Organisation (ISO14001), and Environmental Audit Association
(Canada), Eco-Management and Audit Scheme (EMAS), UNEP. The
Operating and Financial Review (of the UK Accounting Standards Board)
addresses social, environmental, and stakeholder interests and is well
explained by Collier (in Chapter 9). Its adoption, though voluntary, marks a
major shift in the orientation of published accounts from historic reporting to
forward looking statements of strategy, resources, markets, risk and value,
and makes more transparent the results of the governance processes covered
in this section.

Blackboard

Now check Blackboard for the details of your directed and other reading for this
section. You are expected to do all of the directed reading before carrying on.

Concluding Comments

Please now look at the directed and supplementary readings on Blackboard.

Regulation and corporate governance are issues of enduring importance and


have received much academic and practitioner attention over recent years;
particularly as national traditions meet with an ongoing attempt to
systematically harmonise accounting standards and practice internationally.
The following questions are designed to reinforce your knowledge and develop
an insight into this debate.

(4.1) China is a major economy, recently emergent from central state


control. How has this history affected its financial accounting
practices?

(4.2) For your own country, establish which organisation regulates the
preparation and publication of annual accounting reports. How do the
formats for the principal financial statements differ from those
prescribed by IAS1 and IAS7 (International Financial Reporting
Standards)?

(4.3) Briefly outline the corporate governance regime that appertains to


India. Has it been influenced by the UK’s Combined Code?

72 Accounting for Managers


(4.4) For your own country, identify the source of corporate governance
regulation. Was this regulation framed in response to an accounting
scandal? If so, examine the nature of the scandal and consider whether
the regulation would prevent a repetition.

Indicative answers to Exercises 4.1 and 4.3 are provided in Appendix A.

Accounting for Managers 73


MN7006/D

FINANCIAL ACCOUNTING

CASE STUDY PART III

Next plc: Impact of


Governance and
International Accounting
Standards
Financial Accounting Case Study Part III

Next plc: Impact of Governance


and International Accounting
Standards

New regulatory regime


Accounting policies are set out in all published accounts. In the 2006 Annual
Report from Next plc, they cover four pages, and commence,

“The financial statements have been prepared in accordance with


International Financial Reporting Standards for the first time. The
disclosures required by IFRS1 concerning the transition from UK
GAAP are given … (summarised below). The financial statements …
therefore comply with Article 4 of the EU IAS Regulation.

“The financial statements have been prepared on the historical cost


basis except for certain financial instruments, pension assets and
liabilities and share based payment liabilities which are measured at
fair value.”

(p36)

“The Group has not adopted early the requirements of IFRS 7 Financial
instruments: disclosures, which will become mandatory with effect
from 1 January 2007.”

(p39)

Accounting for Managers 77


Adopting a new set of standards means that the accounting treatment of
transactions changes and affects not only the current period, but also the
balances of assets, liabilities and capital accumulated over many years.

Reported data is also no longer comparable with prior years compiled under
the old regulatory regime, and so the last year’s results are restated under the
new standards. At the point of transition, the effect of changes on the opening
balance sheet and on the previous year’s profit & loss account are reported.
Note that no changes are necessary to the cashflow statement because it is not
subject to accrual and matching. For Next plc, the overall effect of the change
in standards was:

Opening balance sheet as at January 2005

Fixed Assets +£30m

Current Assets +£1m

Current Liabilities – £32m

Non-current Liabilities +£59m

Equity (capital & reserves) +£4m

Profit & loss account for year ended January 2005

Operating Profit +£1m

Taxation – £3m

The adoption of IAS related to financial instruments would have had the effect
of reducing the net asset value of the opening balance sheet by £44m. This is
because the fair value of these instruments would have had to have been
adjusted.

Corporate governance
The following are extracts from the section on Corporate Governance in Next
plc’s 2006 Annual Report,

“The Group has complied throughout the year under review with the
provisions set out in Section 1 of the July 2003 FRC Combined Code on
Corporate Governance.

78 Accounting for Managers


The Board of Directors

“The Board is responsible for major policy decisions whilst delegating


more detailed matters to its committees and officers including the Chief
Executive. The Board is responsible for the Group’s system of internal
control and for monitoring implementation of its policies by the Chief
Executive. The system of internal control is designed to manage, rather
than eliminate, the risk of failure to achieve business objectives and can
only provide reasonable and not absolute assurance against material
misstatement or loss.

“The Board held nine formal meetings during the year.

“The Board includes five independent non-executive directors … Meetings


of the non-executive directors without the executive directors being
present are held at least annually, both with and without the Chairman.

“The Board has appointed committees to carry out certain of its duties,
three of which are detailed below. Each of these committees is chaired
by a different director and has terms of reference which are available
for inspection on the Company’s website …”

(p15)

Audit Committee

“The committee … consults with external auditors and senior


management … considers financial reporting and reviews the Group’s
accounting policies and annual statements. The committee also reviews
the effectiveness of the risk management process …”

(p15)

Remuneration Committee

“The committee determines the remuneration of the executive directors


and reviews that of senior management.”

(p16)

Nomination Committee

“… duties of reviewing the Board structure and composition and identifying


and nominating candidates to fill Board vacancies as they arise.”

(p16)

Accounting for Managers 79


Each committee comprises five non-executives, with the Chairman (David
Jones) also present on the Nomination committee.

Chairman

“The Company maintains a division of responsibilities between the


offices of Chairman and Chief Executive, which is set out in writing and
agreed by the Board. The Chairman manages the Board to ensure that

· the Group has appropriate objectives and an effective


strategy;

· that there is a Chief Executive with a team of executive


directors able to implement the strategy;

· that there are procedures in place to inform the Board of


performance against objectives;

· and to ensure the Group is operating in accordance with a


high standard of corporate governance.

“The current Chairman was an executive director of the Group


(formerly the CEO from 1988 until 2001).

“It is intended that he will retire from the Board at this year’s Annual
General Meeting in May and be replaced by the current Deputy
Chairman (John Barton), who is an independent director.”

(p16)

Management Delegation

“The most important management meetings are the weekly NEXT


Brand trading and capital expenditure meetings which consider the
performance and development of the NEXT Brand through its different
distribution channels. These meetings cover all business aspects of risk
management in respect of the NEXT Brand including product, sales,
property, warehousing, systems and personnel. Key performance
indicators are monitored daily and weekly.”

(p16)

Risk Management

“The Board sets guidance on the general level of risk which is acceptable
and has a considered approach to evaluating risk and reward.

80 Accounting for Managers


“The Board confirms that it has carried out a review of the effectiveness
of the Group’s system of internal control covering financial,
operational, compliance and … risk management. This includes:

· identifying and evaluating risks,

· determining control strategies for these risks

· and considering how they impact on the achievement of the


business objectives.

“The risk management process has been in place for the year under
review … and is in accordance with … Internal Control: Guidance for
Directors on the Combined Code.

“Risk management and internal control is a continuous process and has


been considered by the Board on a regular basis during the year. The
Board promotes the development of a strong control culture within the
business. During the year the Board addressed the business risks
which had been identified as key, taking into account any changes in
circumstances over the period. The Audit Committee has reviewed the
level of internal audit resource available within the Group and believes
that it is appropriate to the size and business risks of the Group.

“The Board considers that the Group’s management structure and


timely and continuous monitoring of key performance indicators
provide the ability to identify promptly any material areas of concern.
Business continuity plans, procedures manuals and codes of conduct
are maintained in respect of specific major risk areas and business
processes.”

(p17)

External Auditors

“Ernst & Young LLP have reported to the Audit Committee that, in
their professional judgement, they are independent within the meaning
of regulatory and professional requirements and the objectivity of the
audit engagement partner and audit staff is not impaired. The Audit
Committee has reviewed this statement and concurs with its
conclusion.

“… the Board has established policies regarding the provision of


non-audit services by the auditors … the group’s auditors are in some
cases able to provide certain services more effectively than other
parties. In other circumstances, assignments are subject to

Accounting for Managers 81


independent tender, and decisions on the allocation of work are made
on the basis of competence and cost-effectiveness.”

(p17)

Relations with shareholders

“The board acknowledges that its primary role is to represent and


promote the interests of shareholders. The Board is accountable to
shareholders for the performance and activities of the Group.

“The Board communicates with its shareholders in respect of the


Group’s business activities through its Annual Report and Accounts,
yearly and half yearly announcements and regular trading updates to
the Stock Exchange … The information is also made publicly available
via the Company’s website.

“The Board takes care not to disseminate information of a share price


sensitive nature which is not available to the market as a whole.”

(p17/18)

Directors’ responsibilities

“The directors are responsible for keeping proper accounting records


which disclose with reasonable accuracy at any time the financial
position of the Company and of the Group and enable them to ensure
that the financial statements comply with the Companies Act 1985 and
Article 4 of the IAS Regulation. They are also responsible for
safeguarding the assets of the Group and hence for taking reasonable
steps for the prevention and detection of fraud and other irregularities.”

(p18)

Going Concern

“The directors report that having reviewed current performance and


forecasts they have a reasonable expectation that the Group has
adequate resources to continue in operational existence for the
foreseeable future. For this reason, they have continued to adopt the
going concern basis in preparing the financial statements.”

(p18)

82 Accounting for Managers


Corporate Social Responsibility (CSR)
Next plc produced its second CSR report in January 2005, and this is available
as a pdf download from its website. In his welcome paragraph, the CEO states
that,

“Next is a company that believes that it can only deliver long term value
to its shareholders if we take an ethical approach to the way we do
business. Put simply. this means being fair and honest in our
relationships with suppliers, customers and employees.”

(p3)

Next plc has appointed a CR & Environment Manager and conducts policy
through a forum of 17 internal managers that is subject to six monthly review
meetings with a Group Board Director. The report provides ‘key facts and
figures’ for seven aspects of social responsibility for the year to January 2005:

· economic:

- readers are referred to the Annual Report and Accounts.

· FTSE4GOOD:

- an independent listing of Next plc as an ethical investment.

· suppliers:

- 1353 factories based in 51 countries,

- 378 factories in 21 countries audited against Next’s code of


practice,

- 14 major suppliers appointed internal managers with


responsibility for implementing Next’s code of practice.

· customers:

- 160,000 transactions per day carried out in Next Retail’s stores,

- 1.9 million active Next directory customers.

· people:

- employed 11,000 full-time and 31,075 part-time employees in the


UK and Eire,

Accounting for Managers 83


- 74% of women who took maternity leave returned to work for
Next,

- 4739 staff are members of Next pension schemes.

· community:

- donated £879,000 to charity and community organisations as well


as sponsorship of sports and fashion organisations. Fundraising
events also raised an additional £841,000.

· environment:

- 98 stores recycled cardboard and plastic,

- 11,935 tonnes of cardboard and polythene recycled,

- over 12 million hangars returned by stores for reuse,

- 7.1% decrease in CO2 emissions per 1000 parcels


delivered/collected.

Exercises

Now try these exercises. Outline solutions are given in Appendix B.

(4a) What has been the effect of the adoption of international, rather than
UK, accounting standards on Next plc’s reported redults?

(4b) The directors of Next plc state, ‘they have continued to adopt the going
concern basis in preparing the financial statements’. What is the
meaning of ‘going concern’ and its implication for valuations in the
balance sheet?

(4c) The Board of Next plc have stated that they have complied with the
requirements of the UK Combined Code. Review the report and
identify ten examples of good governance – note, these do not have to
specifically relate to the UK regulation, but can draw upon other
examples provided in Section 4.

(4d) Identify the five steps in the COSO framework. What evidence is there
that Next plc’s approach to risk management reflects this framework?

84 Accounting for Managers


(4e) Review the forum, aspects, facts and figures contained in the CSR
report. How ‘socially responsible’ do you consider Next plc to be?

(4f) In its CSR report, Next plc’s CEO states,

“Next is a company that believes that it can only deliver long


term value to its shareholders if we take an ethical approach to
the way we do business. Put simply, this means being fair and
honest in our relationships with suppliers, customers and
employees.”

How do these two sentences relate to agency and stakeholder theory?


Does this appear to you to represent an adequate approach to
reconcile the potentially conflicting interests of shareholders and
stakeholders?

Accounting for Managers 85


MN7006/D

SECTION 5

Capital Markets and


Shareholder Value
Section 5

Capital Markets and


Shareholder Value

Learning Objectives

This section sits on the boundary between accounting and finance. It is


included because the market price of a share facilitates the additional
ratio analysis necessary from an investor’s perspective. It therefore
completes the interpretation of accounting data given in Section 3.

The cost of finance is also determined by the markets and is used in the
evaluation of strategic projects considered in Section 6. Taken together
with newly introduced criteria for assessing shareholder value, these
provide an unusual but appropriate entry into management accounting
which forms the remaining content of this study book.

After studying this section and its reading, you should:

· understand the role of capital markets and how the data they
convey is used to assess the performance of quoted companies,

· understand the limitations of accounting profit and balance


sheet data in this respect and have an appreciation of
alternative value-based concepts, and

· recognise that the cost of funding is an opportunity cost used


as a key parameter in internal financial evaluation.

Accounting for Managers 89


Role of financial markets
Capital markets provide investment opportunities for willing lenders, and a
source of cash for companies. Unquoted companies (the majority) do not have
direct access to this pool of funds, but it is with such markets that
intermediaries (like banks) interact – and all companies have bank facilities.

Macro-economic factors are reflected by the money markets in interest rates,


and so changes in market perception are transmitted via intermediaries to all
businesses and to the entire population. For quoted companies, the capital
markets upon which their shares are listed also provide a barometer of
corporate performance, by virtue of the trading activity and the price of a
share.

Shareholders Bondholders

Capital Money
Markets Markets

Banks and Other


Interest
Intermediaries
Dividends

loans and
overdraft
leases

Share Debt Working


Balance Sheet

capital capital capital

Retained
Profit Asset Base

Operating Profit

Figure 5.1 Interacting with the capital market.

Figure 5.1 is a simplified form of this interaction. A quoted company may issue
shares or bonds (a loan from the holder) on a capital market. Shares form the
equity capital of a company, shown in the balance Sheet as ‘Capital and

90 Accounting for Managers


Reserves’. Bonds and other forms of loan form the debt capital, and are shown
as ‘Long-term Liabilities’. Both equity and debt capital inject cash into the
business which is converted into the productive assets that create wealth.

With a growing business, additional stock and debtors are required and this
‘working capital’ is funded by debt capital and bank overdraft facilities.
Shareholders’ funds, long-term and short-term liabilities, therefore represent
the cash raised to purchase fixed and net current assets. From this asset base,
sales are generated, and cash flows back into the business to repay the
borrowing (reducing the liability) and service the borrowing (reducing the
profit). Interest on debt is paid first, then the dividend, and finally the
retained profit, which adds to shareholders’ funds, becomes an internal source
of funds for further growth in the business. For the sake of simplicity, only the
injection of funds and their servicing is shown in the diagram – the repayment
of loans, redemption of bonds, and buy-back of shares is excluded.

For the purposes of this study book, we can limit our consideration to the
capital markets, where stocks and bonds are traded, and focus on only two
aspects: shareholder return and the cost of capital.

Shareholder return
Shareholders can earn returns in two ways: from the dividends they receive
from the company, and from the change in the market value of their shares –
which they can sell at any time. By setting these two components against the
price at which the shares were bought, the return on a share can be assessed
as,

Total Dividend Paid on that Share + (Selling Price - Buying Price)


Return on Share =
Buying Price

Of course, the return can be – and normally is – evaluated on an annual basis


by using the market price at yearly intervals,

Annual Dividend + (Closing Price - Opening Price)


Annual Return =
Opening Price

By multiplying the share price by the number of shares issued by a company,


the market value of its equity can be calculated. The book value of equity in the
company is the shareholders’ funds figure in the balance sheet. This figure is
the total amount raised in cash through the original issue of the share plus the
accumulated retained profit and reserves – it does not reflect the rise in the
price of the share as a result of subsequent trading in the capital market. The
two values are therefore incomparable.

Accounting for Managers 91


In the UK, the market value of a company is about three times its book value
on average. Since the market data is more representative of shareholders’ real
interest, the investor ratios which we described in Section 3 need to be
supplemented. You may recall that ‘return on equity’ related earnings to the
book value of equity, but a more realistic indicator of shareholder return would
be based upon the market value of equity: this is called the ‘earnings yield’.
Similarly, the amount of dividend can be compared with the market value: this
is called the ‘dividend yield’. Commonly both are calculated on a per-share
basis,

Profit after Tax


Return on Equity = ´ 100%
Shareholders' Funds

Earnings per Share


Earnings Yield = ´ 100%
Share Price

Dividend per Share


Dividend Yield = ´ 100%
Share Price

Now, it is reasonably argued that investors consider a share price in terms of


its earnings and the growth likely in those earnings – in other words, a
combination of current performance and future potential. This means that,

1
Share Price = Earnings per Share ´
Earnings Yield

The reciprocal of earnings yield is called the ‘price-earnings ratio’ and this is
the leading indicator of potential return.

Look at Table 5.1. This indicates the importance attached to measures of


shareholder return. The fourth column shows the share price in pence (100
pence to the £). Note that the level of a price relative to its peers is
meaningless, but you can compare the level within its range over the last year
(shown in the first two columns). The largest three companies (in bold) are all
trading toward the bottom end of their range. Column 5 shows the change over
the latest day: Chemring, in particular, has been the object of selling activity.
The next column shows the dividend yield: British Aerospace produced a 3%
yield (around the market’s average), Hampson paid none at all. This may be
because it has retained profit to help fund acquisitions: its price-earnings ratio
(in the final column) is the highest rating in the sector.

92 Accounting for Managers


52 WEEK

High Low Stock Price Chg Yld P/E

Aerospace & Defence

450 314 BAE Systems 341.2 0.8 3.0 15.2

1355 548 Chemring 1320.0 –32.5 0.9 23.9

195 134 Cobham 158.0 –0.5 2.2 14.9

187 104 Hampson 155.5 1.5 0.0 28.9

382 273 Meggitt 284.2 –1.8 2.7 14.2

490 329 Rolls-Royce 421.5 0.0 0.0 15.6

1052 831 Smiths Grp 881.5 1.5 3.4 16.0

1115 826 Ultra Elctrncs 987.0 1.0 1.7 18.3

535 420 UMECO 449.8 –5.2 3.2 14.6

500 337 VT Group 487.0 0.0 2.2 19.6

Table 5.1 Share performance data for companies in the defence sector
(source: The Independent, August 10, 2006).

Illustration

Let’s return to the NARC example which we used in Section 3. Assume that
NARC’s share price was 200p at the end of 2002, up from 120p a year earlier,
Table 5.2 shows the effects that this would have on NARC’s performance. The
halving in gearing has reduced risk (more than calculated using book values).
This, together with the increased profitability on a rationalised asset base, has
excited market interest and boosted the p/e ratio. Despite the rise in profits
after tax and dividends, however, yields have fallen because the market’s
expectation of the company is much higher.

Accounting for Managers 93


2002 2001
results for comparison

Return on Equity 200 18% 15%


=
1100

Earnings per Share £200,000 10p 7.5p


=
2,000,000

Earnings Yield 10p 5% 6.3%


´ 100 =
200p

Dividend Yield £100,000 2.5% 3.8%


2,000,000
´ 100 =
200p

Price/Earnings Ratio 200p 20x 16x


=
10p

Gearing (based on market value) 1200 23% 50%


=
( 4000 + 1200 )

Table 5.2 Effects of ratio analysis for NARC using market data.

Cost of capital
Since the majority of trading activity on a stock market is secondary (i.e. the
sale of ‘used’ shares from one investor to another), changes in share price do
not directly affect the company. Only when capital is raised or retired does the
share price have a direct consequence – in the amount of cash raised or repaid.
One might therefore expect the price performance of a share subsequent to its
issue to have little significance to the financial management in a company.
This is not so.

Most companies want to enhance their share’s price (agency theory), and the
Board is keen to avoid the displeasure of its shareholders (especially at the
annual general meeting) and retain their loyalty. So the cost to the company of
servicing equity finance is not regarded as the cash-driven stream of dividends
its Board proposes. If the annual return is insufficient in relation to
alternatives in the market, shareholders will sell their holding and the price
will fall. Therefore the aim of a Board is to deliver sufficient dividends and
capital gain to prevent this occurring.

The cost of equity to a company is what is called an ‘opportunity cost’ – the


return foregone by the shareholder in unpursued alternatives by not selling
their shares. From this, a general principle is formulated of a company’s
relation to its shareholders,

94 Accounting for Managers


Cost of Capital to the Company = Return Required by the Investor

As it is with equity capital, so it is with debt finance – bond prices rise and fall
like shares. For bank loans, the cost is equal to the risk-specific lending rate of
the bank.

Why is all this important? Well, the fundamental financial role for a Board is
to ensure that,

Returns on Productive the Return that can be


Investment (i.e. its products, ³ Earned by Investors in
services, products) Projects of Equivalent Risk

Therefore, the Board can use the cost of capital as a basis for evaluating all its
productive investment opportunities. That way, it ensures that the return
from the use of funds exceeds the cost of funding. You will see how this is
applied in strategic decisions in Section 6, next.

Since most companies are funded from a pool of different types of funds, the
cost of capital is an average of the cost of all the individual sources weighted by
the amount of each that is used. As debt finance is cheaper than equity (and
the cost is tax deductible), gearing is an important influence on the overall cost
of capital, and the merit of applying market values in its calculation is
considerable.

You do not need to be able to calculate the cost of capital for this module of your
studies, just understand its relevance to financial decisions for now.

Value-based measures
The importance of shareholder return, when coupled with shareholder
activism in the 1990s, found expression in a series on new measures that were
value-based. In Chapter 2 of his book, Collier describes many of these
measures, but you simply need to recognise what they have in common and
why conventional accounting parameters were found wanting.

If the primary financial aim of companies is to increase the wealth of their


shareholders, and the primary component in that wealth is a capital gain (and
not a dividend distribution), then companies should adopt parameters that are
more closely aligned with shareholder value. Since this is based on future
expectations of financial performance, then we need to manage using future
projections rather than accounting reports of the past.

Accounting for Managers 95


Accounting profits are short-term, ignore the risk involved in their
achievement, and – as we saw in Section 4 – are more easily manipulated than
cashflow. Balance sheets are an eclectically historic aggregation of past
transactions and current judgements and severely understate the real value of
most going concerns (as we saw earlier in this section). So value-based
measures tend to have the following in common:

· they are aligned with, or are, actual representations of market


value,

· they are current expressions of forecast performance,

· they are based on or are approximations of cashflow,

· they incorporate risk, as reflected in the cost of capital.

Many techniques have been widely adopted, particularly among US


companies and multinationals, but they all have limitations and their allure
has been somewhat damaged by the fall in equity markets after the
millennium. EVA, SVA, and CFROI [Note 11] all use a discounted cashflow as
their vehicle, an important tool for strategic evaluation which we will explore
in more conventional settings in the next section.

Theoretical Market Accounting


Interpretation Interpretation Interpretation

Value of equity present value of future share price x number of shareholders’ funds
dividends shares (market value) (capital and reserves)

Value of debt present value of market value (MV) of liability


interest and debt plus outstanding
repayments discounted loans, etc
at the yield to
redemption

Value of the firm present value of future MV of equity plus the capital employed
cashflows value of debt

Acquisition value value of the firm plus what someone is fair value of assets
the value of any willing to pay for acquired plus goodwill
synergies control

Economic value book value of the firm plus the value of intellectual capital

Table 5.3 Conceptions of ‘value’.

[11] EVA – Economic Value Added; SVA – Shareholder Value Added; CFROI –
CashFlow Return on Investment.

96 Accounting for Managers


Before we move on though, review Table 5.3. It attempts to define the different
notions of value and how they are reflected in the market and captured in the
books of account.

The different interpretations that can be placed on a business that is a going


concern is evidence enough that a balance sheet cannot attempt to represent
value on this basis. The closest it comes is when another business is acquired
(and a full ‘economic’ value is paid after negotiation) where the payment
cannot simply be represented by the tangible assets at a fair value. The excess
is treated as ‘goodwill’ and amortised over the estimated life of the
acquisition’s benefit to the company. Thus, intellectual capital (discussed in
Chapter 7) is included in the accounts, but only when acquired, not when it is
developed from within. The intellectual capital – the people, organisation,
systems, knowledge, and brands – is what provides most companies with their
potential and explains the major difference between market and book value.

Blackboard

Now check Blackboard for the details of your directed and other reading for this
section. You are expected to do all of the directed reading before carrying on.

Concluding Comments

The idea of corporate governance explored in the previous section can be


considered alongside the idea of shareholder value covered in this section.
Milton Friedman famously argued that “there is one and only one social
responsibility of business — to use its resources and engage in activities
designed to increase its profits so long as it stays within the rules of the game,
which is to say, engages in open and free competition without deception or
fraud.” (1970: 6 – full reference and link available on Blackboard). Is this an
adequate description of the responsibility of business?

Please try the following exercises: a solution to Exercise 5.1 is provided in


Appendix A.

5.1 From the following data, calculate the return of capital employed, the
return on equity, the earnings yield and the dividend yield:

Accounting for Managers 97


capital & reserves $4m

long-term liabilities $1m

operating profit $1m

interest payable $0.1m

dividend cover 2x

price/earnings ratio 12x

Ignore taxation.

5.2 Get the main business newspaper for your country and look at the
stock market data. Find your best known clothes retailer and note its
data in the categories used in Table 5.1 earlier in this section. Compare
the movement in its share price with the stock market’s index over the
last year, and its yield and p/e ratio with the sector average. Why is it
divergent? If you can’t offer plausible reasons, read business
commentaries on the sector or visit the company’s website and see if its
annual report provides clues.

98 Accounting for Managers


MN7006/D

FINANCIAL ACCOUNTING

CASE STUDY PART IV

Next plc: Share Prices


and Share Options
Financial Accounting Case Study Part IV

Next plc: Share Prices and Share


Options

Importance of a market perspective


Appraising the financial performance of any quoted company is incomplete –
and arguably flawed – without reference to the capital market on which it is
quoted. In Next plc’s case this is particularly so, because the size of its share
buy-back programme (you can see its affect in Table 5.4) has led to accounting
entries that severely distort a conventional ratio analysis.

2001 2002 2003 2004 2005 2006

Number of shares in issue as at Jan. 31st (millions) 337 331 287 265 261 246

Balance sheet (as at Jan. 31st), £m

Ordinary share capital (10 pence face value) 34 33 29 27 26 25

Shareholders’ Funds 500 547 275 155 276 256

Table 5.4 Selected share and shareholder information for Next (source: Next plc Annual
Reports).

“Over the past five years, there have been significant achievements by
NEXT in many areas.

“Sales have almost doubled, accompanied by a doubling of profit and an


even greater increase in earnings per share. During that time we have
returned £1.4bn to shareholders through dividends and share

Accounting for Managers 101


buybacks. We have also succeeded in delivering excellent levels of
capital growth through a rising share price.”

(Chairman’s statement, Next plc Annual Report, 2006)

From [Chairman] David Jones’ statement, the significance of share


repurchase and earnings per share is evident. The two are related: with no
change in profit, the buying back of shares reduces them in number and
automatically causes an increase in earnings per share (EPS) – dividend
growth is shown in Figure 5.2. Achieve both at the same time – as Next plc
have done over the last five years – and there is a compounded growth in EPS.
But there’s a catch: maintain growth in profit and the value of the company –
its market capitalisation – is spread over a smaller share base, and so the price
will tend to rise inexorably (see Figure 5.3). Each successive tranche of
repurchases will cost more per share, and free cashflow has to keep pace with
the growth in profit and with the growth in share price, otherwise, Next plc
will have to borrow debt to finance the repayment of equity, and this will
increase gearing and the financial risk to the shareholders, and that will put
downward pressure on the share price.

44
41
35
31
Dividend 27.5
per Share
(pence)

2002 2003 2004 2005 2006

Figure 5.2 Next’s dividend growth.

The share buy-back programme is a coherent financial strategy to deliver


exceptional returns for its shareholders, but can only be sustained if
operational growth remains lean in funding terms. The strategy shows no
signs of abating,

“The authority to purchase shares is renewable annually and approval


will be sought from shareholders at the Annual General Meeting in
2006 to renew the authority.”

(p10)

102 Accounting for Managers


but involves an increase in maximum borrowing powers from £1bn to £1.5bn,

“The proposed increase is required to give the Company sufficient


headroom to develop its business and accommodate share buybacks …”

(p14)

2000p
high = 1772
1800p
1600p
1400p
1200p
1000p
800p
600p low = 700
400p
01 Jan 02 01 Jan 03 01 Jan 04 01 Jan 05 01 Jan 06

Figure 5.3 Next’s share price in pence on the London Stock Exchange
(source: www.citywire.co.uk).

Directors’ remuneration policy


Agency theory has already been used to explain the relation of the Board with
that of its shareholders. One of the bonding mechanisms recognised by the
theory to enforce agency is the remuneration package. In Next plc, the
package for the directors is reviewed annually by the Remuneration
Committee and takes into consideration prevailing rates in the market and
the performance of both the individual and the business. The package
comprises:

· a basic salary – based on prevailing rates in the market and the


performance, responsibility, and experience of the individual.

· an annual bonus based on earnings per share (EPS) – where pre-tax


EPS must increase by a minimum of 5%, but the bonus is capped
where EPS rises by 20% or more in the year.

· a long-term incentive based on shareholder return – measured over a


rolling three-year period and compared to a peer group of 20
companies. If the total shareholder return of Next plc lies in the
upper quartile, cash (or the equivalent in shares) is paid to the value

Accounting for Managers 103


of 70% of the annual salary. Next plc must be at least the median
company for any entitlement to arise. In the three year period
leading up to January 2006, Next plc was ranked third or fourth in
its peer group.

· a voluntary participation in a risk/reward investment plan –


involving contributory investment in financial derivatives whose
return will depend on the level of Next plc’s share price in 2009.

“[The] policy is structured to provide a mix of remuneration to ensure


that no one component or measure dominates and that interests are
aligned over different time periods with other employees and
shareholders.”

(p20)

Employees share ownership trust


Shares, or more specifically the option to buy shares at discounted prices, are
used as a wider incentive and loyalty device within Next plc. A trust holds
shares for employees who can contribute up to £250 per month for share
options at a discount of 20% to the prevailing share price. The options can
subsequently be exercised for shares after three years. Employees are invited
annually to participate. Table 5.5 shows some historical data for this scheme.

2001 2002 2003 2004 2005 2006

Number of share options outstanding at 12.7 10.5 9.0 9.3 9.7 10.6
January 31st (millions)

Average exercise price 502p 606p 701p 807p 997p 1128p

Table 5.5 Next’s employee share ownership scheme (source: Next plc Annual Reports).

104 Accounting for Managers


Exercises

Now try these exercises. Outline solutions are given in Appendix B.

(5a) Explain the meaning of the terms ‘share price’, ‘exercise price’, and
‘face value’.

(5b) Explain the term ‘market capitalisation’ and roughly calculate its latest
value for Next using the tabulated and graphical data.

(5c) Recalculate the gearing ratio using market values and contrast the level
with the previous assessment in Section 3. Assume the market value of
debt is close to its book value.

(5d) Using the dividend and share price data, roughly assess the shareholder
return over the five year period and its annualised equivalent (note that
you will find this easier on a ‘per share’ basis).

(5e) Assume this annualised return is required by shareholders in future. If


the after-tax cost of debt capital is 4%, what is Next plc’s weighted
average cost of capital?

(5f) Undertake calculations that show how David Jones came to the figure
of £1.4 billion.

(5g) To what extent do you think that the directors’ remuneration package
has contributed to Next plc’s financial performance?

(5h) Assume you are an employee of Next plc and ‘bought’ options in 2001,
2002, and 2003, exercised them after three years, and sold the shares
on the open market. Perform rough calculations of the percentage gain
you would have made on each of the three holdings. If you had
subscribed to the maximum amount per month, what would your total
gain have been?

Accounting for Managers 105


MN7006/D

SECTION 6

Strategic Investment
Decisions
Section 6

Strategic Investment Decisions

Learning Objectives

As this is the first of a series of sections which address the use of


accounting information for decision purposes, it includes an overview of
the decision process and the nature of information that serves different
decision contexts before concentrating upon the strategic level. After
studying this section and its reading, you should:

· understand the nature of decision making and characteristics


of information required to support the process,

· appreciate how management accounting is responding to


strategic needs, and

· understand the concept behind the net present value approach


to investment appraisal.

Management accounting revisited


Management accounting was elaborately defined in Section 1, so a simple
reminder will suffice here. It is the provision of information that assists an
organisation to plan its activities, control performance, and make decisions. It
is ‘information’ – data that has meaning – in that it has been competently

Accounting for Managers 109


classified, synthesised, analysed, and interpreted. It is primarily financial,
but will have quantitative and qualitative content. It will use sources internal
and external to the organisation, and its purpose and recipients may be at any
level within that organisation.

To plan and control activities, management accounts are normally prepared


on a frequent basis, in detailed or summated form to suit the purpose,
authority and comprehension of the recipient, but result in derived
performance indicators that are aligned to factors critical to the activity
concerned. For decisions, information is often uniquely devised to provide
essential knowledge for the decision maker.

Decision theory
Figure 6.1 sets out the logical steps in the decision making process: in reality,
many decisions are not comprehensively considered, are made under time
pressure with incomplete knowledge, and omit one or many of the steps
outlined:

Step 0 – when present, a problem requires the use of subjective


judgement as to its urgency, priority and whether its
potential significance merits the cost of determining and
correcting its cause.

Step 1 – the setting of objectives triggers decisions over the resources


required for their achievement. No decision can be
constructively made in the absence of objectives since no
judgemental criteria will exist. Similarly, conflicting
objectives lead to confusion.

Step 2 – the identification of alternatives may be simple, may involve


many in imaginative thought, or require a structured search.
There are always alternatives, if only to do nothing. The
availability and accuracy of data should be considered in the
context of time and cost constraints. Invariably, some
imperfection in the database will exist and the decision
maker will have to judge the risk that any omission or fault
would render a decision inappropriate or, at best,
sub-optimal.

Step 3 – if the data is financially quantifiable, this is often the


simplest part of the process. There is usually an appropriate
technique or model available for the evaluation (we will
examine one of these later in this section).

110 Accounting for Managers


Step 4 – this is to ensure that objective criteria are met – if not, then
further iterations of Steps 2 and 3 should occur, or the
process be abandoned.

Step 5 – this is the planning and control process, further explored in


Section 9.

problem recognition
Problem Analysis

Step 0
investigation and diagnosis

assess priority

Step 1
define objectives

identify alternatives
Step 2

ascertain data
Step 3

evaluate outcome and risks


Decision Taking

Step 4

compare with objectives

select action, expectation


and contingent arrangements
Step 5

implement

feedback

Figure 6.1 The decision making process.

Accounting for Managers 111


Decision relevance
The fundamental quality required of management accounting information is
its relevance to the decision context. Historic costs and book values prepared on
a going-concern basis mis-inform when used in a decision about factory
closure, plant replacement, acquisition, pricing, capacity planning, etc. In fact,
the use of any routine cost or profit data is fraught with danger because
accountants attribute nominal charges like depreciation and central
overheads. Decisions are always about the future and therefore only the
incremental financial consequences of taking or not taking a decision are
relevant. In practice, this means cashflow. When faced with a decision, ask the
question, ‘What additional cash will flow into and out of the business if we do
this?’

Characteristics of decisions
The nature of decisions, and the management accounting information that
supports them, is heavily dependent upon the level within an organisation at
which they are taken. Robert Anthony [Note 12] suggested that organisational
management can be classified into three components:

· strategic planning – the setting of aims, strategies and policies to


meet the organisation’s vision,

· management control – resource acquisition, deployment,


co-ordination, monitoring,

· operational control – organising and monitoring of specific tasks.

The problems encountered in routine operations (e.g. the rejection of a credit


card at an EPOS machine) are repetitive, and decisions can be programmed
(e.g. training check-out operators as to their response) because outcomes can
be predicted. In this way, operational control can be viewed as a feedback
system (see also Section 9 later) where a deviation from the standard process
occurs and corrective action is taken to return the system to equilibrium (e.g.
the sale is refused or alternative payment arrangements made).

[12] In Management Accounting, first published in 1956 by Richard Irwin.

112 Accounting for Managers


Strategic planning, except in extremely stable business environments,
involves an act of faith in the future – that the vision is approximately correct
and the strategies devised to achieve goals in the context of that vision are
successful. A high degree of uncertainty exists in the picture that the vision
portrays, the organisation’s position in it, and markets, competitive and
regulatory responses to the strategies. The strategic decision is
unprogrammed, as the outcome cannot be predicted with any certainty. It is
for this reason that strategic planning is often ‘emergent’ or ‘incremental’
(see Collier’s discussion in his Chapter 14) in that it is a small step away from
the present – the known. The significant value of forward-looking, external,
qualitative information is obvious in this regard.

Management control has elements of both strategic planning and operational


control, but its forward horizon is often defined by the budget, and its external
interaction limited to contractual interactions with customers or suppliers.
Traditionally, management accounting concentrates upon management’s
internal control of resources – budgeting (see Section 9) and costing (Section 8)
and insufficient attention has been paid toward pricing (Section 7) and leading
indicators of performance (Section 10). These are now being addressed in a
forward-outward re-orientation that will assist strategic decision making.

These three components are contrasted further in Table 6.1.

Strategic Planning Management Control Operational Control

Organisation level top, central middle, divisional bottom, local

Type of problem environmental systemic ‘irritations’


uncertainty

Nature of decision ‘big’, long-term, getting, using, mechanistic, reactive


futuristic optimising

Characteristics of aggregated, boundaried, current detailed, current,


information required predictive, external, and short-term, internal, certain
risk-based, contingent internal and tactical,
approximate

Table 6.1 The three components of organisational control contrasted.

Strategic management accounting


You are not here expected to understand the techniques that have been
developed over the last twenty years for better addressing the diverse,
dynamic business environment of today – these changes have occurred
because of developments in technology and of new structures for competitively

Accounting for Managers 113


organising in a global marketplace. You are expected to recognise that such
techniques exist and can be drawn upon to provide more relevant information
for strategic decision making.

Strategic management accounting techniques exhibit:

· an external focus that stresses relative financial performance:

- in markets, e.g. monitoring market size and share for competitive


position, brand valuation,

- for customers, e.g. customer profitability analysis, assessing the


cost of product attributes,

- for competitors, e.g. benchmarking and industry comparison,


analysing competitive advantage through the value chain,

· a forward looking perspective with an emphasis on value and risk,


e.g. value-based management techniques (as in Section 5), target
costing (see Section 7),

· project, not period, orientation, e.g. life cycle analysis (see Section 7),
investment appraisal (see this section),

· a combination of monetary and non-financial parameters, e.g.


balanced scorecard (Section 10), the performance pyramid and
performance prism, total quality management and just-in-time
philosophies (see Section 8).

Investment appraisal
The financial evaluation of productive investment opportunities is commonly
termed ‘investment appraisal’, and it is commonly used in decisions to buy
fixed assets since their benefits flow over many years (and are thus strategic
purchases). It can however, be applied to any project, including a product
launch, marketing campaign, and even corporate acquisitions.

Most of Collier’s Chapter 14 is devoted to an explanation and detailed


illustration of the four main investment appraisal techniques used by
organisations. You have already met return on investment (as an accounting
ratio in Section 3), but its validity for investment appraisal is flawed because it
ignores value and risk. We shall concentrate here upon discounted
cashflow, and the net present value (NPV) technique in particular.

114 Accounting for Managers


NPV has the important merit of being able to indicate those productive
investments that generate returns greater than the cost of their funding. It
therefore satisfies the primary financial criteria for strategic decision making.
NPV represents the theoretical change in the current economic value of a
business resulting from an investment in its future. It converts projected
cashflows into a present value by reducing them by a charge which represents
the risk-adjusted cost of capital. To see how this is done requires a minor
diversion into the ‘time value of money’.

Put simply, $1 today is worth more than $1 in the future since inflation will
reduce its spending power in terms of goods and services, and its value could
have been increased through investment over the intervening period. This is
an opportunity cost, since we are not able to use the $1 to, for example, buy
things whilst the money has, for example, been lent to someone else. Thus, we
make a charge for that loss of liquidity. We will also require compensation for
any price inflation which erodes the purchasing power of the money lent when
it is finally returned – if it is returned. And risk is the third reason for making
a charge – risk of non-payment, a risk that will depend on the riskiness of the
use to which the money is put.

Since the growth rate of money supply (inflation) and the availability of credit
(liquidity) will be consistent across an economy, it is the perceived risk of a
business and the projects in which it invests that will determine a credit rating
and thus the ‘price’ of the funds that are lent to its management. As first
discussed in Section 5 then, the cost of capital incorporates a risk assessment
and communicates a benchmark, above which productive returns must be
earned in order that economic value is created.

Interest is charged on a compound basis – that is, it is added to the principal


sum borrowed. The interest paid on $1 over a year @ 12% is as follows,

simple interest $1 ´ 0.12 = 12 cents

interest compounded annually $1 ´ 0.121 = 12c

interest compounded quarterly $1 ´ 0.034 = 12.55c

interest compounded monthly $1 ´ 0.0112 = 12.67c

and the resulting compounded amount (i.e. $1.1267) is called the terminal
value.

Rather than compounding amounts forward to determine a terminal value,


investment appraisal takes future cashflows and discounts them back to their
present value. This is so that the change in value is expressed in terms of the
time at which the decision is made. Discounting cashflows is valid for

Accounting for Managers 115


short-run decisions (i.e. less than a year), but since the effect of the time value
of money becomes immaterial, tends not to be used.

The technique is often applied to long-term decisions on a project-by-project


basis where the periodicity of compounding adopted is conventionally a year,

Cashflow y
Present Value =
(1 + Discount Rate) y

where y is the year – 1, 2, 3, etc. – the present year being equal to 0.

A discounted cashflow table is usually constructed on a spreadsheet. The time


of decision is set at year 0 and the initial investment and subsequent cashflows
tabulated. The discount factor is then calculated for each year and multiplied
by the cashflow in that year to determine its present value. Table 6.2 provides
a fairly typical layout.

Year Cashflow Discount Factor PV

0 Outlay =1 Column

1 Inflows = 1 ÷(1+Discount Rate) 2x3

2 = 1 ÷(1+Discount Rate)2

etc etc, with power = year

NPV = sum

Table 6.2 Discounted cashflow table layout.

The sum of all the present values is the net present value of the investment
opportunity. If the NPV is positive, then the project is financially viable; if
negative, not. The discount rate which results in an NPV of zero is called the
internal rate of return and indicates the break-even point in terms of the
cost of its funding. An illustration based on Project 2 in Collier’s Chapter 14 is
shown in Tables 6.3 and 6.4, and Figure 6.2.

116 Accounting for Managers


Year Cashflow Discount Factor Present Value
0 –125,000 1.0000 –125,000
1 35,000 0.8899 31,145
2 35,000 0.7919 27,715
3 35,000 0.7047 24,663
4 35,000 0.6271 21,947
5 35,000 0.5580 19,530
Net Present Value = 0

Table 6.3 Cashflow table, Project 2 (see Collier’s Table 14.7 where the discount rate is 12.4%).

Discount Rate NPV


0% 50,000
5% 26,532
10% 7,678
15% –7,675
20% –20,329
25% –30,875
30% –39,755
35% –47,301

Table 6.4 NPV values at different rates of discounting, Project 2.

Net £60,000
Present
Value
£40,000
Internal Rate of Return = 12.4%

£20,000

£0 Discount Rate
0% 5% 10% 15% 20% 25% 30% 35%

£20,000

£40,000

£60,000

Figure 6.2 NPV graph, Project 2.

Accounting for Managers 117


Here the IRR is 12.4%. If the cost of capital – upon which the discount rate is
based – is lower than 12.4%, the NPV is positive and the productive return
exceeds its cost of funding. As the discount rate increases, the NPV falls
further. Note that investment appraisal techniques that employ discounting
use the projected cashflows of a project and not future profits. Profits are
accrued, include arbitrary allocations like depreciation, but ignore working
capital which requires funding. Cashflows occur at discrete intervals and can
represent any monetary consequence relevant to a strategic decision.

Blackboard

Now check Blackboard for the details of your directed and other reading for this
section. You are expected to do all of the directed reading before carrying on.

Concluding Comments

Please work through the directed readings and examples available on


Blackboard.

Note when working out the exercises that the four techniques provide
inconsistent signals over the viability and ranking of the different examples.
This is because of theoretical limitations with the techniques, which are
discussed in the directed readings. You should remember that NPV is
considered to be the technique that will provide a correct indication for a
strategic decision in virtually all contexts and is therefore the approach that
should consistently be adopted.

Also note that in investment appraisal the discount rate chosen does affect the
viability of different projects. In the example on Blackboard experiment with
changes in the discount rate. You will be able to calculate an accurate internal
rate of return for the project by trial and error: if the NPV is positive, increase the
discount rate until the NPV becomes zero; if negative, reduce the rate.

118 Accounting for Managers


MN7006/D

MANAGEMENT ACCOUNTING

CASE STUDY PART I

Context: Dynamic
Demand
Management Accounting C ase Study Part I

Context: Dynamic Demand


This case material is factually based. Permission for its use has been granted
by Joe Short MProf MSc BSc, the founder of Dynamic Demand Ltd. The
scenarios used to explore management accounting concepts in Sections 6
through 10, are fictional and no implications should be drawn about their real
validity.

Introductory extracts from


www. dynamicdemand.co.uk
“Dynamic Demand is a not-for-profit organisation established in
January 2005 by independent academics, campaigners and engineers
dedicated to investigating new solutions to the challenges of climate
change.

“Dynamic Demand aims to promote the introduction of ‘dynamic


demand control’ technologies on the UK power grid by advocating
institutional change and stimulating research and discussion.

The technology

“Dynamic demand control is a technology that can be incorporated into


electrical appliances which enables them to provide important services
to the power grid such as peak load management and second-to-second
balancing of supply and demand. The government’s Department for
Environment, Food and Rural Affairs has already funded a laboratory
test of dynamic demand control refrigerators by Intertek. A fridge
needs electricity, but it doesn’t really care exactly when it gets it.
Fridges have large thermal storage. It should be possible to provide the
same stabilising service to the National Grid more cost-effectively

Accounting for Managers 121


using dynamic demand fridges. This means such a fridge could earn
money throughout its life.

“Any electrical appliance that is time-flexible (in other words, is not too
sensitive to when its energy is delivered) could be used. These could
include industrial or commercial air conditioners, water heaters and
refrigeration. Thousands (and eventually millions) of such loads acting
in aggregation could provide an extremely simple and cost-effective
way of helping to manage the power grid. To date, Dynamic Demand
has focused its attention on the potential for such services in relation to
domestic and industrial refrigeration.

“Research is becoming available which indicates that an aggregation of


such ‘intelligent’ loads could be extremely beneficial, for example by
smoothing out the minute-to-minute and hourly variations in demand
on the grid. This would replace certain types of back-up generation and
hence increase efficiency. In future, the technology could be used to
smooth the supply from renewable power. This could theoretically
allow a greater amount of renewables to be connected.

The economics

“At every second of every day, the National Grid must ensure that
electricity supply precisely matches the continually changing demand.

“Although most of the large changes in demand are predictable (such as


the peak which occurs around 6pm each day, when people all over the
country get home from work, switch on lights, and turn on many
electrical appliances), there are continuous smaller fluctuations which
are essentially random. And there is also always the possibility that a
sudden large fluctuation could occur at any time if a power line or
generating station fails.

“For these reasons, the National Grid pays for reserve which involves
certain power plants running at reduced output so they are able to
inject extra power into the grid as it is needed. The National Grid also
has to pay for some of these generators to go into a special ‘response’
mode whereby they continually change their power output to respond to
random changes in demand.

“These so called ‘ancillary services’ are expensive. Response alone costs


in excess of £80m per year and is likely to increase in price. Also, the
need for these services will increase because of the added
unpredictability of renewable energy sources.

“Dynamic Demand Control could provide many if not all of these


services for a fraction of the cost. Instead of the supply responding

122 Accounting for Managers


dynamically to unpredicted changes, certain sections of demand react
instead.

“This means, in principle, for example, if a refrigerator manufacturer


incorporated cheap controllers into their units, they could be earning
millions each year from the National Grid; with only a tiny increase in
the unit cost. Not only that – at the same time they could help the shift
towards greater use of renewable energy and help reduce carbon
dioxide emissions from the operation of the power system.

“The potential of this technology is a reduction in CO2 emissions of the


order of 2 megatons a year.

Political support

“The Climate Change and Sustainable Energy Bill, which carries a


clause requiring the Government to report on the potential for dynamic
demand technologies, passed its final stage in Parliament today (June
20th 2006). … the Bill says,

“The Secretary of State must, not later than 12 months after this
section comes into force, publish a report on the contribution that is
capable of being made by dynamic demand technologies to reducing
emissions of greenhouse gases in Great Britain.”

Megawot: strategic decisions


The following scenario is loosely based on fact and the operation of the
Emissions Trading Scheme is simplified and concentrates on the issues
relevant to us.

There is a consortium of largely European fridge manufacturers engaged in


developing the Dynamic Demand technology. Megawot is a fictional entity,
though the UK’s energy providers are commercial companies subject to a
public regulatory authority.

At the Kyoto summit on climate change in 1994, targets for greenhouse gas
emissions were agreed for 2012. Any country struggling to fulfil these legal
obligations could buy spare emission allowances from those that had been
successful. In this way, environmental damage could be turned into financial
penalty.

Accounting for Managers 123


For the European Union, the target was a reduction of 8% on 1990 levels.
Carbon dioxide (CO2) is one of the most significant pollutants, and the EU
allocated emission allowances that reflect its overall target amongst member
nations, who in turn allocate them to industry. 12,000 industrial plants have
individual allowances within the EU, amounting to about half the total CO2
emissions produced.

In 2005, the EU set up an Emissions Trading Scheme where these allowances


could be traded on the European Climate Exchange (ECX). The carbon price is
the price of an allowance to emit one metric tonne of carbon dioxide, and
‘futures’ contracts in these allowances are available up to the year 2012.
During 2006, the carbon price fluctuated widely between 10 and 29 Euros (¤)
and futures prices as at September 2006 were as shown in Table 6.5.

Year 2006 2007 2008 2009 2010 2011 2012

Price ¤12.00 ¤12.50 ¤15.50 ¤16.00 ¤16.50 ¤17.00 ¤18.00

Table 6.5 Carbon emissions futures as at September 2006.

Megawot supplies 50% of the UK’s electricity using a combination of gas and
coal-fired power stations. As gas is currently cheaper and less pollutive, the
base demand for electricity is provided by this fuel, leaving older, less efficient
coal-fired plants to meet the peak load. Megawot’s heavy reliance upon fossil
fuels means that it breaches CO2 emission allowances and therefore has to
purchase carbon credits (i.e. spare allowances) on the ECX, and these
represent a cost to its business. With rising demand for electricity, Megawot’s
cost of compliance with emission allowances will rise further – though of
course, it benefits from the profit made in supplying the additional electricity.

With rising public concern over climate change, Megawot – as a major emitter
of greenhouse gases – has been recently subject to organised protests outside
some of its coal-fired power stations. Adverse media coverage has damaged its
image. Megawot sees the ‘dynamic demand’ legislation and technology as
providing it with the scope to meet its supply obligations to the national grid
and balancing its load, thus reducing its dependence on coal-fired electricity
generation, and consequently its need for CO 2 emission allowances.

Megawot is willing to make a substantial contribution to a European


consortium of fridge manufacturers who are adapting the freely available
dynamic demand technology. It is expected that this technology can be
incorporated into new fridge and freezer ranges from 2008. Recognising that
the technology could make a considerable contribution to the UK’s
achievement of its national target under the Kyoto protocol, the government

124 Accounting for Managers


has agreed to prohibit the sale of new domestic refridgeration appliances
without the technology from 2010.

There are about 45 million domestic fridge/freezers in the UK. Their average
life is nine years. Three million new appliances are sold every year.

Exercises

Now try these exercises. Outline solutions are given in Appendix B.

(6a) Assume that every new appliance sold from 2008 is fitted with the
device, that Dynamic Demand’s assessment of savings in CO2
emissions is correct, and that Megawot will continue to supply 50% of
UK electricity generation. Work out the accumulated saving in CO 2
emissions for Megawot’s output between 2008 and 2022. (Note, a
megaton = one million tonnes.)

(6b) Evaluate the saving in carbon credits that would otherwise have to be
purchased (in ¤) based on the futures prices from the ECX. Assume the
annual increase will continue until the year 2022. These represent
cashflow savings to Megawot over the fifteen year period.

(6c) Megawot’s cost of capital has been stable at 10% since the year 2000,
but the share price has been in decline as concerns have grown about
the amount of investment needed in clean technologies with no
commercial gain. Megawot believes that the dynamic demand
technology will be regarded as a cheaper way to meet its obligation
and reduce its business risk. It therefore intends to use a discount rate
of 10% in its evaluation of the potential cashflow savings. Calculate the
present value of these savings over the 15 years to 2022 to determine
the maximum sum it should be prepared to contribute to the European
consortium development.

(6d) Identify potential inaccuracies in your evaluation.

(6e) What other strategic considerations would bear upon Megawot’s


decision to support this initiative? Consider the commercial future of its
coal-based plants, its social responsibilities, and other strategic
alternatives.

Accounting for Managers 125


MN7006/D

SECTION 7

Marketing Decisions
Section 7

Marketing Decisions

Learning Objectives

This section primarily concerns itself with pricing. The second and third
objectives in the Module Outline are particularly pertinent: to critically
question the parameters under which accounting information has been
provided and to call for appropriate accounting data. After studying this
section and its reading, you should:

· understand the limitations of cost-based pricing,

· understand the impact of volume and life cycle on costs,


prices and cashflows, and

· appreciate economics and market-based approaches to


pricing.

Simple notions of product profitability


In financial terms, marketing seeks to innovate and sustain products whose
revenues produce adequate returns on the asset base committed to their sale.
When we examined return on investment in Section 3, it was found to be both
a function of profitability and volume,

Accounting for Managers 129


Profit Sales
ROCE = ´
Sales Assets

You will also recall that margin is a useful indicator of profitability as it


relates costs to sales,

Sales - Cost of Sales


Gross Margin = ´ 100%
Sales

Accountants attribute costs to the sales to which they relate (Section 2), but
the basis of attribution varies [Note 13] so external users cannot be sure what
these costs contain.

Some of these costs vary with the volume sold (e.g. the purchase price of goods
sold in retailing or wholesaling), but others are more fixed in behaviour (e.g.
depreciation, rent, administrative staff) and are only partially affected by
changes in volume. This is good when sales are rising as the effect of
(operational) gearing means that there will be a greater than pro-rata increase
in profit. However, if sales fall a business with a substantial proportion of fixed
costs can easily find itself making a loss.

It is obviously important to know the ‘break-even point’ in sales above which


profits are made. For individual products, the break-even point can be
expressed in terms of units of product sold because,

Sales = Volume (in units) ´ Selling Price (per unit)

For internal purposes, the analysis of cost can reflect its behaviour in relation
to volume and accountants use the concept of ‘contribution’ to depict this,

Sales - Variable Costs = Contribution


Contribution - Fixed Costs = Profit

thus,

Contribution = Fixed Costs + Profit

So, if sales of $1m are made on volumes of 50,000kg, where the variable cost is
$8 per kg and fixed costs are $400,000,

[13] Common approaches include marginal costing, full (or absorption) costing, activity
based costing, and throughput accounting.

130 Accounting for Managers


Contribution = $1m - (50,000 ´ $8) = $600,000 [or $12 per kg]

= $400,000 + $200,000 profit

The break-even point is where contribution equals fixed cost, in this case
$400,000,

$400,000
= 33,333kg in volume
$12 per kg

= £666,666 in sales

From these linear relationships, charts can be drawn which depict the
break-even point for a business or a product. Examples of these and the
associated formulae are provided in Collier’s Chapter 10. This is useful for
marketers as they can target a minimum volume to be sold in a campaign,
however, this assumes that the selling price will not deter customer demand.
How do we set the price?

Cost, volume and pricing


Management accounting has traditionally concentrated upon cost and has
approached the issue of selling price on the basis of a mark-up upon that cost.
This will either be:

· Variable Cost + Contribution Mark-up, e.g. $8 + 150%,

· Full Cost + Profit Mark-up, e.g. $16 + 25%,

· Full Cost + Rate of Return, see Collier, Chapter 16 for this


derivative.

There are problems with any cost-plus approach to pricing. A contribution


basis is acceptable for short-term, capacity utilisation situations (e.g. stand-by
fares on airline travel) where any contribution toward fixed costs is welcome
because they are there irrespective of whether a sale is made. However, fixed
costs have to be covered if a profit is to be made and there is a danger that
these ‘marginal’ prices become entrenched (especially with the same
customer). In the example, the selling price of $20 implies a mark-up of 150%
on variable cost and there will be a temptation to ease this apparently high
percentage.

Accounting for Managers 131


A full cost basis threatens to make a selling price uncompetitive because of the
following circular logic. In the example, fixed costs are $400,000 on volumes of
50,000kg and the ‘overhead absorption rate’ would be 400,000/50,000 or $8 per
kg. When added to the variable cost of $8, a full cost of $16 requires a mark-up
of 25% to reach the selling price. Now, say demand was to fall to 40,000 kg at
this price. At this volume the absorption is only 8 ´ 40,000 or $320,000 and the
fixed costs of $400,000 are not fully recovered. So accountants will increase the
absorption rate to 400,000/40,000 or $10 per kg, and the full cost will ‘rise’ to
$18 per kg. Applying the established mark-up of 25% to this figure would drive
the selling price up to $22.50. So, at a time when falling demand is
undermining profitability, there is a pressure from cost accounting to increase
selling price – an action likely to exacerbate the trend in demand!

sales Profit
total costs

Volume

marginal
revenue

marginal cost

Volume

Figure 7.1 Profit optimisation according to economic theory.

Accounting has traditionally over-simplified the relation between volume,


selling price and profit. The break-even charts in Collier, Chapter 10 are
actually based upon economic theory: the left side of the upper part of Figure
7.1. Economic theory recognises the price elasticity of demand and that the
marginal cost (of an additional unit) will fall with an organisation's learning
curve and economy of scale. This means that selling prices are not constant
and fall to stimulate demand until sales reduce because the increase in volume
does not compensate for the reduction in price. Sales therefore reach a peak
beyond which price increases result in negative marginal revenue. The theory
indicates that profits are maximised when the increase in cost of selling an

132 Accounting for Managers


additional unit is greater than the increase in sales generated, i.e. optimal
volume occurs where,

Marginal Revenue = Marginal Cost

Collier accepts that, ‘CVP is used by accountants in a relatively simple


manner’ and identifies a relevant range on the graphs within which linear
interpolation is practicable. Marketing decisions, and pricing in particular,
require a more sophisticated contribution from management accounting.
Profits, we have learnt, vary in a partial, non-linear manner in relation to
volume sold. Profits also vary over time, in that passage through a product’s
life cycle will create different economic and competitive opportunities and
pressures upon demand, pricing and cost structures. This is examined now,
though you will find the life cycle in Collier’s Chapter 11, which forms the core
of Section 8 of this study book.

Life cycle analysis


A life cycle is the duration and pattern of a project’s, product’s, or company’s
existence. By analysing internal factors and external forces at different times
in the journey between the birth of an idea and the death of its life-form,
certain inferences can be drawn about a range of factors. Those depicted in
Figure 7.2 may be characteristic of a product innovation.

sales

profit

risk
birth

research

development

launch

growth

maturity

saturation

decline

death

cashflow

Figure 7.2 Product life cycle.

Accounting for Managers 133


Up to the launch of the product, cash flows out to fund product development,
equipment, marketing, and stock. Financial risks rise over this period in
parallel with funding. If the launch is successful, business risks abate but
cashflow remains neutral because growth will require expanded facilities and
working capital. During this period, selling price and profit per unit is highest
as the product has market leadership and demand outpaces supply.
Competitors will enter the field at discount prices and force margins down
until the market is saturated. Working capital remains constant and no
further investment will be made into product or process and cash is harvested.
During decline, volumes fall suppressing sales, and profits remain lower than
cashflow because development costs and fixed assets are being depreciated or
amortised over the product’s commercial life.

It is evident then, that prices and costs are dynamic over time and are not
simply subject to the influence of volume. The ability to command ‘high’ prices
results from product leadership or significant market share and these
advantages are likely to decline in time as competitors respond and demand is
satiated. Unit costs reduce with experience, value engineering and economies
of scale, but competitors following up the innovator will seek to reduce the cost
base further.

Product innovations which enable a dominant market share to be established


offer the best chance of securing the high price needed to recoup marketing
and research and development costs. The majority of unit production costs are
committed once design is complete, so value analysis involving the marketing
function’s understanding of what customers will value in the product and cost
analysis of various process and supply chain configurations at the design stage
is critical.

In evaluating commercial development, management accountants must not


take a static view of cost or advocate cost-plus pricing: a discounted cashflow
over the life cycle should be used and the decision made contingent upon the
net present value. In this way, changes in price, cost and volume can be
accommodated in the evaluation as well as investments in fixed and working
capital. Where the life cycle is expected to be short or the entry barriers to
competitors are minor, the key aim should be to recover the cash costs
incurred in the pre-launch stage rapidly. Finally, given that selling prices will
inexorably fall, it is important not to under-price at product launch and to
recognise that unit cost reduction must keep pace with this fall so as to protect
margins for as long as possible.

134 Accounting for Managers


Target costing
Target costing is an approach to pricing which incorporates the effect of the life
cycle on margins. Figure 7.3 shows the price and cost of one unit of an
innovative product. Both fall, the former from the launch date, the latter from
a prototype, until the mature stage of the life cycle is reached. At this point,
supply meets demand, selling price is stable, and competitors who have
developed similar products must be profitable to participate in the market.

Target costing assumes that the level of this profit will equate to the average
return on investment of the sector, and that by deducting this margin from the
forecast long-run price a unit cost can be targeted. If the product team believe
that cost can be reduced to the target cost in the time it takes to reach
maturity, then the product is viable and should be launched. To recover
development costs, a minimum margin must be maintained on the planned
cost reduction so that selling prices are also planned – starting at maturity and
working back to a ‘market-skimming’ price at launch. The direction of the
arrows on the price and cost curves indicates this process.

Money

long-run
selling price
selling price

sector
unit cost average
return

target
cost

Launch Maturity

Time

Figure 7.3 Setting a price profile under target costing.

Market pricing
For most businesses, products are not innovative or covered by patent, and
face many substitutes in the market: they do not possess significant market
share (and hence market power) and are ‘price followers’. The pricing decision

Accounting for Managers 135


is a tactical one, but always made with regard to the prevailing price in the
market.

An example of this is a loaf of bread offered by a bakery. If products have real


or perceived attributes that differentiate themselves from others, there is
scope for pricing at a ‘premium’ to the market average (e.g. organic food). The
building of brands and niches is a way of achieving this: a niche is a small
market segment where ‘local’ dominance is possible (e.g. luxury brands in
travel accessories). Differential pricing is possible where markets can be
segmented – by time, geography, quantity, etc. (e.g. the rail fare for commuting
and off-peak periods). Penetrative pricing is used to rapidly establish a
presence by under-cutting existing prices in an undifferentiated market (e.g.
low-cost airlines), but ‘deep pockets’ are necessary to withstand losses whilst
share is being built. This might be a particularly attractive approach where
the market is set for growth (e.g. cell phones), or economic potential is
substantial (e.g. China).

From these illustrations, it is evident that there is a wide range of pricing


strategies available, and whilst price is but one component in the marketing
mix, it is of central importance to profitability. From the discussion in this
section, it should also be evident that cost-plus pricing is discouraged, and that
the role of management accounting is to ensure that any pricing strategy will
cover costs over its term.

Blackboard

Now check Blackboard for the details of your directed and other reading for this
section. You are expected to do all of the directed reading before carrying on.

Concluding Comments

Please work through the set readings and exercises on Blackboard. These
readings demonstrate some of the scepticism about traditional accounting
approaches to pricing that have been explored in this section. Remember those
limitations as you work through the directed exercises on break-even and
contribution analysis. Consider what other techniques might be used in the
price-setting process and how they relate (or not) to accounting models.

136 Accounting for Managers


Make sure that you practise calculation of marginal costs, mark-up and
break-even points – these techniques, once mastered, can provide quick and
efficient evaluations of pricing decisions.

Accounting for Managers 137


MN7006/D

MANAGEMENT ACCOUNTING

CASE STUDY PART II

Pearl: Pricing Decisions


Management Accounting Case Study Part II

Pearl: Pricing Decisions


The dynamic demand technology, when applied to refridgeration appliances,
monitors the electrical input (from the power cable to the power supply grid)
and the programmed and actual temperature of the fridge.

For input, a balance in supply and demand is indicated by a 50 hertz cycle. If


demand for electricity rises on the grid, then the hertz level will fall below 50
until reserve power (e.g. Megawot’s coal-fired stations) is brought on stream.
Similarly, as demand ebbs in off-peak periods, the hertz level will rise above
50, until surplus power generation is shut down. The dynamic demand device
will cut off power supply to the fridge when excess demand on the national grid
is sensed (as the hertz level falls) and restore it when excess supply is sensed.
This switching action will only occur if the temperature of the fridge is within
tolerances programmed by its user. If temperature is at the upper end of the
specified range, then coolant circuits are activated irrespective of the status of
the national grid. If, however, the national grid is over-supplied, the device
will maintain cooling until the temperature reaches the minimum parameter.
In this way, the temperature of the food is kept within its normal range, but
the timing of electrical input shifts toward off-peak periods and thus helps the
balancing of supply and demand. At the heart of the technology lies a
micro-processor whose design is adapted to meet the requirements of each
manufacturer and range of appliances.

In 2007, many fridge manufacturers satisfactorily adapted and tested the


technology on prototype models of the new refridgeration appliances. Various
specifications have been issued by the manufacturers for the mass production
of micro-processors. A Korean micro-chip manufacturer was the first to bring a
processor to market. Originally designed for a single range of freezers, an
adaptable version is available at a price of 5 euro (¤) per unit.

Pearl Delta Manufacturing is a niche micro-chip manufacturer, specialising in


the audio industry in which it has established a reputation for quality and
reliability. The company has design and manufacturing facilities in Hong
Kong. Pearl has been approached by an EU refridgeration appliance company

Accounting for Managers 141


(Eurac) that has not previously sold into the UK market. Pearl has received a
design specification that will require it to commit considerable resources to
re-engineer for chip production. Eurac initially requires 300,000 units in 2009,
but the market in subsequent years could rise dramatically. It is expected that
other governments will follow the UK’s lead as a way to meet their Kyoto
commitments, and many ecologically-concerned consumers elsewhere in the
world are also demanding dynamic demand models.

Pearl has costed the design and production engineering resource required at
HK$1.5 million. The metallic, silicon and other raw materials are standard for
micro-chip manufacturer and minimal in cost – some HK$2 per unit;
protective packaging, a further HK$1. Shipment and air freight cost to the EU
for batches of 1,000 of these small, light-weight components is HK$5,000.
Micro-chips are manufactured in a highly automated, sterile environment, the
cost of which is almost wholly fixed. Pearl attributes a portion of this fixed cost
to each production order – in Eurac’s case, it would be HK$12 million.

Exercises

Now try these exercises. Outline soloutions are given in Appendix B.

(7a) Assuming Pearl prices its micro-chip in line with the Korean company,
calculate the contribution per unit, the net profit margin, and the
break-even point in units. Pearl wishes to recover the cost of design
and engineering over the first year’s order. The exchange rate of the
Hong Kong dollar to the Euro is 10HK$ = ¤1.

Interpret your result. Should Pearl accept the order?

(7b) By 2009, the Korean company will have established market leadership
with a 20% share. The UK market is 3 million units with a further 1
million in other EU countries and 1 million in the rest of the world as
the potential of the technology attains wider recognition. It is forecast
that the demand outside the UK will rise by 500% next year and will
continue to grow until 2017 at least. The mature market price of
dynamic demand chips is forecast to be ¤3. Because of past
over-ambitious investment, the global micro-chip industry has
significant under-utilised capacity and pricing is competitive. Average
net margins are low (4%), and returns on investment are barely
covering the cost of capital. Dynamic demand technology will help
redress the imbalance between supply and demand.

Pearl Delta Manufacturing has the capacity to produce 4 million


micro-chips per annum on a two-shift system. It is currently operating

142 Accounting for Managers


at 75% utilisation, including the Eurac order. If Pearl operated three
shifts, what would be the maximum annual production of dynamic
demand devices?

Assuming Pearl could find orders to utilise this uplifted capacity and
that 24 hour working would increase fixed costs by only 10%, what
would the fixed cost per unit become?

If the Eurac order’s size and variable costs are generally representative
but subsequent design and engineering costs could be halved per
order, what would the total unit cost of a dynamic demand micro-chip
fall to?

(7c) If Pearl is to fill this capacity, it will have to make approaches to a


wider range of refridgeration appliance manufacturers. With
consideration to the size of the market, the profile of the life cycle, and
its position in the market, would you advise Pearl to take this strategic
step?

If it enters the broader market, what pricing strategy should Pearl


adopt? Consider cost plus approaches, target costs, and the Korean
company’s price setting capability. Note that there is no single ‘correct’
solution.

The Euro and £ sterling have appreciated against the Hong Kong $ over
the last year. What implication might this have strategically for Pearl
Delta Manufacturing?

Accounting for Managers 143


MN7006/D

SECTION 8

Operating Decisions
Section 8

Operating Decisions

Learning Objectives

This section continues the theme of Section 7 in critically examining


management accounting practice in different contemporary contexts.
After studying this section and its readings, you should:

· appreciate how resource management is supported by


accounting,

· understand the innovative effect of TQM and JIT philosophies


upon management accounting, and

· recognise the problems associated with accounting for


services.

Resources
Operating decisions are about resources. They are about how management
select and organise resources to most effectively meet output requirements.
What are these resources? They can be referred to as the ‘five Ms’: money,
manpower, materials, machines, and managers.

Accounting for Managers 147


In more informative terms, resources include:

· physical infrastructure, including equipment, technology, software


and systems,

· bought-in supplies and services,

· staff, outsourced personnel, and their intellectual capital,

· funding for fixed and current assets, and for innovation and
development.

Resources are a means to an end, and so anything that is harnessed to achieve


organisation aims is a resource. In businesses, the outputs are sold and
resource management aims to deliver customer value and profit. In
not-for-profit bodies, outputs are public goods and resource management aims
to deliver value-for-money and efficiency.

Farming

Harvesting

Wholesaler

Canning
Processing

Refridgeration

Ready
Meals

Restauranteur Retailer (Grocer)

Consumer

Figure 8.1 A simplistic value chain for the food processing industry.

148 Accounting for Managers


The value chain, described in Collier’s Chapter 11, is a useful tool for
examining how resources are deployed and which activities are performed
within or external to the organisation. The purpose is to ask,

“Why are we doing it and why are we doing it that way?”

If an activity does not create value, or creates insufficient value, then we


should consider re-engineering it. If a resource is not economic or appears less
efficiently employed than by a competitor, we should seek an alternative
source or apply a different technology.

Consider food processing – Figure 8.1 shows a simplistic industry value chain.
The blocks and arrows show value-adding activities. The blocks include
organic produce from the farm gate to prepared meals at hotels (which may
have been bought in cook-chill packs). The arrows range from herding cattle to
market to pizza deliveries. Is each activity undertaken by a separate entity?
Why do some companies vertically integrate to different degrees and over
different ranges of the supply chain? Why do some outsource their logistics
while others have their own fleets? Why are some farms heavily mechanised
whilst others use manual labour? Why do some restaurants employ full-time
staff whilst others use casuals? Why do some processors out-source their
support functions?

By observation, research and analysis, we can form views of the relative costs
of operations and the value added at each stage of the chain. This informs the
strategic engagement of activities and resource dependencies.

Not-for-profit organisations (NFPOs) do not sell their primary outputs and


Michael Porter’s value chain is rarely applied (although it could be). However,
they should seek to provide value-for-money and this can be assessed by peer
comparison and trend analysis. A simple input-process-output model will
illustrate, as seen in Figure 8.2.

Resources Public Good


(money) (value)

INPUT PROCESS OUTPUT

Economy Efficiency Effectiveness


(cost per unit) (output/input) (non-financial indicator)

Figure 8.2 A value-for-money chain for not-for-profit organisations.

Accounting for Managers 149


Resources, which cost money and can be costed, are inputs to the process that
creates the product or service for beneficiaries (the ‘public good’). Unlike
commercial businesses who strive to stimulate demand but have readily
available resources, NFPOs have insatiable demand but limited resources. So
there is no market parameter (e.g. profit) to judge performance, and output is
assessed in terms of whether it has met organisational goals, i.e. its
effectiveness. Resources are invariably limited by funding, but can be assessed
in terms of the cost per unit of resource used (economy) and benchmarked.
NFPOs can be economical but ineffective, and they can achieve their goals at
huge expense, so value for money is measured in terms of some measure of
their output in relation to cost input: this is their efficiency.

To understand the model, consider the treatment of lung cancer. A measure of


economy is the daily cost per patient; effectiveness can be measured in the
survivorship rate after five years; efficiency can be measured in the average
treatment cost per survivor.

Accounting for resources


Management accounting originated in the costing of resources used to make
products. The costs of employment, bought-in supplies or services are directly
attributed to products and the residue treated as overhead (and subsequently
allocated to products on some basis related to the volume produced). The cost
of ‘machines’ is allocated by charging depreciation in the same manner as
overhead. This technique is called absorption and results in the full cost of
resources consumed being attributed between the products that are sold,
those that are finished but in stock, and manufacture that is still in progress.

Absorption costing is commonly applied to individual jobs or contracts, batch


manufacture, and continuous processes (e.g. oil fractionation). Note that the
cost of ‘money’ (i.e. interest and dividend) remains unallocated, and so
products are assessed on their operating profit with no regard to the funding
cost of the productive investment they entail.

Where production is repetitive, ‘standard’ rather than actual costs of resources


are often charged to products because the accounting procedure is too costly
and time consuming. Standard costs are estimated from industrial
engineering estimates of time and parts required, purchase, and employment
contracts. Actual costs emerge in the accounts from a complex, retrospective,
bulk analysis of the variance against the standard cost of manufacture.

In recent decades, overhead costs have risen as a proportion of total cost as


mechanisation has reduced labour’s direct involvement. Overhead has also
risen because of greater supervision and regulation. The accuracy of product

150 Accounting for Managers


costs and their consequent relative profitability has been questioned.
Absorption on the basis of the volume of production will understate the cost of
complex products manufactured in short-runs and overstate the cost of simply
designed, large batches.

Advocates of activity-based costing argue instead that it is activities rather


than volume that drives cost and overhead costs should be attributed to the
main activities (rather than functions) of an organisation. They should then be
absorbed into products using multiple criteria rather than solely a volumetric
parameter.

Marginal costing, which you first met in the last section, classifies resource
costs according to whether they vary with production volumes. In practice this
means that treatment of direct costs is similar to absorption costing. However,
marginal costing ignores fixed overhead costs when costing a product, writing
them off against profit in the period in which they occur. This will result in a
lower value of finished stock and different profits being reported than with the
other approaches. Nevertheless, decisions about volume changes (as we saw
with break-even analysis), product prioritisation, or resource constraints can
only be made using marginal costing. This is because fixed costs, by definition,
won’t change and are irrelevant to a decision and only marginal costing
recognises this. Similarly, decisions about whether to outsource parts of the
manufacturing process can only be made when the contribution foregone
toward fixed costs is considered. Examples of these decision scenarios are
provided in Collier, Chapter 11.

Advanced manufacturing environments


Developments in technology [Note 14] have enabled factories to be equipped
with manufacturing equipment and production control systems that provide
virtually perfect accuracy in meeting product specifications and schedules.
Alongside, or perhaps because of, this changes have occurred in
manufacturing philosophy that have a bearing upon operating decisions and
accounting information. Two of the philosophies are examined here: total
quality management (TQM) and just-in-time (JIT) purchasing and
production.

[14] Examples of these technologies are computerised design and manufacture,


robotics, automated material handling, flexible manufacturing systems, and
manufacturing resource planning.

Accounting for Managers 151


Total quality management (TQM)

Traditionally quality was the subject of independent, retrospective inspection


where tolerance was exercised over faulty products or components. The
rationale behind this was that the cost of reworking or scrapping
non-compliant outputs was offset by the higher manufacturing cost of
achieving assurance. There was therefore a balance to be sought in terms of
the level of quality and its cost. However, enhanced consumer protection,
lower customer tolerance, warranty claims and damage to brand image have
now made the costs of poor quality much greater.

TQM sets a standard of zero defects – popularly applied in the six sigma
statistical test – achieved through an all pervasive culture of quality where
everyone is responsible for compliance and for continuously improving the
process of manufacture. Independent inspections don’t occur as they relieve
responsibility and do not add value. Suppliers are, however, vetted and
required to have equivalent quality assurance protocols and culture. The
costing of prevention versus non-compliance is irrelevant and accounting
information has shifted toward the provision of non-financial indicators and
variance analysis against a perfect standard. Decision making over quality no
longer has a cost trade-off. As zero defects are an essential condition, the aim
of management accounting is to reduce the overall cost of its achievement and
devise measures to monitor continuous improvement.

Just-in-time (JIT)

primary product manufacturer retailer customers

Production Push

supplier base JIT purchasing JIT production customer

Demand Pull

Figure 8.3 Push and pull in the production line.

JIT has literally turned traditional manufacturing and costing orientations


inside-out. Historically, economy of scale dictated large batches where raw
materials and components were gathered together, pushed down the
production line, placed into stock and then sold. Production pushed sales

152 Accounting for Managers


activity (see Figure 8.3). Batch or mass production requires the line to be
operating close to capacity, tying up substantial capital in an array of plant,
work-in-progress, and finished stock. The potential for obsolescence is high.

With the arrival of advanced manufacturing technologies, set-up times could


be dramatically reduced with automated tool changing and process software.
Flexible manufacturing systems meant that one machine possessed the
functionality of many, and the length of the line could be reduced and
machines clustered in complementary cells served by multi-skilled artisans
and automated material handling systems (i.e. conveyors, pallets, and
fork-lifts). Production cycle times could be dramatically reduced and the
prospect of making to order became realistic, providing suppliers could deliver
stock as required. External electronic data interchange provided the
capability to interrogate suppliers’ materials management systems and
trigger delivery and replenishment.

JIT uses all these capabilities to pursue the goal of manufacturing to customer
order where that orders triggers a requirement in finished stock, a routing
through the manufacturing process, and a parts list to be satisfied by
upstream processes and suppliers. All this has to be incredibly rapid, flexible,
and of perfect quality since any component failure will delay the entire
assembly. Demand sucks the product along its supply chain.

Accounting documentation cannot keep pace with this speed and actual costs
are largely irrelevant since they would not be known until long after the
product had been delivered. Moreover, costs are largely irrelevant since the
installed capacity is fixed, the cells of direct workers are salaried, and only the
bought-in supplies will vary with volume sold. The key financial need is for
throughput to be high and, as with a pipeline of fixed diameter, this means
that the speed with which products flow through the process is critical.
Conventional costing priorities had to shift, as seen in Figure 8.4.

from Priority to

costs 1 inventories

sales 2 throughput

inventories 3 costs

Figure 8.4 The shift in priorities.

Inventories – stocks of raw material, work in progress, and finished goods –


are fundamentally antithetical to JIT’s philosophy as they provide a safety net
for failure to seamlessly link the supply chain to demand. They therefore

Accounting for Managers 153


inhibit the maximisation of throughput and therefore profit. In JIT profit is an
inverse function (f) of inventory such that,

æ 1 ö
Profit = f çç ÷÷
è Production Cycle Time ø

Profit = Throughput - (Fixed) Cost

Throughput = Sales - Purchases

Throughput
Throughput Accounting Ratio =
Production Cycle Time

Throughput accounting has evolved in response to the JIT philosophy and


is a variant of contribution in marginal costing. Variable costs, when deducted
from sales, leave contribution but only represent bought-in costs in
throughput accounting because labour costs are fixed. Moreover, since
inventories are absent, the bought-in costs are actually purchases from the
supply chain. This simplifies accounting [Note 15] and enables management
to concentrate upon filling capacity with products that have the highest
throughput accounting ratio and removing bottlenecks in production flow.

Cost management will focus on fixed costs and may use activity-based costing
as it provides a better analysis of overhead and its causation.

Finally, this re-orientation in management accounting priorities is coupled


with non-financial indicators that support continuous improvement in process
time (customer delivery time, production cycle time, supplier lead time),
productivity (of machinery and labour), and quality.

Service environments
Management accounting has traditionally concentrated upon manufacturing,
but service industries comprise an increasing, if not dominant, proportion of
our economies. Some services, like professional advice or plumbing, can use

[15] Cost book-keeping does not try to represent transactions through the production
process, but flushes aggregate purchases through the accounts when sales are
made, reducing administrative costs. This technique is called ‘backflush
accounting’.

154 Accounting for Managers


job costing. Mass services like energy distribution would benefit from
throughput accounting. Retailers can take gross margin further by adopting
direct product profitability which attributes the costs of space and time in
stock turnover and merchandising. However, none of these techniques deal
with the distinguishing feature of services which is, unlike products, they are
qualitative in nature and cannot be stored until required.

Fitzgerald et al (1991, as referenced in Collier, Chapter 11) developed the


results and determinants framework to address this deficiency. The
framework has multiple dimensions to reflect the breadth of factors involved
in operating decisions in a service environment. The key premise is that four
factors – quality, flexibility, utilisation, and innovation – determine the
resulting competitive and financial performance of the organisation.

The four determinants have a close similarity with important features of


advanced manufacturing environments in that quality is critical to sustaining
customer loyalty, utilisation is an imperative in a fixed and costly
infrastructure (e.g. a shop), and innovation and flexibility of resources are
essential to adapt to emerging market needs. Competitiveness stresses the
relative market share and position that we acknowledged as being significant
in Section 7. Finally, financial parameters include profitability, liquidity and
capital structure. Liquidity (see Section 3) comes with the vulnerability from
immediate consumption, and capital structure is a reflection of the risk
involved in funding a fixed infrastructure.

Blackboard

Now check Blackboard for the details of your directed and other reading for this
section. You are expected to do all of the directed reading before carrying on.

Concluding Comments

Please work through the set readings and exercises on Blackboard. These
exercises should provide a range of operational decision situations to examine
– try to consider the applicability of these exercises in ‘the real world’ as you are
working through them.

Management accounting is a discipline that continues to evolve and the


readings indicate some of the areas that are the subject of contemporary debate.

Accounting for Managers 155


Much of it will seem rather technical and superfluous to you, but it is important
to understand that changes in accounting techniques will change perceptions
of business performance. So, even though it is not necessary to grasp all the
different mechanisms of calculation, you should remember that they will
impact upon resource allocation decisions.

More generally, the readings also highlight the behavioural implications of


management accounting – which are of major significance in budgeting, the
subject of the next section.

156 Accounting for Managers


MN7006/D

MANAGEMENT ACCOUNTING

CASE STUDY PART III

Pearl: Operating
Decisions
Management Accounting Case Study Part III

Pearl: Operating Decisions


The manufacture of micro-chips is a highly complex process requiring
sophisticated plant operated in ‘clean’ fabrication environments. Pearl is a
small-scale producer specialising in bespoke integrated circuit design where
the fabrication involves multiple application of the physical technology
involved.

Deposition

Patterning

Etch
repeat until
complete
Ion Implantation

Annealing

Defect Review Scanning

Cutting

Testing

Packaging

Figure 8.5 Micro-chip production process.

In (very) simple terms, Pearl’s process involves the activities depicted in


Figure 8.5. (For an error-free interpretation, visit the demonstration at
http://www.appliedmaterials.com/HTMAC/animated.html). Pearl’s micro-chips are
made from silicon with layers of nano-scale circuits, separated by intervening

Accounting for Managers 159


insulation, and inter-connected at specific points on each circuit by copper
links. Silicon is a semi-conductor, in that it can be an insulator or, when
activated by ion implantation, a conductor. Circuits are ‘photographed’ onto
successive layers and their three-dimensional form revealed by etching.

The underlying ‘raw material’ is a 25cm diameter silicon wafer which is


purchased by Pearl and from which up to 1000 micro-chips can be obtained.
Eurac’s dynamic demand specification enables 500 to be made from each
wafer, but each requires five layers of circuitry. Pearl’s traditional market –
for audio devices – require only two layers, but are larger and only 200 can be
produced from a single silicon wafer.

This contrast has important implications for production scheduling and cycle
times as the copper inter-connections of the Eurac chips place greater
demands upon the deposition process.

The validity of the engineered design, accuracy of the process, and reliability
of the materials used are critical to sustained use of a micro-chip. Pearl Delta
Manufacturing is proud of its quality certification and uses six sigma as a
philosophy and statistical tool. Testing in its manufacturing process
comprises the identification of physical defects at each stage in layer
formation and inter-connection, and in individual testing of each completed
micro-chip. This occurs after they have been ‘cut’ from the wafer and takes the
form of insertion into an electrical wiring loom that mimics the inputs/outputs
of a Eurac refridgerated appliance under power from a public grid. Every
micro-chip that is produced is subjected to this application test, and six sigma
criteria have been fulfilled on the initial order for 2009.

The availability of each process for production depends upon set-up times,
preventative and incidental maintenance. Most processes have a single
computer-controlled machine, but others have two, partly because of need and
partly because of advances in technology. These include deposition of
conductive and insulating film, etching of photo-resistant chemicals, ion
implantation, and testing which requires different rigs for each user
application. Based on the planned three-shift working for 2010, the following
annual capacities are available:

deposition 10,000 hours


patterning 7,000 hours
etch 12,000 hours
ion implantation 8,000 hours
annealing 4,000 hours
defect review scanning 6,000 hours
cutting 5,000 hours

160 Accounting for Managers


Micro-chips for audio and dynamic demand applications have different
process cycle times. The average time in hours needed for a silicon wafer of
each type in each process up to cutting is shown in Table 8.1.

Audio Wafer Dynamic Demand Wafer


(hours) (hours)

Deposition 0.2 1.1

Patterning 0.1 0.3

Etch 0.2 0.5

Ion implantation 0.3 0.5

Annealing 0.1 0.2

Defect review scanning 0.1 0.3

Cutting 0.1 0.1

Table 8.1 Manufacture requirements for chip wafers.

Exercises

Now try these exercises. Outline solutions are given in Appendix B.

(8a) Pearl is reviewing its planned use of capacity in 2010. It assumes that
the volume of audio micro-chips will continue at their current level of
2.7 million units per annum. This should enable it to produce 3.3
million dynamic demand units on a three-shift system.

Calculate the utilisation of each process based on these volumes and


the capacities provided above. Is the planned production volume
possible?

Which process is a bottleneck?

(8b) The contribution from the sale of a dynamic demand micro-chip was
calculated in Part II of the case study at HK$42 per unit. The equivalent
contribution of an audio micro-chip is only HK$20 per unit.

If the deposition process is the bottleneck, it constrains the raising of


production volumes if demand is in excess of that planned. Calculate

Accounting for Managers 161


the contribution of each type of micro-chip in relation to this limiting
factor.

Should the level of production of audio micro-chips be reduced in


order to meet excessive demand for dynamic demand devices?

(8c) The average selling price of an audio micro-chip is HK$33 and its cost
is HK$30. A Shanghai manufacturer has offered to supply them for
HK$25. Pearl would have to spend an additional HK$1 on testing to
assure their quality and the supplier has agreed to replace any defective
chips free-of-charge. Should Pearl accept this offer?

(8d) A new machine that would increase deposition capacity by 50% could
be bought for HK$50m. If the additional capacity could be wholly
devoted to manufacturing dynamic demand devices would this solve
the problem? What else might need to be done?

(8e) Do Pearl’s operations lend themselves to the application of a


Just-in-Time philosophy?

162 Accounting for Managers


MN7006/D

SECTION 9

Budgeting Decisions
Section 9

Budgeting Decisions

Learning Objectives

This section addresses the second and fourth objectives in the Module
Outline: to critically question the parameters under which accounting
information has been provided, and to understand the relevance and
limitations of accounting data. After studying this section and its reading,
you should:

· understand the purpose and process of budgeting,

· understand its relation to strategic planning and organisation


management,

· appreciate its technical and behavioural limitations, and

· be able to compile a simple budget.

What are budgets for?


A budget is a plan, largely expressed in financial terms, and usually compiled
annually, that represents an organisation’s intentions regarding the
immediate future. Budgets are a model of resources – in quantitative, cost,
asset, and funding terms – that are anticipated to be required to meet sales

Accounting for Managers 165


targets and other strategic initiatives. Budgets differ from forecasts because
they convey intent.

Budgets may serve one or many of the following purposes:

· planning resource allocation (to meet strategic objectives),

· co-ordination and communication (to integrate activities and provide


direction),

· motivation (to achieve targets),

· control (by analysing variations in performance from that planned),

· evaluation of managerial performance (or unit or process


performance).

In many cases, these purposes may be in conflict.

Control theory
Budgeting is probably the quintessential activity associated with
management accounting practice. The notion that the future actions can be
objectively controlled is a comforting one. One that is based on the planning
model being an accurate predictor – the feed-forward system – and
management being able to correct any subsequent deviation from the plan –
the feedback system shown in Figure 9.1.

feed-forward
Strategic Plan feed-back

budgetary
One-Year Financial Plan control

budgeting

Resources Process Model Actual Performance

Figure 9.1 Budgetary control system.

166 Accounting for Managers


The characteristic of feed-forward systems like budgeting is that the model is
run iteratively until the predicted outcome is as desired: in other words, that
deviations from plan are anticipated in advance of them occurring (‘ex-ante’).
In contrast, feedback systems wait until actual outcomes have been measured,
deviations analysed, and causation corrected so that subsequent outcomes
return to plan (‘ex-post’).

The budgeting process is a feed-forward system, proactively attempting to


turn intentions into reality. Budgetary control is reactive, explaining
‘variances’ from budget in the expectation that by changing inputs (the
amount or allocation of resources) or process (utilisation/efficiency of
operations or marketing activities), future outcomes (profit) will converge
upon plan.

Budgeting systems, like organisations, are cybernetic and vulnerable to


changes in their environment and so it is commonplace for actual experience
to cause the model itself to be modified because it is inaccurate. Theoretically,
this phenomenon is regarded as a double feedback loop because the standard
against which actual outcomes are compared is itself being altered. This has
important implications for the usefulness of budgets during the control period
for which they were prepared (see later). Chaos theory, however, teaches us
that to try to force convergence in dynamic situations can either lead to
stagnation or a complete loss of control.

Budget preparation
The budgeting process is described by Collier in Chapter 16. The process itself
sits in three contextual frameworks:

· a time framework:

- budgets should be part of the wider strategic planning process


where strategies are formulated to achieve organisational aims
and evaluated in a medium-term financial plan. The budget
should be aligned with this plan and represents an annual step
along the strategic journey.

- the budget itself will be subject to discussion months before the


start of the year to which it refers. Once agreed, it has to be
phased over control periods (usually months) so that actual results
can be compared as they emerge. Only then is the control budget
issued to those responsible for its delivery.

Accounting for Managers 167


- during the control period, reports are generated to provide
feedback (budgetary control).

- as the budget becomes increasingly out-of-date, exercises are


commonly undertaken to re-forecast the ‘end-of-year’ position.
This does not mean that the control budget itself is modified,
although it might be.

· an organisational framework:

- the motivational purpose of budgeting involves the setting of


targets for individual managers and so the structure of a budget
replicates the structure of organisational responsibility.

- if hierarchies are organised by function, resource departments will


be designated cost centres and the marketing function has sales
targets. If a product-based organisational form is adopted, profit
centres will exist. If a divisional structure is present, then
responsibility for sales, costs, and certain assets will lead to a
budget not dissimilar to the principal financial statements covered
in Section 2. The division is designated an investment centre and
is commonly targeted on RONA.

- managers in charge of these budget centres will normally


participate in the preparation of their own budgets and negotiate
the targets with their seniors. This does not mean that some
budgets may be set from above or targets imposed on those
individuals responsible for delivery.

· a technical framework:

- rests with the budget co-ordinator (i.e. the management


accountant) who seeks to ensure that all budget participants have
a clear understanding of organisational goals, strategies,
macro-economic assumptions, reporting formats and timescales.

- sets the sequence with which subsidiary budgets are prepared to


ensure that they will come together to form an integrated whole.
It avoids, for example, a production manger budgeting close to
capacity where the marketing function predicts demand for only
75% of the output.

Figure 9.2 shows how these three contexts shape the preparation of the
budget. The result is validated against the outline parameters set by the
Board or budget committee which will, at a minimum, mean meeting the key
performance indicators envisaged in the strategic planning process. If it fails,
then a re-examination of subsidiary budgets occurs that can involve arbitrary

168 Accounting for Managers


cuts in discretionary areas of cost. Finally, the budget is submitted for
approval.

Strategic plan Organisational framework Technical framework

Budget Co-ordinator

KPIs projections
preparation of
subsidiary budgets
within organisation
demand
modelling
capacities

review Master Budget


priorities

validation

submit to board for approval

Figure 9.2 Budget preparation and contextual frameworks.

The master budget


The three principal financial statements comprise the master budget. Profit,
cashflow, and the opening and closing positions in the balance sheet are
projected for the year ahead. As with the double-entry principle in financial
accounting, the three statements are fully integrated and an illustration of the
flow of analysis for a manufacturer is given in Figure 9.3. The usual starting
point for a business is a market assessment, the prospect for orders, and the
sales budget. Where a resource is constrained – e.g. the production capacity or
supply of a specialist material – then a budget to optimise use of this resource
takes priority. Resource budgets, in quantitative and descriptive terms, are
normally prepared for production, buying, human resource, and productive
investment programmes. An example of the sequential process is
demonstrated in Tables 16.6 to 16.14 in Collier.

Accounting for Managers 169


debtors
sales receipts
production volume stock

purchases

materials

personnel labour
payments

overhead creditors

investment

depreciation fixed assets

resource profit cash balance


budgets budget budget sheet

Figure 9.3 Flow of analysis in building a budget.

Budgetary control

Control Actual Variance


Budget Result

Sales £20,000 £21,200 £1,200 (F)

Material Costs –£8,000 –£8,700 –£700 (A)

Gross Profit £12,000 £12,500 £500 (F)

Labour Costs –£5,000 –£5,250 –£250 (A)

Depreciation –£500 –£500 £0 –

Overhead –£5,500 –£5,350 £150 (F)

Profit £1,000 £1,400 £400 (F)

Units Produced 2000 2200

Units Sold 2000 2200

Figure 9.4 Traditional budget variance report.

170 Accounting for Managers


Budgetary control is the feedback of actual results against the budget. Reports
are frequently produced in the form shown in Figure 9.4 where the control
budget is compared with actual, and a ‘variance’ identified. It is important
that such reports are timely, even if that requires a sacrifice in terms of
absolute accuracy, that they reflect the area of control of the recipient, and
that a commentary is provided with recommended actions to correct adverse
variances and exploit those that are favourable.

In Figure 9.4, profit is £400 higher than budget with adverse variances on
material and human resources and a favourable position on overhead.
Depreciation is a fixed charge. Let’s assume that 50% of labour varies with
volume and overheads are absorbed on labour cost. You will note that the
volume produced and sold has increased by 200 units and we would expect a
related increase of 10% in all variable costs. If the control budget is ‘flexed’ by
the actual level of output, a different picture emerges, as seen in Figure 9.5.

Control Flexed Output Actual Variance


Budget Budget Variance Result

Sales £20,000 £22,000 £2,000 (F) £21,200 £800 (A)

Material Costs –£8,000 –£8,800 –£800 (A) –£8,700 £100 (F)

Gross Profit £12,000 £13,200 £1,200 (F) £12,500 £700 (A)

Labour Costs –£5,000 –£5,250 –£250 (A) –£5,250 £0 –

Depreciation –£500 –£500 £0 – –£500 £0 –

Overhead –£5,500 –£5,775 –£275 (A) –£5,350 £425 (F)

Profit £1,000 £1,675 £675 (F) £1,400 –£275 (A)

Figure 9.5 Flexed budget variance report.

With the sales increase of 10%, we would have expected a profit of £1,675 (the
flexed budget) and an increased contribution of £675. The sales variance has
reversed showing that selling prices were cut (£800A) to obtain the greater
volume (£2,000F). Savings were made in material costs (£100F) either
through reduced consumption, or because they were cheaper. The adverse
£250 variance in labour cost reported originally is entirely due to output and
productivity is as budgeted. Overall costs have been well managed.

This example illustrates the importance of adjusting the control budget by the
actual level of activity before any informative conclusions can be drawn about
the variances.

Accounting for Managers 171


It is not appropriate in this text to develop the analysis further as accountants
will undertake this but, as managers, you should expect a variance analysis to:

· identify cause and responsibility,

· classify the amount according to volume, price and efficiency factors,


and

· provide the basis for decisions about revising targets, reconfiguring


the process and resources, or even changing the model.

Criticisms of budgeting
The criticisms levelled at budgeting are technical and behavioural in nature.
Conventional control budgets are:

· fixed (there is no flexibility to cope with a change in output volumes),

· periodic (set for a year with a defined end date), and

· incremental (based upon last year’s actual plus a percentage).

These characteristics tend to inhibit opportunist, profit-conscious actions and


direct managerial attention on short-term operations, limit innovation whilst
sustaining non-value adding activities.

Alternatives to these three conventional forms are:

· flexible budgets – as demonstrated previously.

· rolling budgets – where a 12 month horizon is maintained by


preparing budgets every quarter; as a control budget for the next
three months, with out-quarters as outline forecasts. This approach
overcomes the inherent obsolescence in an annual budget and
ensures management are forward-looking.

· zero- or activity-based budgeting (ZBB/ABB) – whilst budgets based


on standard costs offer an objective or engineered basis for
calculating budgets for direct costs, they cannot overcome
incrementalism in overhead. ZBB and ABB require the justification
of discretionary expenditure by the budget holder – the former from
a zero-base (no preconceptions), and the latter by linking activities
to the chain of value.

172 Accounting for Managers


The behavioural consequences of budgeting stem from its role in placing
responsibility for achievement with the management hierarchy, and
especially from its link to personal reward. True, this is can be motivational if
genuine participation and ownership is enabled and a constructive response to
uncontrollable variances is present, but often budgets are imposed or
negotiations subject to obfustication and deception in order to create a cushion
for under-performance. Too often, there is a blame culture where adverse
variance attribution is avoided and causation disguised.

The ‘beyond budgeting’ round table advocates an enlightened approach to the


process involving greater devolution and discretion. Some major organisations
have gone further and eliminated budgeting altogether. Jack Welch, ex CEO
of General Electric,

“The budget is the bane of corporate America. It should never have


existed. A budget is this: if you make it, you generally get a pat on the
back and a few bucks. If you miss it, you get a stick in the eye – or worse
… making a budget is an exercise in minimalisation. You’re always
trying to get the lowest out of people, because everyone is negotiating to
get the lowest number.”

Budgeting decisions are about how you do it and why you are doing it, but the
most fundamental decision is whether you should do ‘it’ at all.

Blackboard

Now check Blackboard for the details of your directed and other reading for this
section. You are expected to do all of the directed reading before carrying on.

Concluding Comments

Please work through the set readings and exercises on Blackboard. Pay
particular attention to the cash budget, which is the most important in practice.

Consider examples of budgets that you have encountered both in and out of
work. How do people approach them and are they effective in what they
attempt to manage?

Accounting for Managers 173


MN7006/D

MANAGEMENT ACCOUNTING

CASE STUDY PART IV

Pearl: Budgeting
Management Accounting Case Study Part IV

Pearl: Budgeting
Pearl continues to prepare for 2010. Its optimism about the dynamic demand
market has been encouraged by a dramatic increase in requirement from Eurac, a
substantial purchase order from a US fridge/freezer manufacturer, and enquiries
and requests for quotations. In short, it appears that demand is currently
exceeding supply. Prices have remained stable since 2008, and show no sign of
falling over the coming year. Pearl has priced its dynamic demand micro-chips at
HK$45 – a 10% discount on the market leader with no currency risk. Table 9.1
shows Pearl’s projected sales for chips over the four quarters of 2010.

First Second Third Fourth


Quarter Quarter Quarter Quarter
Dynamic demand chips 700,000 1,000,000 1,300,000 1,600,000
Audio chips 800,000 500,000 700,000 400,000

Table 9.1 Pearl’s projected chip sales for 2010.

Pearl has raised the prices of its audio chips to HK$35 per unit, and expects
average contribution to rise to HK$22. The variable cost of the Eurac order
provided in Part II of this case study remains valid for the supply of dynamic
demand micro-chips.

To cope with the expansion, Pearl has ordered a new deposition machine for
HK$50m which will be installed during the second quarter. It has also
improved the productivity of its ion implanter by a technical upgrade from the
manufacturer. Other capital expenditure of HK$20m is expected during the
first half of 2010. The effect of these investments will be to provide adequate
capacity for the projected demand, but the annual depreciation costs for the
fabrication facility will rise to HK$125m.

Staff costs are projected to be HK$30m and other overhead HK$8m.

Accounting for Managers 177


Exercises

Now try these exercises. Outline solutions are given in Appendix B.

(9a) Evaluate the projected operating profit for the year overall.

(9b) Pearl’s balance sheet at the start of 2010 is shown below:

HK$m

Fixed Assets (net book value) 415

Stock – micro-chips awaiting despatch 20

– raw materials 2

Debtors 60

Cash 18

Current Assets 100

Bank Overdraft –

Creditors (15)

Current Liabilities (15)

Capital Employed 500

Long-term Debt (300)

200

Ordinary Share Capital 50

Reserves 70

Acc’ Retained Profit 80

Shareholders’ Funds 200

The new deposition machine will be leased over a four year period at
quarterly payments of HK$4m. The remaining capital expenditure will
be met from internal cashflow. A third of the long-term debt is due to
be repaid in September 2010 and interest payments of HK$31m on
outstanding loans are anticipated during the year. Customers take 90
days on average to settle their debts. Stock and creditors are expected
to maintain the levels shown in the opening balance sheet.

Prepare a cash budget for 2010.

178 Accounting for Managers


(9c) It is the end of 2010. Actual results for the fourth quarter have just
become available:

Quarter 4, 2010 Budget, Actual, Variance,


HK$m HK$m HK$m

Sales 86 83 3 (Adverse)

Variable cost –18 –19 1 (A)

Depreciation cost –33 –33 –

Staff cost –8 –9 1 (A)

Other cost –2 –2 –

Operating Profit 25 20 5 (A)

The volume of micro-chips sold – at 2 million – was as budgeted, but


because of a Christmas surge in sales of a new audio device,
production had to be switched away from dynamic demand
micro-chips – which fell to 1.2 million.

Prepare a flexed budget for the last quarter and reassess the variances.

Accounting for Managers 179


MN7006/D

SECTION 10

Performance
Management
Section 10

Performance Management

Learning Objectives

This section addresses the second objective in the Module Outline: to


critically question the parameters under which accounting information
has been provided and recognise the implications of this process and its
content. After studying this section and its reading, you should:

· understand the influence that performance metrics have upon


management behaviour, especially in a decentralised context,

· calculate the two principal measures of divisional


performance, and

· understand how perspectives in the balanced scorecard


inter-relate.

Dimensions of performance
The review of management accounting concepts in the second half of this
study book has been necessarily selective in order to display the scope for
decision support available to management. We have seen how context – both
in the decision and the organisation – shapes the relevance of information and
takes it beyond the financial, to the quantitative and the qualitative. We have

Accounting for Managers 183


seen how the three principal statements of external reporting reappear at the
summit of the internal pyramid of management information.

Monitoring corporate performance respects shareholder interests through use


of these statements, and the adoption of criteria that reflect their goals (as
seen in Sections 3 and 5). The internal monitoring framework is therefore
aligned to the objectives of the organisation and the factors critical to
successfully executing its strategy. As explained in the last section, budgets
are short-term paths along a strategic route and feedback provides regular
reports upon strategic progress. Thus corporate performance management
combines forward, leading indicators – which are often non-financial in nature
– with historical financial reports.

An example of this principle is the results and determinants framework


described in Section 7; another – the balanced scorecard – is explored here. If
the same performance parameters are consistently applied throughout the
organisation, the actions and decisions of managers are more likely to be
congruent with the direction set at the top. To reinforce this, the remuneration
of individual managers is often linked to the performance of the organisational
unit for which they are responsible (see Figure 10.1).

Corporate Goal

feed-forward

Individual Goal
feed-back

Individual Performance Individual Reward

Figure 10.1 Aligning individual reward with corporate goals.

This approach to performance management is apparent where organisations


adopt a divisional structure. The implications on managerial behaviour of
using corporate accounting ratios to measure the performance of the division
and its manager are examined later in this section.

Balanced scorecard
Probably the most well-known multi-dimensional performance framework,
the balanced scorecard is a generic model developed from empirical

184 Accounting for Managers


business practice by Robert Kaplan and David Norton in the early 1990s [Note
16]. It adopts four perspectives which are argued as having to be in balance for
successful strategic development. Each perspective contains goals and
derivative performance measures linked to the overall vision of the
organisation. They also contain targets and initiatives to reflect progress
along the strategic paths to that vision (see Figure 10.2).

Financial

Goals Measures

Targets Initiatives

Internal
Customer Business Process
Vision
Goals Measures and Goals Measures
Strategy
Targets Initiatives Targets Initiatives

Innovation
and Learning

Goals Measures

Targets Initiatives

Figure 10.2 The balanced scorecard model (after Kaplan and Norton, 1996).

The financial perspective ultimately represents the shareholders’ interest, but


it is recognised that shareholder value is driven by customer satisfaction. This
perspective, in turn, is driven by the excellence of internal business processes
and both are supported through new products, technology, and organisational
learning. Results in each of the three other perspectives are thus successive,
leading indicators of the financial result. Illustrative measures or criteria
include:

· financial perspective – return on investment, economic value added,

· customer perspective – market share, retention rates,

[16] As described in The Balanced Scorecard, published in 1996 by Harvard Business


Press.

Accounting for Managers 185


· internal business perspective – quality, productivity,

· innovation and learning – rate of innovation, time to market,


competences.

These might be routinely reported at Board level, but one of the characteristics
of the scorecard is that it can be cascaded down the organisation so that each
function and even individuals have a version that reflects their specific
contexts, but still retain the four perspectives. After all, every organisational
unit can develop, has a core role which it provides to a ‘customer’ (albeit an
internal one), and has a financial cost or value. In particular, corporate
parameters are mirrored where an organisation is divided into strategic
business units.

Divisional performance management


Divisions are mini-businesses within a more diverse corporate entity which
possess comprehensive, if not complete, functionality and responsibility for
their operational and financial performance (see Figure 10.3 for a rough
schema). They have a strategic integrity in that activities are logically
severable from other parts of the organisation and therefore the synonym
‘strategic business units’ is often applied.

(a) centralised (b) divisional

strategy
makers

managers divisional
manager

operations

divisions or sbus
(strategic business units)

Figure 10.3 Unitary-centralised and divisionalised-devolved organisation structures.

The overall rationale behind this decentralised structure is to differentiate the


focus on commercial operations for, say, a brand from that on strategic activity
at corporate headquarters. This approach to organisational form is in sharp

186 Accounting for Managers


contrast to the unitary hierarchy characteristic of functional structures where
there is a greater penetration of operational decision making at the top.
Decentralisation, however, places significant responsibility on the role of the
divisional manager as the principal link between headquarters and the
divisional unit, between the strategic and the operational.

Decision making will be much quicker and responsive to external markets at


divisional level than in a unitary structure, but the autonomy that facilitates
this can also lead to parochial actions that are not in the best interests of the
overall company. So there is a paradox at the core of decentralisation:
divisional empowerment is both motivational and dysfunctional.

Just as with agency theory and the relationship between shareholders and the
executive Board, the Board strives to ensure that divisional managers act in a
manner that does not disadvantage the company as a whole. The role of
management accounting is thus important in setting protocols for the pricing of
inter-divisional work and defining the boundaries of divisional responsibility.

The bases upon which the performance of the unit and its manager are
monitored may well differ because the cost of the remaining centralised
functions (e.g. IT services) are attributed to the division even though its
manager has no control over them. Table 10.1 illustrates how performance can
be differentiated between the divisional unit and its manager. The ‘total’ profit
includes a full attribution of cost, irrespective of source, and would be the
benchmark for comparing performance against other divisions. The
‘controllable’ profit represents the scope of autonomy of the manager and
would be used for the setting of personal targets and individual reward.

Controllable Uncontrollable Total

Sales 100 100

Variable costs (30) (30)

Contribution 70 70

Divisional overhead (45) (2) (47)

Central services cost (8) (8)

Operating profit 25 (10) 15

Managerial Performance

Divisional Performance

Table 10.1 Attributing performance in a divisionalised context.

Accounting for Managers 187


In addition to sales and operating costs, assets will be assigned for divisional
use – buildings, plant, inventories – but monetary assets and liabilities
relating to divisional receipts and payments may rest with a central credit
management function.

Strategic and working capital finance will remain with HQ and the division
will be funded from a corporate treasury. The divisional balance sheet will
thus have an abbreviated form and will represent the net asset value and the
central funding. The division can therefore be regarded as an investment by
corporate HQ, designated an investment centre (see Section 9), and charged
with making a return on the funds invested. Recalling the book-based
accounting ratios in Section 3, the relevant measure is return on capital
employed, appropriately reduced in scope and termed ‘return on investment’.
The calculation and consequences of adopting this and a competing measure,
‘residual income’, are now explored.

Return on investment (ROI)

Year 0 Year 1 Year 2 Year 3

Fixed assets – opening value 30 20 10

Depreciation (10) (10) (10)

Fixed assets – closing value 30 20 10 0

Current assets 45 45 45 45

Total assets 75 65 55 45

Operating profit 15 15 15 15

Return on Investment 20% 23% 27% 33%

Table 10.2 Static profile of ROI.

Return on investment is the divisional operating profit divided by the


divisional asset base. The net margin in Table 10.1 is 15% (15÷100). Let’s
assume it has equipment with a net value of 30 (and a remaining life of 3
years), and stock and work-in-progress with a value of 45. Its assets are 75 and
the unit’s ROI will be 20% (15÷75) as seen in Table 10.2. If the HQ treasury
can source funds at a cost less than the ROI of 20%, the division will continue
to enjoy investment.

188 Accounting for Managers


A divisional manager can increase ROI by:

· increasing profit or reducing assets,

· increasing profit by more than an increase in assets,

· reducing profit by less than a reduction in assets.

However, with a conventional depreciation policy, the manager can increase


ROI by also doing nothing! Assume the depreciation charge included in
controllable divisional overhead in the example is 10 (fixed assets of 30÷3
years life left). Now, it could be argued that operating profits would fall off
because maintenance costs would rise but, in the short run, this tactic will
raise divisional ROI and the manager’s ROI.

Year 0 3 year Total


annuity
Investment (21) – (20)
Annual cashflow 10 30
Annuity Factor [Note 17] 1.00 2.40
Present value (21) 24 3

Table 10.3 A present value analysis.

We saw from Section 6, that strategic investments should be evaluated using


the NPV technique. Let’s assume the division can buy a machine that would
cost 21 and increase annual cashflow by 10 for three years (see Table 10.3).
The Treasury could find funds for this at 12% interest. The present value of
this investment is 3 (positive) and it should be undertaken. However, its
immediate effect on ROI is to reduce it to 19%. This is because the ROI on the
new machine is 14% (profit of 10 – 7 depreciation = 3 ÷ assets of 21). So, the
divisional manager will not want to make a viable investment because its
return, whilst higher than the cost of capital, will lower the existing divisional
return. This is an illustration of dysfunction from decentralisation. 17

ROI is, however, widely-adopted. It is a relative measure that facilitates


inter-divisional comparison, irrespective of size. It ignores the time value of
money and the cost of funding the asset base and therefore lacks a benchmark.

[17] An annuity is a constant annual sum. Rather than multiply the same amount by
different discount factors in successive years, it is quicker to multiply the annuity
by the sum of the discount factors.

Accounting for Managers 189


Residual income (RI)
Residual income is not as popular as return on investment. It is an absolute
measure that includes a benchmark by deducting from profit a notional cost
for the division’s use of its asset base,

Residual Income = Operating Profit – a Notional Capital Charge

In the previous example, the notional charge could be based on a 12% cost of
capital and multiplied by the division’s net assets of 75, or 9 per annum. It is
possible however, to adjust this charge to reflect the relative level of risk
between divisions, so,

RI = 15 - 9
=6

If the RI is positive, then the division is generating an adequate return; if it is


negative then the return is insufficient to cover the cost of funding assets. The
decision rule is thus the same as in net present value appraisals, but RI shares
another commonality with the discounted cashflow technique: the NPV of
projected RI will be the same as the NPV of projected cashflows. This is
demonstrated in Table 10.4 using the previous machine investment example,
whose cashflows discount to a positive NPV of 3.

Year 1 Year 2 Year 3

Total assets (opening value) 21 14 7

Interest rate 12% 12% 12%

Notional capital charge 2.5 1.7 0.8

Cashflow 10 10 10

Depreciation (7) (7) (7)

Operating profit 3 3 3

Residual income (RI) 0.5 1.3 2.2

Discount factor (12%) 0.9 0.8 0.7

Present value 0.4 1.1 1.5

Net present value 3

Table 10.4 Discounting residual income using conventional depreciation.

190 Accounting for Managers


Residual income does suffer from the same disadvantage as ROI in that it will
naturally rise as assets depreciate (as in Table 10.2) and discourages
investment, however, this can be overcome by writing down the value of fixed
assets using the annuity depreciation method. The calculation is complex and
it is unnecessary for you to be aware of anything other than it produces a
consistent RI over the life of the asset and therefore does not distort decision
making. A summary of the results using this technique is shown in Table 10.5.

Year 1 Year 2 Year 3

Total assets (opening value) 21 14.8 7.8

Interest rate 12% 12% 12%

Notional capital charge 2.5 1.8 0.9

Cashflow 10 10 10

Depreciation (6.2) (7.0) (7.8)

Operating profit 3.8 3.0 2.2

Return on investment (ROI) 18% 21% 28%

Residual income (RI) 1.3 1.3 1.3

Discount factor (12%) 0.9 0.8 0.7

Present value 1.1 1.0 0.9

Net present value 3

Table 10.5 Discounting residual income using annuity depreciation.

The residual income is constant at 1.3, unlike the return on investment which
still rises over the three years, although at a reduced rate than if a
conventional depreciation policy had been used. Residual income is thus the
recommended criteria for divisional performance management.

Performance review
‘WYMIWYG’ is an oft recounted acronym that means ‘What You Measure Is
What You Get’. Performance measures influence behaviour, so influence
performance. From the market-based measures of Section 5 and the
accounting ratios of Section 3 to the budgetary targets of Section 9 and the

Accounting for Managers 191


internal parameters of Section 10, accounting records the score, changes the
score, affects the score.

The notion of agency extends from shareholder to manager to employee to


stakeholder, but the agent – in possession of greater information – is able, if it
chooses, to circumvent or manipulate the parameters of control for personal
advantage. The design of performance management systems has to be
carefully considered in this light and customised to context and culture.

This is also true of the information needed to support decisions in Sections 6, 7


and 8 where the essential quality is relevance to the decision situation, its
timing, and the knowledge, responsibilities and attitude of the decision
maker. The Economist once stated “profit is opinion” [Note 18], but so are asset
values, liabilities, share prices and costs. There is no absolute truth in any
financial number or accounting statement; there is simply a professional view
of what is fair, reasonable, and useful. Once you recognise this, then the
inaccuracy inherent in much information is easier to accept.

Non-financial and qualitative data adds depth and context to a financial


analysis. Leading indicators forewarn and therefore better equip us to make a
decision about the future. Externally sourced data equips us to perform more
competitively. ‘Accounting for Managers’ suggests that you, as future
recipients of accounting reports, manage the information that accounting
provides.

Blackboard

Now check Blackboard for the details of your directed and other reading for this
section. You are expected to do all of the directed reading before carrying on.

Concluding Comments

Please work through the set readings and exercises on Blackboard. The
principal reading examines the behavioural implications of choices made
regarding performance measurement, and the prices at which supplies are

[18] 2nd August, 1997, page 62.

192 Accounting for Managers


transferred between divisions. Such decisions have material effects on how
individual units may be judged and are frequently an area of heated debate
within organisations. Additionally, the readings highlight the conflict between
divisional autonomy and corporate interests. In neither case is there clearly one
right answer and questions of this sort highlight the way in which decisions
about accounting techniques influence the understanding of company
performance.

Accounting for Managers 193


MN7006/D

MANAGEMENT ACCOUNTING

CASE STUDY PART V

Pearl: Performance
Measurement
Management Accounting Case Study Part V

Pearl: Performance Measurement


Pearl Delta Manufacturing is an unlisted company. It was established in 1996
by Inoue, a senior engineer with a leading manufacturer of AV equipment, and
Li, a doctoral student of integrated circuit design. Equity funding came from
the extended families of the founders with the critical support of a long-term
loan from the AV manufacturer in exchange for a 50% holding of ordinary
share capital. The loan is still being repaid. No dividends have ever been
declared as any cash left after servicing the loan has been re-invested in the
business. The aim of the founders is to remain cash generative whilst growing
the business. The aim of the AV company, since Pearl has diversified into
non-audio markets, is to disengage from its investment within three years.

Pearl’s physical infrastructure is small scale, but almost entirely automated.


There are only 30 staff, half of whom are electronic engineers: they are
well-paid for the locality and staff turnover is very low. The founders adopted a
‘kaizen’ philosophy and encourage the involvement of all in continuously
improving business processes. The engineers are engaged in setting up the
automated plant, monitoring and testing the quality of its output. They are
also engaged in adapting customer specifications and designs for efficient and
effective manufacture. The fitness-for-purpose and durability of the
micro-chip is significantly influenced by this production engineering
competence. The liaison between Pearl’s engineers and the technical and
buying functions of customers is where intellectual capital is levered. Pearl
has built an enviable reputation in its chosen niches.

Accounting for Managers 197


Exercises

Now try these exercises. Outline solutions are given in Appendix B.

(10a) Draw up a balanced scorecard for Pearl Delta Manufacturing. Key


performance criteria for each perspective should be aligned with
organisational aims and strategies. Explain your choices.

(10b) The two founders are concerned, but not entirely surprised, by the exit
strategy of the AV company. Li recognises that sale of their 50% stake
could present an uncertain and unwelcome future for the close-knit
group of staff that have been established. Li proposes that Pearl be split
into two divisions, the first responsible for manufacture (MA) and the
second for design and engineering (DE). MA is capital intensive, whilst
DE is labour intensive and could be divested from the Pearl company if
necessary.

Inoue is close to retirement and is happy to manage manufacture,


leaving Li with control of the intellectual capital vested in the DE
division. Each division will draw upon its counterpart’s resources, but
the arrangement does not preclude either division from undertaking
work for independent parties.

The profit and capital employed of Pearl Delta Manufacturing have


been allocated between the two divisions as shown,

MA division, DE division,
HK$m HK$m

Profit 51 9

Capital employed 436 64

Calculate the return on capital employed and residual income for each
division.

(10c) Explain why divisionalisation and the use of divisional performance


measures like ROCE and RI could give rise to conflicts within Pearl
Delta Manufacturing, giving three illustrative examples.

How might these conflicts be overcome?

198 Accounting for Managers


MN7006/D

APPENDIX A

Solutions to Tutorial
Exercises
Appendix A

Solutions to Tutorial Exercises

Section 4
4.1 Accounting dates back to 2200BC in China, where it was used to
value wealth and assess performance. In the communist era,
accounting was part of the central economic planning system and
was industry-specific. Financial reporting enabled the centre to
monitor output, compare costs, provide funding, and vet the use of
those funds.

The gradual but consistent market oriented reforms that occurred


under Deng Xiaoping required modification in the form and purpose
of accounting. Accounting principles are defined by statute,
reporting requirements by the State Council and accounting and
auditing standards by the Ministry of Finance. Accounting
Standards for Business Enterprises is a conceptual framework
issued in 2000 and applying to state-owned companies, joint stock
companies, foreign enterprises, and most new companies.

The China Accounting Standards Committee within the Ministry issues


specific standards and intends eventual harmonisation with
international standards. The principles and content of a set of accounts
after 2005 should therefore be recognisable to a scholar of this text.

(adapted from Choi and Meek [Note 19])

[19] pp. 124–132 of International Accounting, 5th edition, published by Pearson in


2005.

Accounting for Managers 201


4.3 The first steps toward regulation on corporate governance were
taken in 1998 by the Confederation of Indian Industries in its
published Code of Conduct, but it was not until 2000 when the
Securities and Exchange Board of India made listing subject to
meeting the requirements of its Report on Corporate Governance.
This has recently been strengthened, but it falls short of ‘western’
practice in that there is no specific emphasis upon risk
management and the suitability of internal control mechanisms.

There is a requirement for 50% representation of independent


directors and the establishment of four committees, three of which
have similar roles to those covered in the Section, and a ‘corporate
governance’ committee responsible for setting the ethical conduct
of business affairs. Whilst there is no separation of the
Chairman/CEO role, there are restrictions on the number of
committees upon which any one director can sit. The liaison
between the Board and the shareholders is also more formalised,
including the requirement for a ‘Shareholders/Investors Grievance
Committee’.

Indian practice appears to share some commonality with the UK


system in that it is self-regulatory and not statutory, and requires
a going concern declaration. Compliance with the listing
requirement is, however, made the subject of audit certification.

Section 5
5.1 Operating Profit
ROCE =
Capital Employed

Capital Employed = Capital and Reserves + Long-term Liabilities

= $4m + £1m

= $5m

$1m
ROCE =
$5m

= 20%

202 Accounting for Managers


Earnings
ROE =
Shareholders’ Funds

Earnings = Profit after Tax

= Operating Profit - Interest Payable

= $1m - $0.1m

= $0.9m

Shareholders’ Funds = Capital and Reserves

$0.9m
ROE =
$4m

= 22.5%

1 Earnings
Earnings Yield = =
Price-Earnings Ratio Market Capitalisation

1
=
12

= 8.3%

$0.9m
Market Capitalisation =
8.3%

= $10.8m

Accounting for Managers 203


Dividend Payable
Dividend Yield =
Market Capitalisation

Dividend
Dividend Cover =
Earnings

$0.9m
Dividend =
2

= $0.45m

$0.45m
Dividend Yield =
$10.8m

= 4.2%

204 Accounting for Managers


MN7006/D

APPENDIX B

Outline Solutions to
Case Exercises
Appendix B

Outline Solutions to
Case Exercises

Section 2 – Introducing Next plc


(2a) Consistent year-on-year growth in sales which have tripled over
the decade. The profile of profits – on trading, after interest and
tax, and after dividends – reflects this substantial growth with one
slight dip in 1998. The absolute level of dividends is misleading
because Next’s repurchases have reduced the number of shares by
over 25%. In relative terms (that is on a per-share basis),
dividends have consistently risen. The repurchase programme is
also responsible for the reversal in the upward trend in
shareholders funds since the year 2000, see also Questions (2c)
and (2k).

(2b)

Capital Employed = Fixed Assets + Current Assets - Current Liabilities


= £562m + £912m - £756m
= £718m

or

Long-term Liabilities + Capital and Reserves = £462m + £256m


= £718m

Comparative figure for 2005 was £709m.

Capital employed is stable.

Accounting for Managers 207


(2c) Shareholders’ funds is the accumulated wealth of the shareholders
as reflected on the balance sheet. It is the total of capital and
reserves, and as such includes:

· the original capital issued by the company at the price at


which it was issued,

· the accumulated retained profits (i.e. the annual profit left


after distribution of the dividend),

· accumulated reserves.

Accumulated reserves can reflect many things, but include gains


or losses not passed through the profit & loss account. This could
arise through the disposal of an asset (e.g. a building) for a price
that differs from its book value. It can also arise where book
values are continually updated to reflect their realisable value in
the market (e.g. financial investments).

(2d) In Next’s case, there is a significant negative balance on reserves


(of £1.5 billion). This is largely due to the repurchase programme
where shares were bought back from the market by the company
at prices considerably in excess of those at which they were
originally issued. The nominal value of a Next plc share is £0.10.
Let’s assume it was issued at that price and then repurchased at a
market price of £5.00. The book-keeping entries would be:

CR Cash £5.00

DR Share Capital £0.10

DR Reserves £4.90

Since the balance on capital is normally a credit, this will result in


a reduction in reserves and even, as in Next’s case, negative
reserves.

(2e) The immediate cash position of a company should take account of


any bank overdraft because this is recallable without warning. For
Next, it has cash of £70m with an overdraft of £31m, and thus net
cash of £39m. In 2005, the bank overdraft was lower and the net
position was £50m.

It should be noted that a £100m bank loan was taken out in 2006,
but since this is only withdrawn if there is a breach of the loan
contract, it should not be treated as a deduction from cash even
though it is repayable within the ensuing year.

208 Accounting for Managers


(2f) Assets are payments that are expected to bring future benefit.
Pre-payments are in advance of the period in which they will be
treated as a cost – an example might be a quarterly rental for the
use of premises.

(2g) A non-current liability is an obligation to make payments after a


year into the future; it is for this reason often termed a long-term
liability. A pension obligation occurs where there is an anticipated
deficit on a pension fund that is the responsibility of the
employing organisation to make good. This occurs where the
actuarial assessment of future benefits to current and past
employees exceeds that of the re-invested value of currently
accumulated contributions.

(2h) Original Cost


Average Life =
Annual Depreciation

643
=
81

= 8 years

Accumulated Depreciation
Average Age = ´ Average Life
Cost

360
= ´8
802

= 3.6 years

(2i) By comparing the net additions (i.e. additions minus disposals) in


the year to the asset base at its start, an indication of the growth
in investment is possible.

For plant and fixtures, additions of £179m out-weighed disposals


(£20m) by 9:1 and showed a net growth of 25% on the opening
gross book value of £643m. If wear and tear is taken into account
(by using the written down value), the growth rate is even higher
at 27% ([179 – 20 – 65] ¸ 347). This could be compared with the
growth in sales of 9%, or even the growth in retail space (14%),
and indicates Next plc is financially supporting its growth
strategy.

Accounting for Managers 209


However, there have been no additions to freehold or leasehold
property – in fact there have been disposals – so it is likely that
Next has changed the policy on the ownership of retail space and
is renting new premises.

(2j) Property prices tend to rise – and have done so dramatically in the
UK over the long term. A policy that depreciated freehold
buildings by 2% per annum is therefore likely to severely
understate the realisable value of retail premises. Given the cost
of such premises is stated as £76m and that acquisition could have
been made 20 years ago, it is possible that sale could add
substantially to shareholders’ funds.

(2k) Next plc has cash in hand, current assets that cover current
liabilities, and fixed assets that cover the debt finance (i.e. the
loan and the bond). The growth in fixed assets and stock is
adequate to keep pace with the growth in sales, and there is no
sign of under-capitalisation (i.e. insufficient capital to fund
productive investment for the future). The shareholders’ funds
figure (of £256m) is low for a £3bn turnover business, but the
cause of this has already been explained (in Question 2c).
Providing retained profits sustain their current level, there
appears to be no problem in meeting the longer-term liabilities
and the balance sheet looks strong.

Section 3 – Next’s Accounts


(3a) The following notes might emerge from a quick review:

· sales have grown, but by less than 10% which is the lowest
rate in many years and reflects the CEO’s comment about
‘difficult trading conditions’,

· operating profit has risen by less than sales, so some costs


must have increased disproportionately,

· not unusually in a retail clothing business in such conditions,


there is evidence of price discounting as the costs of goods sold
has risen by over 10%,

· depreciation and lease rentals are also much higher, but we


know there has been major recent expansion in retail area,
the growth in sales is thus doubly disappointing,

210 Accounting for Managers


· there are no anomalous increases in interest or tax, and so
earnings are marginally up,

· the cashflow statement shows a managed position – £12m


movement in a £3bn turnover business; the free cashflow of
£230m after re-investing in operations has been used to pay
dividends and repurchase shares, both of which are
discretionary activities,

· in reviewing the detail of cashflows, note the expected


increases in stock, debtors, and creditors (because of business
growth), but reference to the balance sheet’s opening and
closing levels suggests the circa 20% rise in debtors is
excessive – perhaps management have granted more lenient
credit terms,

· use of a bank loan is evident from the cashflow statement, but


the balance sheet shows that it is repayable within the year
and will constrain management’s ability to repurchase shares
in the coming year,

· no other inconsistent movements are evident in the balance


sheet, but the (high) level of other creditors and accruals is
intriguing – the notes do not provide an adequate explanation
as to what they might be.

(3b) Operating Profit


Net Margin =
Sales

320
Next Retail = = 14%
2217

Next Directory = 15%

Next sourcing = 5%

Ventura = 9%

Operating Profit
Return on Capital Employed =
Assets

320
Next Retail = = 11%
2905

Next Directory = 9%

Accounting for Managers 211


Next sourcing = 16%

Ventura = 12%

Sales
Asset Turnover =
Assets

2217
Next Retail = = 0.8´
2905

Next Directory = 0.6´

Next sourcing = 3.3´

Ventura = 1.4´

UK = 2.1´

RoEurope = 3.3´

Middle East = 5´

Asia = 0.2´

Margins are highest in the retail and directory businesses, but


their ROCE is poor because of the low asset turnover. Given the
inflated attribution of assets, it is difficult to judge the efficiency of
these operations – it is particularly surprising that Directory has
the lower asset utilisation given the potential for more rapid
stockturn and the lower spatial requirements in this business.

Asset turnover is highest in Europe and the Middle East but,


without data on margins for these market segments, their
comparative profitability cannot be judged. The results for Next
sourcing are not reliable because its sales are internal and
therefore subject to artficially set transfer prices. It is evident that
investment is being concentrated on the Retail business in the
UK, but the relative level is greatest in Europe and Asia. The
Asian market is a recent initiative, but the amount of assets is
very high if it is a franchised operation.

212 Accounting for Managers


(3c) Measures:

Debtors
Debtor Settlement Period = ´ 365
Sales

415
= ´ 365
3106

= 49 days (for 2006)

= 46 days (for 2005)

Current Assets - Stock


Acid Test =
Current Liabilities

912 - 311
=
756

= 0.8 (for 2006)

= 0.9 (for 2005)

Debt
Gearing =
Debt + Equity

(298 + 100 + 3)
=
(298 + 100 + 3) + 256

= 61% (for 2006)

= 53% (for 2005)

Accounting for Managers 213


Operating Profit
Interest Cover =
Interest

471
=
22

= 21 ´ (for 2006)

= 23 ´ (for 2005)

Earnings
Return on Equity =
Shareholders’ Funds

313
=
256

= 122% (for 2006)

= 110% (for 2005)

Earnings
Earnings per Share =
Number of Shares in Issue

£313m
=
246.1m

= £1.27 per share (for 2006)

= £1.17 per share (for 2005)

The first two measures are indicators of liquidity. The average


settlement period of Next’s customers has extended since 2005.
The acid test has also deteriorated, although it is strictly an
examination of monetary assets and liabilities and more would
need to be known about the nature of other creditors, accruals,
and liabilities due within the year. In the context of the clothing
industry, stock can be more readily converted into cash through

214 Accounting for Managers


discounting. With cash in hand and a £450m draw-down facility,
liquidity is unlikely to present a problem for Next plc.

The second pair of measures relate to risk. Gearing has risen, but
the cover for interest on debt is generous. Equity has been
artificially reduced by the repurchasing policy of management,
and the asset base of the balance sheet can support more debt if
necessary. Technically, gearing is high but the risk is being
controlled by Next’s management.

The final pair represent shareholder returns and it is in these that


the benefit of the repurchase policy is evident. ROE is high and
increasing as earnings rise and shareholders funds fall. Similarly,
the persistent reduction in the number of shares in circulation
automatically puts upward pressure upon eps.

Section 4 – Next and the Impact of


Governance and International Accounting
Standards
(4a) A judgement on the impact can only be made on the comparative
figures since the results for the year ended and as at January
2006 have been solely prepared under IFRS, and we do not know
what they might have been under UK accounting standards.

The overall impact on both the balance sheet and the profit & loss
account appears to be negligible, though the deferred adoption of
IFRS7 does involve what was a materially significant amount –
£44m or 16% of the shareholders’ net asset value. Of the changes
implemented, the small net change hides substantial movement in
the classification of assets and liabilities: in particular, fixed
assets have risen by 6% and long-term liabilities have risen by
14%. Given that the historical cost convention is common to both
approaches, the inference from Next plc’s statement is that the
changes are due to where ‘fair values’ and not historical cost has
been applied (the main impact is actually due to restatement of
pension fund liabilities).

As we saw in the BP example, the application of different


standards can result in a different picture being painted of a
company’s financial position and can therefore alter the viewer’s
perception of that position.

Accounting for Managers 215


(4b) Going-concern is an accounting convention explained in Section 2.
It is the presumption that there is no known impediment to the
business continuing to trade in the future – fundamentally, that
there is no risk of insolvency. This means that asset values are
justified by their potential to generate future commercial returns
and liabilities that would arise in the event of difficulty are not
recognised.

The liquidation value of a business is likely to be much less than


even its historic cost as many of its assets are specific to the
business context. In Next’s case, its fixed assets include high
street property and vehicles which have general utility and, in the
case of the owned property, would fetch a value greater than
historically reported. However, as with any ‘fashion’ business, the
carrying value of its stock is vulnerable and could require heavy
discounting to liquidate – though there is a readily available
market. Its debtors are its customers and include store card
finance – they are not going to be susceptible to a write down any
greater than is usual through consumer credit risk. If Next were
not a going-concern, the major implication would be on liabilities
related to closure.

(4c) The following list is not exhaustive:

· comply or explain principle – Next have ‘complied’,

· going-concern declaration,

· three independent review committees,

· non-executive meetings without any executive influence,

· separation of role of chairman and CEO,

· affirmation of reasonable effectiveness of internal controls,

· considered use of auditors beyond compliance work (not


compliant with SOX),

· demonstration of shareholder communication,

· evidence of a coherent strategic planning framework,

· fair treatment of shareholders in the selectivity and timing of


announcements (avoidance of insider trading),

· transparency of governance practices (through the website),

216 Accounting for Managers


· formal review of Board effectiveness,

· various risk management dimensions (this point is enlarged


in Question 4d).

(4d) COSO Framework steps:

(1) Control Environment:

· The Board is responsible for major policy decisions


whilst delegating more detailed matters to its
committees and officers.

· The Board promotes the development of a strong control


culture within the business.

· The Board sets guidance on the general level of risk


which is acceptable and has a considered approach to
evaluating risk and reward.

· The system of internal control is designed to manage,


rather than eliminate, the risk of failure to achieve
business objectives and can only provide reasonable and
not absolute assurance against material misstatement
or loss.

(2) Risk Assessment:

· During the year the Board addressed the business risks


which had been identified as key, taking into account
any changes in circumstances over the period.

(3) Control Action:

· These (NEXT Brand) meetings cover all business


aspects of risk management in respect of the NEXT
Brand, including product, sales, property, warehousing,
systems and personnel.

· The Group’s management structure and timely and


continuous monitoring of key performance indicators
provide the ability to identify promptly any material
areas of concern. Business continuity plans, procedures
manuals, and codes of conduct are maintained in respect
of specific major risk areas and business processes.

Accounting for Managers 217


(4) Control Information:

· Key performance indicators are monitored daily and


weekly (at the NEXT Brand meeting).

(5) Monitoring:

· The Board confirms that it has carried out a review of


the effectiveness of the Group’s system of internal
control covering financial, operational, compliance and
… risk management.

· The audit committee also reviews the effectiveness of


the risk management process.

(4e) The forum – is purely internal and has a Board presence only
bi-annually. To be genuinely engaging in social responsibility,
participating external representatives of stakeholder groups,
including environmental advisors and pressure groups, would be
expected.

The aspects – represent an appropriate range of CSR dimensions.

The key facts and figures – only headline information is contained


in the study book and therefore the following critique is limited to
the selection of data that has been highlighted by Next plc.

Economic – no comment is made regarding Next plc’s contribution


to the countries in which it operates.

FTSE4GOOD – whilst a listing is commendable, the index is


essentially designed to exclude corporate investments in unethical
areas (e.g. tobacco, defence, etc.).

Suppliers – the presence of a Code of Practice is commendable but


hardly unusual for a high-profile company. The extent of audit
and adoption is not encouraging – less than 30% of factories in
less than 40% of countries. Why do Next plc not ensure that all
suppliers are Code of Practice approved prior to engaging in
business? We don’t know how many suppliers there are, but if the
number of factories is indicative, then it may be that the supplier
base is too large for Next plc to develop deep partnerships based
on dimensions beyond product quality and price.

Customers – are these volume-based criteria really measures of


responsibility toward customers?

218 Accounting for Managers


People – the illustrative statistics on maternity leave and pension
facilitation are encouraging.

Community – that Next plc engage in supporting communal


projects is commendable. Taken together, the financial
contribution amounts to 0.6% of earnings.

Environment – Next plc has a range of initiatives relating to


reducing the impact of its business operations on the environment.
We should note that less than a quarter of its stores actually
engage in recycling.

Next plc evidently recognise a responsibility toward society and


the environment. Whether the data demonstrates an adequately
socially responsible attitude is a matter of individual opinion.
Next plc have yet to publish their third CSR report.

(4f) Agency theory defines the primary external relation of a company


with its shareholders. It asserts that management acts as the
agent of shareholder interest and suggests measures by which
managerial interest is aligned, incentivised, and constrained by
various mechanisms (e.g. share option arrangements).

Stakeholder theory advocates a wider duty to all who affect or are


affected by the aims and operations of the company. Its advocacy
is either based on the ethical conduct of business relations with
society, or that engaging stakeholders is instrumental in
delivering financial rewards to all, including shareholders.

Next plc defines its stakeholders very narrowly – suppliers,


customers, employees – but these do represent Michael Porter’s
‘chain’, through which value is created. They are therefore the
‘instruments’ of financial reward for shareholders: sales, margins,
productivity, profit, dividends. Whether treating them fairly and
honestly is a minimum condition or a motivating force for their
engagement is arguable. Moreover, whether fairness and honesty
are sufficient qualities for an ‘ethical’ approach is highly
questionable.

It is suggested that, from the balance of policies and statements


made throughout their published reports, Next plc are very
shareholder centred.

Accounting for Managers 219


Section 5 – Next Share Prices and Share
Options
(5a) Share price is the market price of the share; exercise price is the
price provided by an option to purchase a share over some future
period; face value is the original denomination of the share
capital, and is represented on the balance sheet in the value of
ordinary share capital.

(5b) Market capitalisation is market value of the ordinary share


capital – it is the total market value of equity. It is calculated by
multiplying earnings by the p/e ratio or, as in this case, the
number of shares in issue by the share price,

246,000,000 ´ £17 (approx) = £4.2 billion

(5c) Value of debt capital is £401m; therefore,

401
Gearing = = 9%
(401 + 4200)

This contrasts with a gearing based on book values of 61% and


would lead to an entirely more relaxed conclusion about the
financial risk of Next plc’s capital structure.

(5d) Share price in 2001 is about £10, so there is a gain of £7 over five
years. In addition dividends of (27.5 + 31 + 35 + 41 + 44 =) 178.5
pence have been declared. In total, a return of £8.785 on an
investment of £10, or 88%. This can be annualised by taking the
fourth root of 1.88, which is 1.17 or 17% pa.

(5e) The £400m debt costs 4%, the £4.2bn equity costs 17%. The
weighted average is,

(400 ´ 4 ) + (4200 ´ 17)


= 165
. %
(400 + 4200)

220 Accounting for Managers


(5f)

2006 2005 2004 2003 2002 2001

Shares in issue (m) 246.2 261 265 287 331 336.5

Shares repurchased (m) 14.8 4 22 44 5.5

Average share price £15.00 £14.00 £10.00 £9.00 £9.50

2006 2005 2004 2003 2002 Total

Buyback payment (m) £222 £56 £220 £396 £52 £946

Dividend per share £0.44 £0.41 £0.35 £0.31 £0.28

Dividend payment (m) £108 £107 £93 £89 £91 £488

£1434m

(5g) There is a very significant alignment between the package and the
characteristics of financial performance. One incentive specifically
targets earnings per share, whilst the other targets share price
relative to the sector. Taken together, they can increase salary by
170%. In addition there is a further share price growth driven
incentive. The package has obviously been designed to fit the
financial objectives of Next plc but, with its singular pursuit of eps
growth, is it possible the financial strategy has fitted the package?

(5h) Average exercise price in 2001 was 502p, and these could be
exercised in 2004 when shares were about 1000p for a gain of
about 100%.

For 2002, exercise price was 606p, and the 2005 share price was
1400p for a gain of 130%.

For 2003, exercise price was 701p, and the 2006 share price was
1500p for a gain of 115%.

If an employee had contributed £250 per month or £3000pa, then


the total gain would have been,

£3000 ´ 345% = £10,350

Accounting for Managers 221


Section 6 – Dynamic Demand
(6a) Total potential saving 2,000,000 tonnes of carbon
dioxide pa

Total number of appliances 45,000,000

Annual saving per appliance 0.044 tonnes per annum

Megawot market share 50%

Futures price 2012 €18


2008 €15.50

Annual growth (sixth root) 7%

Megawot cost of capital 10%

Year Number of Megawot CO2 saving, Futures Cash Discount Present


appliances market tonnes price savings factor value
share

2007 1.000
2008 3,000,000 1,500,000 66,667 € 15.50 € 1,033,333 0.909 € 939,394
2009 6,000,000 3,000,000 133,333 € 16.00 € 2,133,333 0.826 € 1,763,085
2010 9,000,000 4,500,000 200,000 € 16.50 € 3,300,000 0.751 € 2,479,339
2011 12,000,000 6,000,000 266,667 € 17.00 € 4,533,333 0.683 € 3,096,328
2012 15,000,000 7,500,000 333,333 € 18.00 € 6,000,000 0.621 € 3,725,528
2013 18,000,000 9,000,000 400,000 € 19.26 € 7,703,375 0.564 € 4,348,354
2014 21,000,000 10,500,000 466,667 € 20.60 € 9,615,600 0.513 € 4,934,323
2015 24,000,000 12,000,000 533,333 € 22.05 € 11,757,551 0.467 € 5,484,984
2016 27,000,000 13,500,000 600,000 € 23.59 € 14,152,004 0.424 € 6,001,831
2017 30,000,000 15,000,000 666,667 € 25.24 € 16,823,795 0.386 € 6,486,301
2018 33,000,000 16,500,000 733,333 € 27.00 € 19,800,000 0.350 € 6,939,779
2019 36,000,000 18,000,000 800,000 € 28.89 € 23,110,125 0.319 € 7,363,598
2020 39,000,000 19,500,000 866,667 € 30.91 € 26,786,313 0.290 € 7,759,041
2021 42,000,000 21,000,000 933,333 € 33.07 € 30,863,571 0.263 € 8,127,343
2022 45,000,000 22,500,000 1,000,000 € 35.38 € 35,380,009 0.239 € 8,469,693

Thus accumulated savings are 8,000,000 tonnes.

(6b) Accumulated carbon credits are ¤212,992,342.

(6c) Maximum contribution to European consortium is ¤77,918,921.

222 Accounting for Managers


(6d) The replacement rate of existing fridges is partly due to the
incremental price of new appliances. The futures price has been
highly volatile and will be inaccurate, however, even in 2006,
carbon credits have risen to as much as ¤29 per tonne so the
projection may not be unrealistic. Cost of capital could vary
substantially over the 15 year period.

(6e) This initiative will reduce the need for Megawot’s coal-fired
generation – which is good in ecological and image terms, though
not necessarily in commercial terms. The initiative is aligned with
Megawot’s social responsibility aims. Is this the best use of ¤78m
(ca £50m) that Megawot could make in this respect? Alternative
investments could include clean technologies to reduce the
ecological impact of burning fossil fuels or renewables (e.g. wind
turbines).

Section 7 – Pearl’s Pricing Decisions


(7a) Contribution = Selling Price – Variable Cost

5000
Variable Cost = 2 + 1 + = HK$8
1000

Selling price = ¤5 ´ 10 = HK$50

Therefore,

Contribution = HK$42 per unit

And,

Total Contribution = HK$42 ´ 300,000 units = HK$12,600,000

Now, break-even occurs where contribution equals fixed cost,

Fixed Cost = HK$12m + HK$1.5m = HK$13,500,000

Operating Loss = HK$900,000

Sales = HK$50 ´ 300,000 units = HK$15,000,000

Profit
Net Margin = = –6%
Sales

Accounting for Managers 223


So,

Fixed Cost
Break-even (in units) =
Contribution per Unit

HK$13.5m
= = 321,429 units
HK$42

Contribution is positive so, providing Pearl has sufficient capacity


to manufacture the order, it should be accepted. The fixed cost is
so great that it results in a loss, but at least HK$12m of this cost
would have occurred anyway. Given that the potential UK market
could sustain Eurac for many years, the initial design and
engineering cost could be spread over many orders – ignoring it
would have resulted in a profit on this order. The break even point
is only 20,000 units above this first order, and if Eurac’s market
entry is successful, then this point could be easily reached. Pearl
should take a strategic view of this order as it enables it to enter a
new market with substantial potential.

(7b) Two-shift capacity is 4m units and current production 3m.

Three-shift capacity would be 6m and therefore maximum


production of dynamic demand chips would be 3m plus 300,000, or
3.3 million.

Pearl’s attribution of fixed cost for 300,000 units equals HK$12m.


As overall production is 3m units, Pearl’s total fixed costs are
HK$120m. These will increase by 10% to HK$132m. Spread over
6m chips, the fixed cost per unit is,

HK$132m
= HK$22 per chip
6m chips

HK$1.5m
Unit Cost (design and engineering) = = HK$2.5
2 ´ 300,000

Other Variable Costs = HK$8 per unit

Therefore,

Total Costs (per unit, revised capacity) = HK$22 + HK$2.5 + HK$8 = HK$32.50

This is a fall of over HK$20 from the unit cost of Eurac’s order of
HK$53.

224 Accounting for Managers


(7c) The global market currently (the year in the question is 2009) is
5m units; by the next year it will rise to 30m units, and will not
reach maturity for another nine years after that. There is
substantial demand potential, but even in 2010 Pearl could only
achieve a maximum 11% market share (3.3m / 30m). It is a price
follower. Providing it can maintain a cost profile that is below the
market leaders, a wider participation in the market is rational.
However, it should attempt to identify scope for product
differentiation by focus on market segments so as not to
precipitate a hostile reaction from the main micro-chip suppliers
to the market.

Projected unit cost is HK$32.50. Average industry margins are


4%. Therefore the minimum price that Pearl should consider is
approx HK$34.

Market leader prices are at ¤5 (or HK$50 equivalent), but these


can be expected to fall as competitive pressures build and product
maturity is approached, when a long-run price of ¤3 is anticipated.
Pearl has to price under the market leader, but should reject a
penetrative pricing strategy (i.e. a deep discount) as it hasn’t the
capacity to achieve a dominant market share.

Pearl should initially aim to widen its market presence at over ¤4


and be prepared to reduce this as general market prices fall.

Pearl should exit the market before maturity unless it can replace
(or expand) its manufacturing capability for a lower investment
than is currently the case, or otherwise reduce its fixed costs.

Accounting for Managers 225


Section 8 – Pearl’s Operating Decisions
(8a)

Volume Number of chips Number of


per wafer wafers required

Audio micro-chip 2,700,000 200 13,500

Dynamic demand micro-chip 3,300,000 500 6,600

Time per
Time per dynamic Dynamic
Three shift audio demand demand Total
capacity wafer Audio total wafer total requirement
(hours) (hours) (hours) (hours) (hours) (hours) Utilisation

Deposition 10,000 0.2 2,700 1.1 7,260 9,960 99.6%


Patterning 7,000 0.1 1,350 0.3 1,980 3,330 47.6%
Etch 12,000 0.2 2,700 0.5 3,300 6,000 50.0%
Ion 8,000 0.3 4,050 0.5 3,300 7,350 91.9%
implantation
Annealing 4,000 0.1 1,350 0.2 1,320 2,670 66.8%
Defect 6,000 0.1 1,350 0.3 1,980 3,330 55.5%
scanning
Cutting 5,000 0.1 1,350 0.1 660 2,010 40.2%

Intended volume of production is just within the capacity of the


deposition processes.

(8b)

Per micro-chip Per wafer Per hour in


depostion

Audio contribution $20 $4,000 $20,000

Dynamic demand contribution $42 $21,000 $19,091

No. Slightly more contribution to profits is made by devoting the


deposition process to audio micro-chips.

(8c) The total cost is irrelevant in a make or buy decision, since fixed
costs will not be saved. Contribution would fall from HK$20 per
unit to HK$7 (33 – 25 – 1).

226 Accounting for Managers


Pearl should reject the offer as the contribution foregone would not
be compensated by allocating freed capacity for dynamic demand
chips.

(8d) A new machine would increase deposition by 5000 hours per


annum. With a contribution per hour of HK$19,091, the machine
would pay for itself in less than a year. However, the bottleneck
would shift to ion implantation as shown in the table:

Volume Number of chips Number of


per wafer wafers required

Audio micro-chip 2,700,000 200 13,500

Dynamic demand micro-chip 4,000,000 500 8,000

Time per
Time per dynamic Dynamic
Three shift audio demand demand Total
capacity wafer Audio total wafer total requirement
(hours) (hours) (hours) (hours) (hours) (hours) Utilisation

Deposition 15,000 0.2 2,700 1.1 8,800 11,500 76.7%


Patterning 7,000 0.1 1,350 0.3 2,400 3,750 53.6%
Etch 12,000 0.2 2,700 0.5 4,000 6,700 55.8%
Ion 8,000 0.3 4,050 0.5 4,000 8,050 100.6%
implantation
Annealing 4,000 0.1 1,350 0.2 1,600 2,950 73.8%
Defect 6,000 0.1 1,350 0.3 2,400 3,750 62.5%
scanning
Cutting 5,000 0.1 1,350 0.1 800 2,150 43.0%

Only 700,000 additional dynamic demand micro-chips could be


sold per annum before ion implantation became the constraint and
deposition would only be 77% utilised.

However, if the capacity of ion implantation could be raised at the


same time by a quarter, a more balanced throughput would result
in over 2 million additional micro-chips being produced.

(8e) Not particularly. Raw materials are not diverse, have common
use, and are a relatively minor cost, so JIT purchasing has few
advantages. The cost of a stock-out in copper or silicon wafers is
huge because of the delay to manufacturing processes. It is these
processes where value is added and batch manufacture is
essential to limit the cost of setting up. Once produced,

Accounting for Managers 227


micro-chips would not be supplied individually or even in small
batches given their size, weight, and nature of transportation.
Pearl’s micro-chips are, in any case, bespoke and supplied to
customer order.

Section 9 – Pearl’s Budgeting


Q1 Q2 Q3 Q4 2010 total Selling Budgeted
price sales

Dynamic 700,000 1,000,000 1,300,000 1,600,000 4,600,000 HK$45 HK$207,000,000


demand

Audio 800,000 500,000 700,000 400,000 2,400,000 HK$35 HK$84,000,000

(9a) Budgeted Profit for 2010 would be as follows:

HK$ million

Sales 291

Variable cost – dynamic demand 36.8

– audio 31.2

–68

Depreciation cost –125

Staff cost –30

Other cost –8

Operating Profit 60

(9b) Pearl’s cash budget for 2010 is shown below. Note that Year End
debtors will be equal to fourth Quarter Sales such that,

Year End Debtors = (1.6m ´ HK$45) + (0.4m ´ HK$35)


= HK$86m

228 Accounting for Managers


Operating Profit 60

Depreciation 125

Increase in debtors – year end 86

– opening 60

–26

Operational cashflow 159

Capital expenditure –70

Lease finance 50

Debt repayment (100 + 3 x 4) –112

Interest payments –31

–4

Opening cash balance 18

Closing cash balance 14

(9c) Flexed budget figures for the fourth Quarter of 2010 would be as
follows.

Flexed Original Variance,


budget, budget, HK$m
HK$m HK$m

Sales – dynamic demand 54


(1.2m x HK$45)

– audio (0.8m x HK$35) 28

82 86 4(A)

Variable cost – dynamic demand 9.6

– audio 10.4

–20 –18 2(A)

Depreciation cost –33 –33 –

Staff cost –8 –8 –

Other costs –2 –2 –

Operating profit 19 25 6(A)

Variance due to mix of production = HK$6 million (adverse).

Accounting for Managers 229


Flexed Actual Variance,
budget, results, HK$m
HK$m HK$m

Sales – dynamic demand 54


(1.2m x HK$45)

– audio (0.8m x HK$35) 28

82 83 1(F)

Variable cost – dynamic demand 9.6

– audio 10.4

–20 –19 1(F)

Depreciation cost –33 –33 –

Staff cost –8 –8 –

Other costs –2 –2 –

Operating profit 19 21 2(F)

Variance due to pricing and efficiency = HK$2 million


(favourable).

Section 10 – Pearl’s Performance


Measurement
(10a) The aims of the founders are potentially in conflict with those of
the AV company. A harmonious set of criteria cannot be aligned
fully but could recognise the need for an exit strategy by
incorporating value into the financial perspective. Otherwise
criteria would follow the growth aspirations of the founders. The
following are suggested criteria:

230 Accounting for Managers


Perspective Criteria

Financial · shareholder value


· cash generation
· net margin

Customer · market share


· average unit selling price
· %tage failure of micro-chips in use

Internal Business Processes · Six Sigma failures


· plant utilisation
· staff satisfaction

Innovation and Learning · kaizen indicators


· rate of innovation
· design-production cycle time

The above selection is illustrative. Its choice is based upon the


following logic:

· the first two financial criteria attempt to address the


competing aims of the shareholders and the third is a key
parameter in the industry (as indicated in Part II of the case
material on pricing).

· the first two customer criteria also reflect the industry and, in
particular, the impact of the life cycle on Pearl’s market niche.
The third is a critical parameter for durability of the chip in
use. It might represent the number of warranty claims
received, the average number of failures per million supplied,
or the life before failure occurred. Any failure is likely to
trigger investigative action in order to identify and attribute
responsibility for its cause.

· the first of the internal process parameters is again related to


quality, but is a statistical measure aimed at reducing
failures to less than 1 in 3.4 million. The second is an
indicator of capacity, the importance and financial
implications of which were demonstrated in Part III of the
case material. The third recognises the importance of human
resources in the context explained in Part V – it might take
quantitative form (e.g. absenteeism), or be qualitative
through a survey of staff attitudes, or meaningful staff
suggestions toward continuing improvement. Given the small
number of staff, it is likely that informal monitoring will be
adequate.

Accounting for Managers 231


· the first criterion continues the theme of continuous
improvement by monitoring the number of initiatives. In a
leading technology business, the rate and speed of innovation
is critical to sustained success and these make up the
remaining criteria.

(10b) First,

MA division DE division

Profit, HK$m 51 9

Capital employed, HK$m 436 64

ROCE (Profit ¸ Capital Employed) 12% 14%

Also,

Residual Income = Profit - Notional Capital Charge


Notional Capital Charge = Capital Employed ´ Cost of Capital

MA division DE division

Cost of Capital 10% 10%

Notional Capital Charge, HK$m 43.6 6.4

Residual Income, HK$m 7.4 2.6

(10c) Conflicts will arise if either of the founders adopts a parochial


attitude where the interests of a division supercede those of Pearl
as a company. This will be aggravated if ROI or RI performance
criteria are regarded as targets, and start to influence
performance and actions. This is possible because both divisions’
returns are greater then the costs of funding their asset base, but
MA produces a higher RI but lower ROI than DE. Examples of
conflicts could include:

· investment in a financially viable machine that temporarily


reduces ROI or RI (especially likely in the MA division),

· the acceptance of a manufacturing order by MA from an


external design party which would breach capacity
constraints,

· the subcontracting of design engineering by the MA division


or manufacture by the DE division,

232 Accounting for Managers


· insistence on a transfer price that makes an external quote
uncompetitive in the market.

To overcome these potential problems, divisional performance


criteria should not be used as targets, monitoring devices, or as
bases for remuneration incentives. Issues and opportunities
should always be discussed from the perspective of Pearl Delta
Manufacturing, and continuing liaison should be maintained
between Inoue and Li and their personnel.

Accounting for Managers 233