Mbaz502 Accounting For Manager

ZIMBABWE OPEN UNIVERSITY
bp
Master of Business
Administration
Accounting For Managers
Module (MBA 502)
ZOU
Published by: The Zimbabwe Open University
P.O. Box MP1119
Mount Pleasant
Harare, ZIMBABWE
The Zimbabwe Open University is a distance teaching and

open learning institution.
Year: 2001, Reprinted 2004
Cover design: B. Pillay
Layout and Design :S. Mapfumo
Printed by: Benaby Printing and Publishing (Pvt) Ltd
Typeset in Garamond, 12 point on auto leading
© . .
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Authors: J. Mujuru
BSc. Hons (Econ)
MBA. ACIS.
X. Nyika
BSc. (Econ), MBA
Editor: D. Mupunga
Masters in Distance Education (Indira Gandi National Open
University)
P.G.D.D.E (Indira Gandi National Open University)
B.A. (UZ)
GradeCE, (UZ)
Content Reviews: J. Mujuru

BSc. Hons (Econ)
MBA. ACIS.
X. Nyika
BSc. (Econ), MBA
Forewor d To the student
The demand for skills and knowledge
and the requirement to adjust and
be an all-round performer in the field
of your own choice. Our course
change with changing technology, teams comprise academics,
places on us a need to learn technologists and administrators of
continually throughout life. As all varied backgrounds, training, skills,
people need an education of one experiences and personal interests.
form or another, it has been found The combination of all these
that conventional education qualities inevitably facilitates the
institutions cannot cope with the production of learning materials that
demand for education of this teach successfully any student,
magnitude. It has, however, been anywhere and far removed from the
discovered that distance education tutor in space and time. We
and open learning, now also emphasize that our learning
exploiting e-learning technology, materials should enable you to solve
itself an offshoot of e-commerce, has both work-related problems and
become the most effective way of other life challenges.
transmitting these appropriate skills
and knowledge required for national To avoid stereotyping and
and international development. professional narrowness, our teams of
learning materials producers come
Since attainment of independence from different universities in and
in 1980, the Zimbabwe Government outside Zimbabwe, and from
has spearheaded the development of Commerce and Industry. This
distance education and open openness enables ZOU to produce
learning at tertiary level, resulting in materials that have a long shelf life
the establishment of the Zimbabwe and are sufficiently comprehensive to
Open University (ZOU) on 1 March, cater for the needs of all of you, our
1999. learners in different walks of life.
You, the learner, have a large
ZOU is the first, leading, and number of optional courses to choose
currently the only university in from so that the knowledge and skills
Zimbabwe entirely dedicated to developed suit the career path that
teaching by distance education and you choose. Thus, we strive to tailor-
open learning. We are determined make the learning materials so that
to maintain our leading position by they can suit your personal and
both satisfying our clients and professional needs. In developing the
maintaining high academic ZOU learning materials, we are
standards. To achieve the leading guided by the desire to provide you,
position, we have adopted the course the learner, with all the knowledge
team approach to producing the and skill that will make you a better
varied learning materials that will performer all round, be this at
holistically shape you, the learner to certificate, diploma, undergraduate
or postgraduate level. We aim for products collaborate synchronously and
that will settle comfortably in the global asynchronously, with peers and tutors whom
village and competing successfully with you may never meet in life. It is our
anyone. Our target is, therefore, to satisfy intention to bring the computer, email,
your quest for knowledge and skills through internet chat-rooms, whiteboards and other
distance education and open learning modern methods of delivering learning to
all the doorsteps of our learners, wherever
Any course or programme launched by they may be. For all these developments and
ZOU is conceived from the cross-pollination for the latest information on what is taking
of ideas from consumers of the product, place at ZOU, visit the ZOU website at
chief among whom are you, the students www.zou.ac.co.zw
and your employers. We consult you and
listen to your critical analysis of the concepts Having worked as best we can to prepare
and how they are presented. We also your learning path, hopefully like John the
consult other academics from universities the Baptist prepared for the coming of Jesus
world over and other international bodies Christ, it is my hope as your Vice
whose reputation in distance education and Chancellor that all of you, will experience
open learning is of a very high calibre. We unimpeded success in your educational
carry out pilot studies of the course outlines, endeavours. We, on our part, shall
the content and the programme continually strive to improve the learning
component. We are only too glad to subject materials through evaluation,
our learning materials to academic and transformation of delivery methodologies,
professional criticism with the hope of adjustments and sometimes complete
improving them all the time. We are overhauls of both the materials and
determined to continue improving by organizational structures and culture that
changing the learning materials to suit the are central to providing you with the high
idiosyncratic needs of our learners, their quality education that you deserve. Note
employers, research, economic that your needs, the learner ‘s needs, occupy
circumstances, technological development, a central position within ZOU’s core
changing times and geographic location, in activities.
order to maintain our leading position. We
aim at giving you an education that will Best wishes and success in your
work for you at any time anywhere and in studies.
varying circumstances and that your
performance should be second to none.
As a progressive university that is forward

looking and determined to be a successful
part of the twenty-first century, ZOU has
started to introduce e-learning materials _____________________
that will enable you, our students, to access Dr. Primrose Kurasha
any source of information, anywhere in the Vice Chancellor
world through internet and to
communicate, converse, discuss and
Contents
Overview ________________________________________________ 1
Unit One: Background Information to Accounting
1.1 _______ Introduction ____________________________________________________ 5

1.2 _______ Objectives ______________________________________________________ 6
1.3 _______ What is Accounting? ____________________________________________ 6
__________ 1.3.1 Branches of accounting ___________________________________ 7
__________ 1.3.1.1 Financial accounting ____________________________________ 7
__________ 1.3.1.2 Financial management __________________________________ 8
__________ 1.3.1.3 Management accounting ________________________________ 8
__________ 1.3.1.4 Auditing ________________________________________________ 9
__________ 1.3.1.5 Tax accounting __________________________________________ 9
1.4 _______ Users of Accounting Information _______________________________ 9
__________ Activity 1.1 ___________________________________________________ 1 0
1.5 _______ Characteristics of Information from Financial Reporting ______ 1 0
1.6 _______ Organizations Influencing Accounting Practice _______________ 1 1
1.7 _______ Forms of Business Organizations ______________________________ 1 2
__________ 1.7.1 Sole proprietorships ____________________________________ 1 2
__________ 1.7.2 Partnerships ____________________________________________ 1 3
__________ 1.7.3 Corporations ____________________________________________ 1 3
__________ Activity 1.2 ___________________________________________________ 1 3
1.8 _______ Summary ______________________________________________________ 1 4
1.9 _______ References ____________________________________________________ 1 4
Unit Two: Principles and Concepts of Accounts
2.1 _______ Introduction __________________________________________________ 15

2.2 _______ Objectives ____________________________________________________ 16
2.3 _______ Nature of Accounting Principles ______________________________ 16
2.4 _______ Sources of Accounting Principles _____________________________ 17
2.5 _______ Financial Statements and Accounting Principles ______________ 18
2.6 _______ Nature of the Balance Sheet ___________________________________ 19
__________ Activity 2.1 ___________________________________________________ 20
__________ 2.6.1 The business entity concept _____________________________ 20
__________ 2.6.2 The going concern concept _____________________________ 21
__________ Activity 2.2 ___________________________________________________ 22
__________ 2.6.3 The money measurement concept _______________________ 2 2
__________ 2.6.4 The historical cost concept _____________________________ 2 3
__________ 2.6.5 The dual aspect concept (or duality concept) ____________ 2 3
__________ Activity 2.3 ___________________________________________________ 2 4
2.7 _______ Principles Relating To Income Statements _____________________ 2 4
__________ 2.7.1 The accounting period concept (also called the time _______
__________ period principle) _____________________________________________ 2 6
__________ 2.7.2 The conservatism concept _______________________________ 2 6
__________ 2.7.3 The realisation concept _________________________________ 2 7
__________ 2.7.4 The matching concept __________________________________ 2 7
__________ 2.7.5 The consistency concept ________________________________ 2 8
__________ 2.7.6 The materiality concept _________________________________ 2 9
2.8 _______ Summary ______________________________________________________ 2 9
2.9 _______ References ____________________________________________________ 3 0
Unit Three: Fundamentals of Accounting Transactions
3.1 _______ Introduction __________________________________________________ 31

3.2 _______ Objectives ____________________________________________________ 32
3.3 _______ Definition of Terms ___________________________________________ 32
3.4 _______ The Accounting Cycle ________________________________________ 33
__________ 3.4.1 Source documents: ______________________________________ 34
__________ 3.4.2 Subsidiary books of accounting __________________________ 34
__________ Activity 3.1 ___________________________________________________ 35
__________ 3.4.3.Double entry system _____________________________________ 36
__________ 3.4.4.The ledger ______________________________________________ 37
__________ 3.4.5 The trial balance ________________________________________ 37
__________ 3.4.6. Reporting on financial information ____________________ 39
__________ 3.4.6.1 The balance sheet _____________________________________ 39
__________ 3.4.6.2 Trading, profit and loss accounts _____________________ 40
__________ Activity 3.2 ___________________________________________________ 48
3.5 _______ Depreciation __________________________________________________ 51
__________ 3.5.1 Causes of depreciation __________________________________ 51
__________ 3.5.2 Methods of computing depreciation _____________________ 52
__________ 3.5.3 Treatment of depreciation _______________________________ 54
3.6 _______ Summary ______________________________________________________ 55
__________ Activity 3.3 ___________________________________________________ 55
3.7 _______ References ____________________________________________________ 56
Unit Four: Interpretation of Financial Statements
4.1 _______ Introduction __________________________________________________ 57

4.2 _______ Objectives ____________________________________________________ 58
4.3 _______ What is Interpretation of Financial Statements? _______________ 58
4.4 _______ Techniques Used in Interpretation of Financial Statements: ___ 58
4.5 _______ Interested Parties: ____________________________________________ 59
4.6 _______ Intended Results From Financial Statements Analysis _________ 59
__________ 4.6.1 Profitability _____________________________________________ 60
__________ 4.6.2 Solvency ________________________________________________ 60
__________ 4.6.3 Ownership ______________________________________________ 60
__________ 4.6.4 The market for the enterprise’s products/services ________ 60
__________ 4.6.5 Capital investment ______________________________________ 61
__________ 4.6.6 Financial strength ______________________________________ 61
4.7 _______ Ratio Analysis ________________________________________________ 61
__________ 4.7.1 Main ratios: _____________________________________________ 61
__________ 4.7.1.1 Profitability ratios: ____________________________________ 62
__________ 4.7.1.2 Liquidity ratios _______________________________________ 63
__________ 4.7.1.3 Efficiency Ratios ______________________________________ 64
__________ 4.7.1.4 Investment ratios ______________________________________ 66
__________ Activity 4.1 ___________________________________________________ 72
4.8 _______ Cash Flow Statements _________________________________________ 74
__________ 4.8.1 Sources and uses of cash ________________________________ 74
__________ 4.8.2 Importance of cash flow statements. _____________________ 75
4.9 _______ Summary ______________________________________________________ 79
__________ Activity 4.2 ___________________________________________________ 79
4.9 _______ References ____________________________________________________ 82
Unit Five: Management Accounting
5.1 _______ Introduction __________________________________________________ 8 3

5.2 _______ Objectives ____________________________________________________ 8 4
5.3 _______ Definitions of terms___________________________________________ 8 4
5.4 _______ Function and Environment of Management Accounting _______ 8 4
__________ 5.4.1 Need and relevance for accounting information _________ 8 5
__________ 5.4.2 Differences between financial and management _____________
__________ accounting ____________________________________________________ 8 5
__________ 5.4.3 Elements of Cost Accounting Systems ___________________ 8 6
__________ Activity 5.1 ___________________________________________________ 8 7
5.5 _______ Cost- Volume-Profit Analysis.__________________________________ 8 7
__________ 5.5.1 Introduction ____________________________________________ 8 7
__________ 5.5.2 Cost- Volume-profit analysis using the marginal income ____
__________ method _______________________________________________________ 8 8
__________ 5.5.3 Break- even analysis_____________________________________ 8 9
__________ 5.5.3.1 The calculated method ________________________________ 8 9
__________ 5.5.3.2 Break- even graphs ____________________________________ 9 1
__________ 5.5.4 Evaluation of cost-volume- profit analysis _______________ 9 7
5.6 _______ Pricing Decisions _____________________________________________ 9 8
__________ 5.6.1 Cost- based pricing approaches._________________________ 9 8
__________ 5.6.1.1 Total cost-plus mark-up approach _____________________ 9 8
__________ 5.6.1.2 Product cost plus mark- up pricing approach_________ 100
__________ 5.6.1.3 Variable cost plus mark-up approach. _________________ 101
__________ 5.6.1.4 Activity- based costing (ABC) ________________________ 102
__________ 5.6.2 Market-based pricing approach _________________________ 103
__________ 5.6.3 Product life cycle costing ______________________________ 104
__________ Activity 5.2 __________________________________________________ 107
5.7 _______ Standard Costing and Variance Analysis ______________________ 108
__________ 5.7.1 Uses of standards and standard costs ___________________ 108
__________ 5.7.2 Advantages of standard costing ________________________ 109
__________ 5.7.3 Materials standards and variances ______________________ 109
__________ 5.7.3.1 Materials price variance ______________________________ 110
__________ 5.7.3.2 Materials quantity variance ___________________________ 111
__________ 5.7.4 Labor standards and variances _________________________ 113
__________ 5.7.4.1 Labor rate variance ___________________________________ 113
__________ 5.7.4.2 Labor efficiency variance _____________________________ 114
__________ 5.7.5 Manufacturing overhead standards and variances _______ 115
__________ 5.7.5.1 Variable manufacturing overhead variances ___________ 116
__________ 5.7.5.2 Fixed manufacturing overheads variances _____________ 118
__________ 5.6.5.6 Total overhead variances _____________________________ 120
__________ 5.7.6 Sales standards and variances __________________________ 121
5.8 _______ Summary _____________________________________________________ 122
__________ Activity 5.3 __________________________________________________ 122
5.10 ______ References ___________________________________________________ 127
Unit Six: Planning and Control: The Budgetary Process
6.1 _______ Introduction _________________________________________________ 129

6.2 _______ Objectives ___________________________________________________ 130
6.3 _______ Definition of Terms __________________________________________ 130
6.4 _______ Budgeting and Budgetary Control ____________________________ 131
6.5 _______ Uses and Benefits of Budgets ________________________________ 132
__________ 6.5.1 Uses of budgets: _______________________________________ 132
__________ 6.5.2 Benefits derived from budgeting _______________________ 133
6.6 _______ Budget Making Process ______________________________________ 134
__________ 6.6.1. Budget preparation____________________________________ 134
__________ 6.6.2. Budget timetable ______________________________________ 135
__________ Activity 6.1 __________________________________________________ 136
6.7 _______ Master budgets _______________________________________________ 136
__________ 6.7.1 Steps in the preparation of a master budget ____________ 138
6.8 _______ Sales Budget _________________________________________________ 139
6.9 _______ Production Budget ___________________________________________ 140
6.10 ______ Cash Budgets ________________________________________________ 141
6.11 ______ Capital Budgeting. ___________________________________________ 142
6.12 ______ Flexible (Variable) Budgets ___________________________________ 143
6.13 ______ Zero Based Budgets __________________________________________ 145
6.14 ______ Incremental Budgeting. ______________________________________ 145
6.15 ______ Continuous Budgeting _______________________________________ 146
6.16 ______ Summary _____________________________________________________ 146
__________ Activity 6.2 __________________________________________________ 147
6.18 ______ References ___________________________________________________ 151
Overview
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Module Overview
W elcome to the MBA 502: Accounting for Managers a core

course in the Master of Business Administration program through
distance education and open learning.
It is not necessary for a professional manager to be an expert in account-

ing but, it is of fundamental importance that managers are able to read,
understand and interpret accounting and financial information in order
to make value-added decisions for the benefit of their organizations.
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Zimbabwe Open University 1
Accounting For Managers Module MBA 502
As part of your final assessment in this course, you are expected to com-
plete three assignments and submit them for marking. The copies of the
assignments and the dates of submission are provided by the ZOU MBA
office. The second part of your assessment is the final examination. Final
mark is made up of both the assignments and the final examination.
A synopsis of the broad areas covered by this accounting course is given

below.
Â Define accounting and outline the various branches of accounting;
Â Describe the basic accounting concepts and list organizations that

influence accounting practice
Â Draw up the traditional financial statements such as the income

statements, the balance sheet and the cash flow statements and to
understand the characteristics of information in these financial
reports
Â Conduct an analysis and interpretation of financial statements as

part of the decision making process;
Â Prepare and interpret the budgets and use them as part of the
decision making process;
Â Outline some basic management accounting concepts;
Unit one gives you the accounting background including the broad defi-
nition of accounting, areas covered by accounting and the uses of ac-
counting information.
Unit two covers basic accounting concepts and it includes the following
broad areas:
Â Explaining the concepts.
Â Describing how they are used in practice in the formulation of both

the income statement and the balance sheet.
Â Giving some illustrative examples of the practical application of

the accounting concepts.
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2 Zimbabwe Open University
Overview
Unit three deals with drawing up of the traditional financial statements

such as the income statements, the balance sheets and the cash flow state-
ments. The deals with, inter alia, the following:
Â The preparation and presentation of financial statements, includ-

ing the trial balance, the income statements, the balance sheet and
the cash flow statements.
Â Gives practical examples of the treatment of assets, profit or losses,

generation and uses of cash and depreciation.
Unit 4 deals with conduct an analysis and interpretation of the financial

statements as part of the decision- making process. The unit looks at the
interpretation of the financial statements in order to assist management
to make decisions. It includes the analytical and interpretation methods
such as ratio and comparative analysis.
Unit 5 covers the basic management accounting. It gives the back-ground

to the management accounting and also covers the following broad areas:
Â Background to management accounting.
Â Cost-volume- profit analysis.
Â Pricing decisions.
Â Standard costing and variance analysis.
Unit 6 dwells on understanding, preparing and interpreting of the budg-

ets and their use for planning and controlling purposes. It looks at plan-
ning and control process through a budget making process. It discusses
the budget making process, the different types of budgets and how they
are prepared including a number of illustrative examples of what to look
for in budgets. We also explain how the budgets are used for planning and
control purposes.
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Unit 1 Background Information to Accounting
1
Unit One
Background Information to
Accounting
1.1 Introduction
T he purpose of this unit is to give you the background information

on accounting. This unit covers the nature of financial and man-
agement accounting and analyses how the information flowing therein is
used by internal and external users such as management, shareholders,
bankers, financial analysts and government.
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Accounting For Manager Module MBA 502
1.2 Objectives
By the end of this unit, you should be in a position to:
* Define accounting accurately;

* Outline the various branches of accounting;
* Discuss the characteristics of information contained in financial
reports;
* List organizations that influence accounting practice;
* Describe the basic accounting concepts;
1.3 What is Accounting?

Accounting is the means by which we measure and describe the results of
economic activities. Whether one is managing a business, making an in-
vestment, an income tax return or paying a telephone bill, one is working
with accounting concepts and accounting information.
The purpose of accounting is to provide decision makers with informa-

tion useful in making economic decisions.
Accounting is often called the language of business because it is widely

used to describe all types of business activities. Every business investor,
manager and business decision maker needs a clear understanding of the
accounting terms and concepts if he or she is to participate and commu-
nicate effectively in the business community. The language of business
provides the answer in the understanding the world of business.
You will realize that the use of accounting information is not limited to
the business world alone. Individuals, companies, non-profit making or-
ganizations, cities, states and schools all use accounting information as a
basis for controlling their resources and measuring their accomplishments.
Accounting information is a tool, which should be used by managers to

assist them in business management and decision-making. While some
managers may not be expert accountants, they should endeavour to be
expert users of financial information derived from accounting statements.
In the modern business environment, you need to be familiar with ac-

counting concepts such as budgeting techniques and ratio analysis to as-
sist you in making correct and timely decisions.
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As you already aware, accounting is a practical subject, which requires a

fair amount of number crunching. You are expected to have a calculator
and besides the assignments given to you, you are required to do a lot of
exercises on your own.
1.3.1 Branches of accounting

The work that accountants undertake range far beyond that of simply
summarizing information in order to calculate how much it owes and
how much is owed to it. They have gradually got involved in other types
of work and this has resulted in the creation of new branches of account-
ing which are shown in fig1.1
Accounting
Financial Management
Auditing Taxation
Financial Management
Fig 1.1
These branches are closely related and do often overlap one another be-
cause they use the same accounting concepts.
We discuss each of these branches below:
1.3.1.1 Financial accounting
Financial Accounting is a more specific term applied to the preparation

and publication of highly summarized financial information of an entity.
The information is usually presented for the benefit of the owners of an
entity but management can also use it for planning and control purposes.
The information is also of interest to others e.g. employees and creditors.
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Financial accounting is usually referred to as the general-purpose infor-

mation describing the financial resources, obligations and activities of an
economic entity. It has a past orientation in that it uses historical data
and is constrained by the Generally Accepted Accounting Principles
(GAAP). These principles are to discuss later.
1.3.1.2 Financial management

Financial Management is a relatively new branch of accounting that has
developed over the past 20 years. Financial managers are responsible for
the setting of the objectives, making plans based on those objectives,
obtaining the finance needed to achieve the plans and generally safeguarding
all the financial resources of an entity.
Financial managers are much more involved in the management of an

entity than is generally the case with either financial or management ac-
countants. They also rely more extensively on non- financial data than
does the more traditional accountants.
1.3.1.3 Management accounting

Management accounting is another all embracing term, which incorpo-
rates cost accounting data and adapt them for specific decisions which
management may be called upon to make. It follows that the manage-
ment accounting system incorporates all types of financial and non-fi-
nancial information from a wide range of sources far beyond those used
by the traditional financial accounting. Non-financial information includes
such factors as the political and environmental considerations, product
quality, and customer satisfaction and workers productivity.
Management accounting involves the development and interpretation of

accounting information intended specifically to aid management in run-
ning the business. Managers use the information in setting the company’s
overall goals, evaluating the performance of departments and individu-
als, deciding whether to produce new lines of products and making all
types of managerial decisions.
Lastly, management accounting is concerned about the details of parts of

an entity, products, territories, etc and uses budgets as well as historical
records.
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1.3.1.4 Auditing
The checking of accounts and the reporting on them is known as audit-
ing. Once prepared, the accounts have to be checked in order to ensure
that they do not present a distorted picture.
Auditors are usually trained accountants who specialize in checking ac-

counts rather than preparing them. If they are appointed from outside the
organization, they are known as external auditors.
In a limited liability company the auditors are appointed by the share-

holders, and not by the management. The auditor’s job is to protect the
interests of the shareholders as they answer to them and not to anyone in
the management.
In contrast, internal auditors are the employees of the company who per-
form routine tasks and undertake detailed checking of the company’s
accounting procedures
1.3.1.5 Tax accounting

Tax accounting is accounting for tax purposes. The preparation of ac-
counts for income tax returns is a highly specialized and technical branch
of accounting. The accountants involved in tax work are responsible for
computing the amount of tax payable by both business entities and indi-
viduals.
To conclude this section, you realize that the fields of financial account-
ing, financial management, management accounting and tax accounting
are closely related and cannot be placed into neat categories. Account-
ants in practice usually specialize in auditing, financial accounting and
taxation whilst those working in industry or in the public sector are em-
ployed as management accountants
1.4. Users of Accounting Information

There are several users of accounting information. They are generally
divided into two groups; the internal and external users.
Internal users include shareholders, directors, accountants, managers and

other employees. This group of users requires the information for a number
of purposes. They require the information for short-term and long–term
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planning and controlling routine operations, decision-making, formulat-

ing of overall policies and to ensure that the organizations they are run-
ning are properly managed.
. External users include banks, investors, creditors, debtors, government

agencies and investment advisors. They use the information in various
ways including investment and lending decisions. Financial accounting
information is designed primarily to assist investors and creditors in de-
ciding where to place their scarce investment resources. Government agen-
cies also require the information for tax purposes.
Activity 1.1
* Define the term accounting.
? * Compare and contrast the branches of Financial Manage-
ment and Management Accounting.
1.5 Characteristics of Information from Financial

Reporting
Financial information has many characteristics and financial reporting
should provide information that is useful to the running of an entity. The
characteristics include the following:
Â Firstly, the report must have information useful to present to

potential investors and creditors in order to assist them in making
rational investment and credit decisions.
Â Secondly, it must be comprehensible to those who have a reason-

able understanding of business and economic activities and are
willing to study the information with reasonable diligence.
Â Thirdly, it provides information about the economic resources of

an enterprise, the claims of those resources and the effects of trans
actions and events that change resources and claims to those re
sources
Â Fourthly it presents information about an enterprise’s financial

performance during the period.
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Â Finally, to help users assess the amounts, timing, and uncertainty

of prospective cash receipts and from the dividends or interest and
the proceeds from the sale or redemption of securities or loans.
Both internal and external users use the financial information to make
decisions. Their use are not restricted to business entities only but is used
by different types of organizations. They are also used by non-profit mak-
ing organizations such as the clubs and government agencies
1.6 Organizations Influencing Accounting Practice

The generally accepted accounting principles of (or GAAP) are ground
rules in financial reporting that have been developed over the years. They
provide the general framework determining what information is included
in financial statements and how this information is to be presented. A
number of terms such as objectives, standards, concepts, assumptions,
methods, and rules are often used to describe specific generally accepted
accounting principles.
A number of organizations have been involved in the development of

the generally accepted accounting principles and in improving the finan-
cial reporting. These include the Financial Accounting Standards Board,
The American Institute of Certified Public Accountants, Securities and
Exchange Commission, The American Accounting Association, and The
International Accounting Standards Committee:
Â The Financial Accounting Standard Board,
Â The American Institute of Certified Public Accountants,

Securities and Exchange Commission,
Â The Financial Accounting Standards Board (FASB). This is

the most authoritative source of the generally accepted accounting
principles. It is a highly independent rule-making body, consisting
of members from the accounting profession, industry, government
and accounting education. It is allowed to issue Statements of
Financial Accounting Standards, which represent the generally
accepted accounting standards.
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Â The American Institute of Certified Public Accountants

(AICPA).
The AICPA is a professional association of certified public account-
ants which actively participates in many aspects of accounting
Â Securities and Exchange Commission (SEC).

The SEC is a USA governmental agency with the legal power to
establish accounting principles and the financial reporting require-
ments for public institutions. It adopts the accounting principles
developed by the private sector through the FASB and gives them
the force of law.
Â American Accounting Association (AAA)

The AAA is a body made up of accounting educators and it
sponsors studies on various accounting views.
Â The International Accounting Standards Committee (I ASC)

This is a worldwide body whose purpose is to formulate and
publish international accounting standards to be observed in the
presentation of financial statement. This is to ensure that they are
accepted worldwide. The body works generally to improve the stand-
ards and to harmonize the regulations, accounting standards and
procedures relating to the presentation of financial statements. Most
International accounting bodies are affiliated to this body.
1.7 Forms of Business Organizations

Business organizations are organized as sole proprietorships, partnerships
or corporations. The generally accepted accounting principles apply to
the financial statements of all the three forms of organizations. Below
we look at each form of business organizations.
1.7.1 Sole proprietorships

A sole proprietorship is an unincorporated business owned by one per-
son. Often the owner acts as a manager. This form of business organiza-
tion is common for small retail shops, farms, service businesses and pro-
fessional services such as law, medicine and public accounting. In fact the
sole proprietorship is by far the most common form of business organiza-
tion in Zimbabwe.
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From an accounting viewpoint, a sole proprietorship is regarded as a busi-

ness entity separate from the other affairs of its owners. From a legal
point of view, however, a sole proprietorship and its owner are not re-
garded as separate entities. Thus the owner is personally liable for the
debts of the business.
1.7.2 Partnerships
An unincorporated business owned by two or more persons voluntarily
acting as partners (co-owners) is called a partnership. Partnerships, like
sole proprietorships, are widely used for small business.
The owners of the partnership are personally responsible for all debts of
the business. From an accounting standpoint, a partnership is viewed as a
business entity separate from the personal affairs of its owners.
1.7.3 Corporations
A corporation is the only type of business organization that is recognized
under the law as an entity separate from its owners. The owners are
therefore not personally liable for the debts of the business and can lose
no more than they have invested in the business, a concept known as the
limited liability.
The corporations are the most dominant form of business organization in

terms of their business value and their business activity. They are made
up of two or more people who agree to be formed into a company for the
purpose of entering into business.
The importance of corporations is that their owners have limited liabili-

ties, that is, to the extent of the capital they have contributed into the
company.
Activity 1.2
* List the different forms of business organisations. Explain the
? relationships between the organisations and their owners. How
do these relationships affect the accounting systems?
* Compare and contrast the ownership of sole proprietorship
and partnership.
* In your opinion, what are the advantages and disadvantages
of Corporation?
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1.8 Summary
In this unit, we defined the term Accounting and discussed its various
branches such as financial accounting, financial management, manage-
ment accounting, auditing and taxation. We also discussed the users of
accounting and described the characteristics of financial reporting. We
also briefly described the organizations that influence accounting prac-
tice such as the American Institute of Certified Public Accountants and
Securities and Exchange Commission.
1.9 References
Robert N. Anthony, James S, Reece and Julie H. Hertenstein: Accounting:
Text and Cases. 9th Edition, 1995. Irwin McGraw-Hill. Boston
Prof. M.A. Fault, Dr P. C. du Plessis, S.J. Van Vuuren, Dr. A. Niemand
and E.Kock: Fundamentals of Cost and Management Accounting. 3rd
Edition, 1997. Butterworths, Durban
Meigs&Meigs, Bettner and Whittington: Accounting – The Basis for Business
Decisions. 10th Edition, 1996. The Mcgraw-Hill Companies Inc.,
New York
The Zimbabwe Institute of Chartered Accountants: International Account-
ing Standards Handbook (Revised in1997), Harare
Prof. Charles Horngreen, Prof. Gary L Sunden and Prof. William
O.Stratton: Introduction To Management Accounting, 10th Edition. 1996,
Prentice- Hall International, London.
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Unit 2 Principles and Concepts of Accounting
2
Unit Two
Principles and Concepts of

Accounting
2.1 Introduction
A ccounting has developed into a science with elaborate conventions,

postulates and terms that are specific and peculiar to the account-
ing usage and to the accounting profession. This unit outlines in sum-
mary form some of the commonly used terms and conventions funda-
mental to the whole body of accounting science. They should be well
understood as a basis of appreciating the whole concept of accounting.
You are required to master these as they form the basis of understanding
the rest of the topics covered in this module.
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2.2. Objectives
By the end of this Unit, you should be able to:
* define the accounting principles and state their char

acteristics.
* describe the nature of the various accounting conventions.
* give sources of accounting principles
* relate financial statements and accounting principles.
* explain the nature of both the Income Statement and the
Balance Sheet and the application of the conventions.
2.3 Nature of Accounting Principles

Principles of accounting generally refer to a set of rules and conven-
tions used in accounting. The word principle is used here to refer to “the
general laws, conventions or rules adopted or professed as a guide to
action or a settled ground or basis of conduct or practice” (Source: Ac-
counting: Text and Cases. 8th or 9th Edition by Robert N. Anthony, James
S, Reece and Julie H. Hertenstein.).
Note that the definition describes the principle as a general law or guide
to action. The above means that accounting principles do not prescribe
exactly how each event occurring in an organization should be recorded
but gives the general principles of how the events should be recorded.
Many matters of accounting practice differ from one organization to an-

other. These differences are inevitable because a single detailed set of
rules could not conceivably apply to every organization. The differences
reflect that within the generally accepted accounting principles, the ac-
countants have considerable latitude to express their own views and ideas
as to the best way to record and report a specific event.
The following are some the characteristics of accounting principles that

operate in an organization:
Â They originate from a combination of traditions, experience of

accountants in their respective organizations and official decree
either by the accounting bodies such as the Financial Accounting
Standards Principles (FASB) or as the case in Zimbabwe, the
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Council of the Institute of Chartered Accountants or by governments

passing some of the rules into legislation.
Â They require authoritative support and some means of enforce-

ment. A number of organizations discussed below give the required
authority and support and help in enforcing the principles.
Â They may change over time as shortcomings in the rules existing

come to light.
Â The rules must be clearly understood by those who use them.
Â The general acceptance of an accounting principle usually depends

on how well it meets the three criteria of relevance, objectivity
and feasibility. Generally when a new principle is being developed,
there is need to strike a balance between relevance, objectivity and
feasibility.
Â Relevance refers to the extent to which the principles result

in information that is meaningful and useful to those who
need to know something about an organization .If the princi-
ple has no relevance, and then it is likely to be rejected and to
go unused.
Â Objectivity refers to the extent that the information is reli

able, trustworthy and verifiable and is not influenced by the
personal bias or judgment of those who furnish it.
Â Feasibility refers to the extent to which the principles can

be implemented without undue complexity and unnecessary
cost to the user.
2.4 Sources of Accounting Principles

The main foundation of accounting consists of what is known as the
Generally Accepted Accounting Principles (GAAP), established by the
Financial Accounting Standards Board (FASB) in the USA. The FASB
produces a publication of the Statement of Financial Accounting Con-
cepts, which provides the conceptual criteria to help resolve future ac-
counting issues.
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Even though the Americans have their own board they are also members
or the worldwide accounting standards committee known as the Interna-
tional Accounting Standards Committee (IASC). The purpose of this com-
mittee is to set up the international accounting standards and to ensure
that they are accepted worldwide.
Regulating bodies in different countries should as far as possible comply

with IASC’s recommendations.
In Zimbabwe, the authority for establishing the accounting standards rests

with the Council of the Institute of Chartered Accountants, which is an
associate member of the IASC. The Council has undertaken to support
the standards established by that body. The Zimbabwe Institute of Char-
tered Accountants published “The Framework for the Preparation and
Presentation of Financial Statements” which deal with, among other
things, the accounting concepts discussed in this unit. The publication
gives guidelines on how you should apply these principles.
2.5 Financial Statements and Accounting Principles

The end product of the financial accounting process is a set of reports
called Financial Statements. The accounting process is described in some
detail in unit three. The GAAP requires that three such reports be pre-
pared and these are:
Â The Balance Sheet,
Â The Income Statement and
Â The Statement of Cash flow.
The purpose of the above financial statements is to show the financial

position of the business organization in terms of its profitability and its
net worth. The financial statements are a principal means of reporting
the general-purpose financial information to management and to persons
outside the organization.
The preparation of these statements is dealt with in the next Unit. We

however need to briefly look at these for the purpose explaining the ac-
counting principles.
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2.6 Nature of the Balance Sheet

The purpose of the balance sheet is to show the financial position of a
given business entity at a specific date.
It consists of a list of assets, liabilities and owner’s equity of a business.

Here is an example of Chitani Travel Agency, which has given us, the
following details about its balance sheet.
Chitani Travel Agency
Balance Sheet as at 3oth June 2000
Liabilities & Owners’ s Equity Assets
$ $
Liabilities
Notes Payable 35000 Cash 22500
Accounts Receivable 25000 Receivables 18200
Salaries payable 5000 Supplies 2000
Total Liabilities 65000 Buildings 60000
Land 100000
Office
equipment 62300
Owners Equity
John Chitani, Capital 200000
Total 265000 265000
The above example gives an outline of a balance sheet. It gives the name
of the business entity, the name of the financial statement and the bal-
ance of the assets as at a specific date. Note that all major items are listed
separately.
As you can see from the example, the body of the balance sheet consists
of three sections: assets, owner’s equity and liabilities. In dealing with
the accounting principles you continuously refer to the above balance
sheet.
There are five principles or conventions dealing with the preparation of

the balance sheet and these are:
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Â The concept of business entity (also called the Entity Principle)
Â The going concern concept
Â The money measurement concept
Â The cost or historical cost concept
Â The dual concept
Activity 2.1
* Explain the influence of relevance, objectivity and feasi-
? bility in the operation of a business entity.
* Describe the characteristics of a balance sheet.
* In what accounting period does the matching concept indi-
cate that an expense should be recorded?
* Chirenga (Pvt) Limited purchased some consumables in late March
2000 with payment due in 90 days. The company used all the
consumables during April. At the end of 90 days, the company
paid for the consumables. In what month must the company recog-
nize the cost of the consumables as an expense? If the company
had sold all the consumables on 90 -day credit at the end of May,
what month must the company recognize the selling price as rev-
enue? What generally accepted accounting principle determines the
answer to this question?
2.6.1 The business entity concept

The GAAP requires that a set of the financial statements describe the
affairs of the specific business entity. A business entity is an economic
unit that engages in identifiable business activities separate from its owner
For accounting purposes it is regarded as a separate identifiable entity, a

different persona from the owner who is the provider of capital.
Accounts are prepared for the business and the providers of capital are
recorded as having claims on the business in the owner’s equity.
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In our example above, Chitani’s Travel Agency is a business organization

operating a travel agency. J Chitani, the owner of the business could be
having his assets that are not involved in the business and these do not
appear in the financial statement of Chitani’s Travel Agency.
The business organizations conduct their business as entities completely

separate from their owners and the entities records can only reflect the
owner’s interest as owner’s equity.
2.6.2 The going concern concept

Financial statements are prepared under the assumption that the business
is a going concern and will continue in operation for the foreseeable fu-
ture after the balance sheet date, that is, that the business entity will
continue to operate for an indefinitely long period in the future. The re-
sources currently available to the entity will therefore be used in its future
operations.
Because of the concept, the accounts do not change the recorded values
of assets to correspond with changing market prices for these assets. Since
the balance sheet of an entity is prepared on the assumption that the
business is a continuing enterprise, the present prices at which the assets
can be sold are of less importance for the purposes of preparing the fi-
nancial statements.
Taking Chitani’s Travel Agency in our first example, the business will not
alter its records to reflect current market values when it prepares its bal-
ance sheet. The balance sheet continues to reflect the values of the as-
sets at cost. This is because we assume that the business will go on oper-
ating indefinitely.
Another example is that of a manufacturer of cooking oil who has the

sunflower seed in various stages of the production process. If the busi-
ness were liquidated today, the partially completed cooking oil would
have little value. Accounting does not attempt to value this cooking oil at
what it is currently worth. Instead, accounting assumes that the manufac-
turing process will be carried through to completion. The amount of money
for which the partially completed oil will be sold if the company were
liquidated is therefore irrelevant at this stage. This forms the heart of
the going concern concept.
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To conclude this section, you will realize that in accounting, we are not
worried about the current value of the asset but will record the value at
its historical cost. The market value will only considered when the asset
is being disposed of.
Activity 2.2
* When do accountants consider revenue to be realized?
? What basic question about recording revenue in account
ing records is answered by the realization principle?
* Explain briefly the concept of business entity. Assume that busi-
ness becomes insolvent; in what circumstances can its owner (or
owners) be held personally liable for the debts of the business?
2.6.3 The money measurement concept

In financial accounting, a record is made only when it can be expressed in
monetary terms. The advantage of the money measurement concept is
that money provides a common denominator by means of which all as-
pects of the entity can be expressed and compared.
The money measurement concept means that all transactions in a

business should be expressed in monetary form. This should be the case
whether the assets are being sold or occasionally when a revaluation exer-
cise is being carried out. Money is the only acceptable means by which
the values can be expressed for accounting purposes
Let us look once again at the Chitani Travel Agency. It may own $100000
of land, $60000 of buildings, $63200 of office equipment, $22500 of
cash, 10 members of staff, two of whom have been sick, two bicycles
and so on. These amounts cannot be added together to produce a mean-
ingful total of what the business owns. If however, they are expressed in
monetary terms, the addition is possible. You can add them if you ex-
pressed both of then in terms of a common denominator which is repre-
sented by their respective monetary values.
Thus the use of money measurement helps us achieve objectivity in the

valuation and accounting of any entity’s assets because money measure-
ment provides a finite and factual basis for valuation and can be verified
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2.6.4 The historical cost concept

The historical cost concept, commonly known simply as the cost con-
cept, is closely related to the going concern concept in that assets are
ordinarily entered in the accounting records at price paid for to acquire
the asset, that is, the historical cost and not at their current market or
replacement value. The items in financial statements are therefore re-
corded at their cost or historical values.
The current prevailing view is that the asset is shown in the balance sheet
at its ‘historical or original cost and this value may be different from
asset’s current market value. The accounting measurement of value of
an asset therefore does not reflect what the assets are worth except at the
time they are acquired.
This may however be misleading as the current market values of such

items at the time of the accounts may be completely different from the
historical cost. The current or replacement value of items reflected in the
financial statements would be very useful for planning purposes espe-
cially in times of inflation or weakening currencies.
The cost concept however provides a relatively objective foundation for

accounting particularly where we need to compare values.
2.6.5 The dual aspect concept (or duality concept)

As already discussed in Chitani Travel Agency’s balance sheet, all eco-
nomic resources (or Assets) of an entity are claimed either by sharehold-
ers (owners) or by creditors. Since all claims cannot exceed the amounts
to be claimed, it follows that every business transaction has a duality.
The recording of each business transaction has two aspects, a debit and a
credit. This duality convention is fundamental to accounting and it un-
derlines the accounting equation that states that debits are equal to cred-
its in any set of prepared accounts.
The accounting equation, which is the formal expression of the dual con-
cept, states that in any set of accounts: DEBITS=CREDITS.
For every debit made to an account there must be a corresponding and

equal credit to another account. Whenever a debit entry of a transaction
is done in the books of accounting, then we should ensure that a corre-
sponding and equal credit entry is done.
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A summary of the account balances is called a trial balance.
For any set of balance sheets: ASSETS = EQUITIES (LIABILITIES

+OWNERS EQUITY). It follows therefore that every transaction has a
dual impact on accounting records. Accounting systems are set up so as
to record both aspects of a transaction and this is called the double entry
system
The accounting records of the business show the following assets and
liabilities:
Assets Liabilities
Cash……….. $10000 Loan from Bank ………$25000
Assets………. $50000 Owners’ Equity………. $35000
Total Assets…. $60000 Total Equities………… $60000
This example shows that in any business, assets must always be equal to
liabilities and this gives the essence to double entry concept. This duality
aspect also means that corresponding entries will always be required in an
accounting system of recording transactions.
Activity 2.3
* How does an organization determine its accounting
? *
period?
Why are the total assets shown in a balance sheet always
equal to the total of the liabilities and the owner's equity?
2.7 Principles Relating To Income Statements

The income statement summarizes the results of operations for a period
of time and states the results of operations for that period of time. Un-
like a balance sheet, which is a status report, it is a flow statement as it
shows the flow through time. Over time the business financial flow in-
volves creation of assets (called revenues) and the outflows of resources
(called expenses). Profit is the amount by which the revenues exceed ex-
penses and a loss is the amount by which the expenses exceed the rev-
enues.
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We look once again at Chitani Travel Agency as an example:
Chitani Travel Agency
Income Statement
For the year ended 30th June 2000
------------------------------------------------------------------------------------------
Revenue $ $
Sale of tickets 50 000
Expenses
Wages 40000
Supply expenses 1500
Advertising 850
Depreciation expense: buildings 5000
Depreciation expense: Equipment 700
Total expenses 48 050
Net income 1 950
Note that the income shown on the above income statement relates to a
specified period of time such as a month or a year. So for the year ending
June 30, 2000 Chitani Travel Agency recorded a net income of $1 950.
Income is generated through flows into the entity and these are continu-
ous from the purchasing/production activities and sales activities. There
are several accounting conventions dealing with the generation of in-
come/losses and the income statements and these are:
Â The accounting period
Â The conservatism concept
Â The realization concept
Â The matching concept
Â The consistency concept
Â The materiality concept
These conventions are discussed below.

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2.7.1 The accounting period concept (also called the time

period principle)
Income statements must relate to a specified period of time, that is, must
show results over a span of time. This can be monthly, bi-monthly, quar-
terly, half yearly or annually. The time covered by an income statement is
known as the accounting period.
The accounting period concept is one of the generally accepted princi-

ples that guide the interpretation of financial events and the preparation
of financial statements. The length of the accounting period depends on
how frequently the managers and other interested people require infor-
mation about the entity’s performance.
Businesses are generally required by law to prepare accounts annually

either for tax purposes, or for public accounting purposes or for account-
ability purposes. However during the year, management needs informa-
tion more than once, usually monthly or bi-monthly, quarterly or half
yearly. In practice businesses do prepare accounts monthly, quarterly, bi-
annually and annually.
For the purposes of comparison of performance, accounts are normally

prepared consistently for each accounting period. If you look through
most newspapers, in Zimbabwe, you realize that they publish sets of ac-
counts, whose heading will include the length of period the accounts
cover and they also give comparative figures for the previous year.
2.7.2. The conservatism concept

The conservatism concept is designed to ensue that accountants are
conservative in their recognition of revenues and expenses.
The concept states that:
Â You recognize revenues only when they are reasonably

certain and
Â You recognize expenses as soon as they are reasonably

possible.
The best way to understand the concept of conservatism is to articulate

it as a preference for understating rather than overstating the net income
or net assets of the organization. The concept helps you when dealing
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with measurement of uncertainties. If therefore, two estimates of the

future amount of revenue are equally likely, there is preference for using
smaller amount to measure the value of the assets and the larger amount
to measure expenses/ liabilities. The above implies that in estimating rev-
enue, the accountants should be conservative but must be generous with
estimation of expenses.
Consider an amount reported as inventory (stocks). If in late 1999 an

entity learns that the selling price of the inventory has declined to less
than the cost of these goods, this loss is recognized and expenses in
1999.even though in actual fact prices may rise again and the goods sold
in the year 2 000 at a profit.
2.7.3 The realisation concept

The realization concept states that the amount of revenue recognized
or realized is that amount that is reasonably certain to be realized, that is,
the amount that that customers are reasonably certain to pay to the seller.
The realization concept refers to the inflows of cash or claims to cash

that arise from the sale of goods and allows you to take into account only
those revenue flows you are certain will be received or will be paid.
Assume, for example, a customer purchases $200 worth of fuel at a ga-

rage, paying cash. The garage therefore, realizes $200 from the sale. If
however another person buys the same product on credit for $1000 and
eventually 10% of the amount becomes a bad or doubtful debt, then the
amount of revenue for that period would be $900 and not $1000.
In practice, bad debts are often treated as an expense even though their
estimated amounts are part of the calculated revenue.
2.7.4 The matching concept

Every sale has two aspects, that is, revenue reflecting increases in re-
tained earnings and expenses reflecting decreases in retained earnings.
In order to measure correctly the sales net effect on revenues both as-
pects must be recognized in the same accounting period. This is what is
known as the matching concept.
Under this concept, operating expenses for each period are matched with
the revenues they relate to for that accounting period. The expenses in-
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curred, whether actually paid or outstanding and the revenue for the re-
spective period, are matched in the income statement to determine the
profitability or lack of it.
In applying the matching concept, you determine the items of revenue to

be recognized for the period and their amounts and then matching items
of cost to these revenues. If inventories costing $5500 are sold for $7000,
we determine when the $7000 is reasonably expected to be realized, and
then the $5500 cost of sales is matched with revenue as an expense re-
sulting in $1500 as income from the sale. The matched cost then be-
comes costs for that period.
The above example provides a criterion for deciding what costs are
expensed in an accounting period so that revenue and expenses of a given
period should be recognized in that period.
The costs associated with activities of the period are therefore costs that
should be recognized during that period. If there are costs that cannot be
associated with revenues for future periods, then they should also be treated
as expenses of the current period.
2.7.5 The consistency concept

The consistency concept states that once an entity has decided on the
use of one method of accounting, it should use the same method for all
subsequent events of the same character unless it has a sound reason to
change the method. Therefore the accounting bases adopted in one ac-
counting period must be maintained consistently in subsequent account-
ing periods. It is not expected that management of the business should
change, for instance the depreciation policy for equipment from year to
year.
We use consistency, in this concept as having a narrow meaning in the

sense that it refers only to being consistent over accounting periods.
In dealing with the entity’s assets, fixed or long-lived assets are recorded
at cost but inventories or stocks are recorded at the lower of their cost or
market value. This is done consistently over time.
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2.7.6 The materiality concept

Financial accounting is concerned with the recording of all the transac-
tions and events capable of monetary measurement. In that respect, fi-
nancial statements only reflect such items with a monetary measurement.
The materiality concept states that only significant events should be

made to record events. This means that no attempt should be made to
record events so insignificant that the work of recording them is not jus-
tified by the usefulness of the results. There must however be full disclo-
sure of all-important information
Conceptually a ballpoint pen is an asset of an entity and every time the

pen is used part of the asset is used up and that fact should be recorded.
Theoretically it is possible to ascertain the number of partly used pens
that are owned by the entity at the end of the accounting period and to
show the amount as an asset. However the cost of such an effort would
be unwarranted. Accountants would normally take a simpler course of
action and treat the asset as being used up either at the time the pen is
purchased or at the time it is issued from the supplies inventory to the
user. This forms the basis of materiality concept.
2.8 Summary
In this unit, we discussed the nature of Accounting Principles. We dis-
cussed the characteristics of accounting principles that that apply to the
preparation of financial statements.
Further, we examined the business entity and how concepts such as the
going concern, the money measurements concept the historical cost con-
cept and the dual aspect concept are related to the entity. Finally, we
explored the principles relating to income statements.
The accounting concepts form the basis of accounting principles. This

Unit looked at the various accounting principles and practical examples
were given to demonstrate how these principles are used in practice.
Accountants and other finance managers should be aware of these prin-

ciples and be able to ensure that they are observed at all times. The im-
portant thing is that they should be consistent in their application.
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2.9 References
Text and Cases. 9th Edition, 1995, Irwin McGraw-Hill, Boston
Meigs&Meigs, Bettner and Whittington: Accounting – The Basis for Business
Decisions. 10th Edition, 1996, The Mcgraw-Hill Companies Inc, New
York
The Zimbabwe Institute of Chartered Accountants: International Account-
ing Standards Handbook (Revised in1997), Harare. The following
Chapters of the International Accounting Standards:
Â The framework of Preparation and Presentation of Financial State-
ments (Revised on 1997);
Â Underlying assumptions, pages 22-23
Â Qualitative Characteristics of Financial Statements, pages 24-46
Â Presentation of Financial Statements (revised in 1997) pages

10-41.
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Unit 3 Fundamentals of Accounting Transactions
3
Unit Three
Fundamentals of Accounting
Transactions
3.1 Introduction
P reparation of financial accounting statements is one of the most

important functions of financial accountants. These statements, if
properly prepared, provide a useful tool to help management and other
stakeholders make decisions.
The main objective of any business enterprise is to earn a fair profit by

producing and/or distributing goods or rendering services while at the
same time maintaining a sound financial position.
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In this unit, we look closely at fundamental of accounting transactions.

We begin by defining terms that you need to know, as they are part of the
accounting jargon. We briefly look at the accounting cycle, the sources of
documents in accounting world. We discuss the subsidiary books of ac-
counting, the double entry system, the ledger, the trial balance and finan-
cial statement/reports. Finally, we examine the concept of depreciation.
3.2 Objectives
By the end of this unit you will be able to:
* Describe how the books of accounts are prepared, start-
ing with source documents, going through subsidiary books
and the ledger.
* A trial balance;
* Prepare a trading and profit and loss account and the balance sheet,
* Explain the concept of depreciation and its purpose, and
* Describe what means in accounting profit.
3.3 Definition of Terms

In this section we define various terms you meet in this unit.
Accruals – An accrual is an amount outstanding for a service provided

during a particular financial year, which is still to be paid for at the end of
it. It is expected that the amount due will normally be settled in cash in a
subsequent financial year.
Capital – is what the owner would have contributed or given to the en-
tity out of his private resources in order to start the business. For exam-
ple, a building for the factory or plant and machinery or cash.
Creditor – is a supplier who is owed some money by the enterprise for

goods and/or services purchased or supplied on credit. For example, a
manufacturing company may obtain raw materials throughout the month
and is expected to pay say after 30 days.
Debtor – is a customer who owes the enterprise some money for goods
and/or services sold to him on credit.
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Discount allowed – refers to cash discount granted to the enterprise’s

customers for the prompt payment of any debts due to the enterprise.
Discount received – refers to cash discount given by the enterprise’s

suppliers for the payment of any amounts due to them.
Drawings – refer to cash and/or goods the owner has withdrawn from
the business for his personal use.
Prepayment is an amount paid in cash during a financial period for a

service that has not yet been provided.
Purchases relate to those goods that are bought specifically with the
intention of selling them, usually at a profit.
Sales refer to the value of goods sold to customers during a particular

financial period. This covers both cash and credit sales.
3.4 The Accounting Cycle

Accounting data are processed within a definite time framework, which
is known as the accounting cycle. The following diagram shows the
accounting cycle:
Entering Determining Recording
into Transactions transaction data transactions in the
from source subsidiary books
document e.g.
Invoices, Receipts,
and Credit Notes
Reporting on Checking by Trial Posting into the

financial Balance ledgers
information e.g.
financial
statements,
reports
Analysis and Decision Making

interpretation
of information
Fig 3.1
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The above steps in an accounting cycle are discussed below. The cycle
can be covered in a month or quarterly or by annually depending on the
needs of the users. Most organizations produce financial reports monthly
for management use and by-annually for the rest of the stakeholders
3.4.1 Source documents:

Financial accounting data originate in financial transactions. These trans-
actions, also known as the accounting events are captured by source
documents such as invoices, receipts, credit notes, etc. which are de-
signed specifically for that purpose.
By now you must be familiar with these documents and what they show.
It may be advisable to re-look at each of them.
Data flows generated within an enterprise may be classified into two

groups, according to their sources:
Â Firstly are those generated from activities conducted between the

enterprise and external groups such as customers and suppliers of
materials, goods, services and finance.
Â Secondly there are those generated from within the enterprise for
the internal purpose of the business, which generally constitute a
substantial volume of the total information flows.
3.4.2 Subsidiary books of accounting

The starting point of processing raw data captured by using source docu-
ments is recording the data in the subsidiary books which are called
the books of accounting. It involves the use of the following subsidiary
books of entry:
Â The purchases day book, in which credit purchases are entered:
Â The sales day book, in which credit sales are entered;
Â The cash book, in which are recorded all cash transaction (both
receipts and payments), and
Â The journal, in which are recorded transactions that cannot be

recorded in the other subsidiary books.
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With the expansion of trade and the number of transactions handled

multiplying, it becomes necessary to group the entries into the following:
Â Purchase of trading goods on credit terms;
Â Sales of trading goods on credit terms;
Â Cash receipts and payments, and
Â All other transactions.
This classification not only enables entries of like nature to be kept to-
gether, but also facilitates the operation of entering basic data into the
books of subsidiary records as used in your organization. However, you
must realize that they have name of the company, date, value of transac-
tion etcetera.
Since the greatest bulk of source documents relates to the purchase and/
or sale of goods, the function of the purchases and sales daybooks is to
allow such data to be collected and transferred in a summarized form
to the ledger. The purpose of the sales and purchase daybooks is, there-
fore, to keep the ledger relatively free from unnecessary data.
The posting of the purchase daybook to the ledger is affected by transfer-

ring the value of the goods supplied in the period to the account of each
creditor/supplier, and then transferring the total value of all purchases to
the purchases account affect the posting of the purchases daybook to the
ledger.
Only cash transactions are entered in the cashbook, the purpose of which
is to record all receipts and payments of cash. The cashbook has a dual
role, for in addition to being a book of original entry, it is also part of the
ledger.
Activity 3.1
* List the several steps in the Accounting cycle.
? * Explain what is meant by source documents and discuss their
use.
* Identify the source documents and subsidiary books used in your
organization and explain how the accounting information flows
from the source documents from into the subsidiary books
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3.4.3. Double entry system

We explained the principle double entry mentioned in Unit 2 when we
looked at the accounting equation. The principle can now be illustrated
by applying the following rule: Debit the receiver and credit the giver.
Using the above rule, the double entry system can be applied to some of
the accounts as follows:
Type of Account Debit Credit
i) Personal Accounts The Receiver The Giver
ii) Real Accounts Property acquired Property disposed

e.g. Plant, fixtures, etc. of or sold
iii) Nominal Accounts Expenses/Losses Income/Gains
v) Cash Book Receipts Payments
You can record accounts in the ledger either in the form of the tradi-
tional ‘T’ account or the more modern running balance method,
the format looking like a bank statement. The latter format has the ad-
vantage of allowing the balance to be known immediately after each trans-
action. You need to practice the use of both methods.
The advantages of the double entry system are: -
Â It provides a complete record of every transaction, from both its

personal and impersonal aspects.
Â It provides an arithmetical check on the records since the total of

the debit entries must equal the total of the credit entries, and con-
sequently the total of the debit balances must equal the total of the
credit balances.
Â The amounts due to and by each person with whom the business
deals can at any time be ascertained from the personal accounts.
Â The balances of the Nominal Accounts can be collected together

in a Trading and Profit and Loss Account, which discloses the
results of operations, i.e. the profit or loss for any given period.
Â By means of a Balance Sheet, in which the balances of accounts

representing capital/equity, assets and liabilities are set out; the
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financial position of an enterprise at any given moment can be as

certained.
Â With a reliable system of internal organization, it reduces the risk,

and facilitates the detection of errors and fraud.
3.4.4. The ledger

The ledger is the principal book of accounts. Although normally a number
of subsidiary books are also necessary, it is the ledger in which all trans-
actions are ultimately recorded in double entry form. It is divided into
accounts, each being devoted solely to transactions with a particular per-
son, or of a particular kind.
Accounts dealing with persons are called “PERSONAL ACCOUNTS’

whilst those in which transactions are recorded from the viewpoint of
the business are called “IMPERSONAL ACCOUNTS”.
The impersonal accounts are further divided into real and nominal ac-
counts:
Real Accounts, which are concerned with things (e.g. land and build-
ings, plant and machinery, etc.)
Nominal Accounts in which the various kinds of expenses, income,

profit and loss are recorded.
3.4.5 The trial balance

A Trial Balance is a statement compiled at the end of a specific ac-
counting period. It lists all the debit balances and all the credit balances
extracted from each of the accounts throughout the ledger system. The
total of all the debit balances is then compared with the total of all the
credit balances. If the two totals agree, then one can be reasonably con-
fident that the bookkeeping procedures have been carried out accurately.
Its main purpose is that it is a convenient method of checking that all the
transactions and all the balances have been entered correctly in the ledger
accounts. It serves as a working paper in the course of preparing the
financial reports/statements and does not form part of the double-entry
process.
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The following is an example of a trial balance prepared from the ledgers

of High Glen Auto Service.
High Glen Auto Services

Trial Balance
October 30, 2000.
$ $
Cash 13 420
Accounts receivable 6 600
Shop supplies 1 400
Land 52 000
Building 36 000
Tools and equipment 12 000
Notes payable 30 000
Accounts receivable 8 870
Tachengetwa Nongwa, capital 81 000
Tachengetwa Nongwa, Drawings 3 100
Repair service revenue 10 380
Advertising expense 830
Wages expense 4 900
TOTAL 130 250 130 250
Note that a trial balance does not reveal the following types of er-
rors: -
Â Errors of omission, where a transaction has been completely over

looked.
Â Errors of principle, where an amount is correctly recorded but it

is placed in the class of account, e.g. where the purchase of a fixed
asset like a motor vehicle is shown under purchases rather than
under motor vehicles.
Â Errors of commission, where an amount is correctly recorded in

the right class of account, but is entered in the wrong account, e.g.
where a credit purchase of $10 000 from Jaggers Wholesalers is
entered in Makro’s account.
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Â Errors of original entry, where the transaction is recorded in the

wrong amount, e.g. where a sale to Mr. Jerenyenje of goods to the
value of $600 is recorded as $60.
In order to detect these errors one would have to closely examine each
and every entry into the books of accounts including balancing sales with
cash received and debtors and purchases with cash paid out and credi-
tors.
Â Compensating errors, which cancel each other out will not be

revealed, e.g. an error in adding up the debtors which is cancelled
out by a similar error in adding up the creditors will not be revealed.
3.4.6. Reporting on financial information

Financial statements play an important role in the decision-making proc-
ess. Information from financial statements is used both internally in the
enterprise, and by parties outside the enterprise to evaluate the current
position as well as the past trading results of the enterprise, and to project
the future position. The purpose of these statements, therefore, is to con-
vey useful financial information regarding an enterprise.
The said financial information can be divided into two categories: the
balance sheet and the trading and profit and loss account.
3.4.6.1 The balance sheet

The balance sheet embraces the present position of the enterprise, while
the trading and profit and loss account refers to the enterprise’s activities
over a specific period of time, i.e. the income
A balance sheet is a statement showing, on one hand, the amount of

capital sunk or employed in the business and the source from which it is
derived, (e.g. capital/equity provided by the owners, loan capital, retained
profits, etc.) and, on the other hand, the form in which such capital is
employed, i.e. the unexpired expenditure on the various assets by which
the total capital fund is represented at the date of the balance sheet
In the balance sheet, the fixed assets are normally valued at cost, less the
provision for depreciation and the current assets at cost or net realizable
value, whichever is the lower.
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The balance sheet does not relate to a period, but sets out, as already
mentioned above, the book values of assets, liabilities and capital as at a
particular date. Because it is a ‘snapshot’ at a particular point in time, it
is a status report rather than a flow report.
3.4.6.2 Trading, profit and loss accounts

The period of time when the trading and profit and loss account and the
balance sheet are prepared depends upon how often management wants
to calculate the profit/loss of the enterprise. This could be as often as
once a month, or half yearly or just once a year. However all business
enterprises need to prepare their financial statements once per year.
Procedurally, the trading and profit and loss account is part of the ac-
counting system, that is, it is itself an account, and by contrast, the bal-
ance sheet is not an account but a list showing the balances of the ac-
counts following the preparation of the former.
In order to ascertain the profit or loss made during a period, it is neces-

sary, on the last date of the period under review, to transfer the balances
on the nominal ledger accounts {see paragraph (4)(b) above} to a trad-
ing and loss account, in which the expenses and losses will be set against
the gains to show the net profit or loss. Where an enterprise comprises the
buying and selling of goods, the trading and profit and loss account is
divided into three parts, that is:
Â The trading section
Â The profit and loss section
Â The appropriation section
The purpose of the Trading Account is to find the amount of the gross
profit on sales, i.e. the excess of the realized proceeds of goods sold
over their costs before taking into account the operating expenses in-
curred in selling and distributing the goods and in running the enterprise.
Here is a worked example of Andrea Muketiwa who runs a small shop

and his trading figures for the month of September, 2000 were:
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$
Purchases 2 600
Purchases returns 60
Stock – 1 September, 2000 1 900
Sales 7 700
Sales returns 100
Wages 1 720
Electricity & water 85
Telephone 50
Advertising 155
Cash 50
General expenses 115
Repairs & maintenance – vehicle 230
Discount received 15
Stock – 30 September, 2000 1 250
If you had been asked to draw up Andrea Muketiwa’s Trading and Profit
and Loss Account for the month ending 30 September 2000, it could be
as follows:
ANDREA MUKETIWA
TRADING AND PROFIT AND LOSS ACCOUNT
FOR THE MONTH ENDING 30 SEPTEMBER, 2000
------------------------------------------------------------------------------------------
$ $
Sales 7 700
Less: Sales returns 100 7 600
Less: Cost of goods sold
Opening stock 1 900
Add: Purchases 2 600
Less: Purchases returns 60
Goods available for sale 4 440
Less: Closing stock 1 250
Cost of goods sold 3 190
GROSS PROFIT 4 410
Add: Discount received 15
---------------- 4 425
Less: Operating expenses

Wages 1720
Electricity & water 85
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Telephone 50
Advertising 155
Petty cash expenses 50
General expenses 115
Repairs & maintenance – vehicle 230
2405
NET PROFIT 2020
NOTE
Gross profit = sales – cost of goods sold

Net profit = (gross profit + other revenue) – operating expenses
Example 2
The following information relates to Nice Time Entertainers Ltd.
Trial balance at 31 December 1999. $ $

Ordinary share capital issued 200 000
Preference share capital issued 50 000
General Reserve 10 000
Retained income – 31 December, 1998 5 000
15% Debentures 50 000
16% Long-term loan 30 000
Trade creditors 80 000
Trade debtors 150 000
Stock– 2nd January, 1999 90 000
Provisional tax paid 15 000
Sales 975 000
Purchases 700 000
Salaries & wages 95 450
Interest paid on bank overdraft 2 000
Bank overdraft 15 000
Interest paid on long-term loan 4 800
Interest paid on debentures 3 750
Investment in – Listed company at cost 25 000
- Unlisted company at cost 20 000
Land & buildings at cost 150 000
Motor vehicles at cost 60 000
Furniture & equipment at cost 52 000
Printing & stationery 3 000
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Dividends received from –Listed company 2 000

- Unlisted company 3 000
Provision for bad debts – 2nd January, 1999 5 000
Freight on purchases 6 000
Freight on sales 4 000
Discount received 4 000
Discount allowed 3 000

Commission paid to salesmen 9 000
Accounting & audit fees 6 000
Directors’ remuneration 15 000
Preliminary expenses (less amounts written off) 8 000
Insurance 6 000
Sundry expenses 8 000
Sales returns 5 000
Accumulated depreciation on
- Motor vehicles 10 000
- Furniture & equipment 12 000
1 446 000 1 446 000
Additional information
Â Nice Time Entertainers Ltd. was incorporated on 2nd January 1992

with an authorized share capital of600 000 ordinary shares of 50c
each and 50 000 12% preference shares of $1 each.
Â Stock at 31 December 1999 amounts to $95 000
Â An amount of $5 000 must be transferred to the general reserve.
Â The provision for bad debts must be adjusted to 5% of the out

standing debtors at 31 December 1999.
Â The interest on debentures is payable half-yearly on 1 July and 1

January.
Â ‘The investments consist of:
Â 20 000 $1 ordinary shares in Nyala Ltd. On 31 December

1999 the shares were traded at 150c per share on the
Zimbabwe Stock Exchange.
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Â 25 000 no par value ordinary shares in XXX Ltd. According

to the directors, the value of the shares was 70c per share on
31 December 1999.
Â $1 000 of preliminary expenses must be written off.
Â An instalment of $5 000 is payable on the long-term loan on 30

June 1999.
Â Included in sundry expenses is an amount of $2 000 representing a

loss on the sale of surplus equipment.
Â Provision must be made for the following:
a) Depreciation as follows:
- Motor vehicles 20% on cost price
- Furniture & equipment 10% on the diminished balance.
b) Dividend on preference shares and a dividend of 5c per share

on the ordinary shares.
c) An additional amount of $500 for accounting and audit fees
. d) An amount of $40 000 for the current year taxation.
Required
Prepare the trading and profit and loss account for the year ended 31
December 1999 and the balance sheet at 31 December 1999 Solution
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SOLUTION
NICE TIME ENTERTAINERS LTD.

FOR THE YEAR ENDED 31 DECEMBER, 1999
$ $
Sales 975 000
Less: Sales returns 5 000
970 000
Less: of Cost sales
Stock – 2nd January, 1999 90 000
Freight on purchases 6 000
Goods available for sale 796 000
Less: Stock – 31 December, 1999 95 000
701 000
GROSS PROFIT 269 000
Add: Other income:

Dividends received on:
- Listed investment 2 000
- Unlisted investment 3 000
Discount received 4 000
9 000
Sub-Total carried forward (c/f) 278 000
Sub-Total brought forward (b/f) 278 000
Less: Operating expenses:
Discount allowed 3 000

Accounting & audit fees 6 500
Interest on bank overdraft 2 000
Interest on debentures 7 500
Interest on long-term loan 4 800
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Printing & stationery 3 000

Insurance 6 000
Freight on sales 4 000
Commission paid to salesmen 9 000
Directors’ remuneration 15 000
Provision for bad debts 2 500
Loss on sale of furniture & equipment 2 000
Sundry expenses 16 000
Depreciation:
- Furniture & equipment 4 000
16 000
192 750
Net profit before taxation 85 250
Less Taxation 40 000

NET PROFIT FOR THE YEAR
AFTER TAXATION 45 250
Less appropriation
Transfer to general reserve 5 000
Preliminary expenses written off 1 000
- 5c per share on ordinary
shares 20 000
- Preference shares 6 000
26 000
32 000
RETAINED INCOME FOR THE YEAR 13 250

Add: Retained income - 31 December 1988 5 000
RETURNED INCOME – 31 DECEMBER 1999 18 250
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BALANCE SHEET
AS AT 31 DECEMBER 1999
CAPITAL EMPLOYED
Share Capital: $ $
Authorised:
600 000 ordinary shares of 50c each
50 000 12% preference shares of $1 each
Issued:
400 000 ordinary shares of 50c each 200 000
50 000 12% preference shares of $1 each 50 000
250 000
Distributable reserves:
General reserve 15 000
Retained income 18 250
33 250
Total Shareholders’ equity 283 250

Long-Term Liabilities:
15% Debentures 50 000
6% Long-term loan 25 000
75 000
TOTAL CAPITAL EMPLOYED 358 250
EMPLOYMENT OF CAPITAL $ $
Fixed assets (1) 224 000
Listed Investments:
20 000 $1 ordinary shares in Nyala Ltd. at cost
(Market value 20 000 x $1.50 = $30 000) 25 000
Unlisted investment
25 000 no par value ordinary shares in XXX Ltd at cost 20 000
(Directors’ valuation 25 000 x $0.70 = $17 500)
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Current Assets:
Stock 95 000
Trade Debtors 142 500
237 500
Less: Current Liabilities:

Accrued expenses – interest 3 750
- accounting & audit fees 500
Dividend payable to:
- Ordinary shareholders 20 000
- preference shareholders 6 000
Instalment on long-term loan
payable on 1 July, 1999 5 000
Taxation 25 000
155 250
Net Current Assets 82 250
Intangible asset
- Preliminary expenses less amounts written off 7 000
TOTAL EMPLOYMENT OF CAPITAL 358 250
Activity 3.2
* QUESTION 1.
? * The following trial balance was extracted from the account-
ing records of Dickson Enterprises Ltd. on 31 December
1999.
$ $
Land & buildings at cost 150 000
Capital 61 560
Motor vehicles at cost 15 000
Furniture & equipment at cost 4 000
Drawings 3 500
Bank 42 580
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Accumulated depreciation – Motor vehicles 6 000

- Furniture & equipment 760
Stock – 31 December, 1999 15 400
Trade debtors 2 500
Mortgage loan 80 000
Provision for bad debts 155
Cost of sales 101 500
Sales returns 200
Rent received 9 750
Municipal charges 660
Packing material 280
Electricity & water 2 000
Interest on mortgage loan 10 000
Bad debts 110
Printing & stationery 190
Discount allowed 120
Fuels & oils 1 420
Repairs to office door 325
Advertising 12 890
Sales 213 170
380 675 380 675
Additional information:
Packing materials on hand, $55

The account of a debtor, L. Bottom, who owes the enterprise $100
must be written off as irrecoverable.
Adjust the provision for bad debts to 5% of debtors.
Provide for depreciation as follows: Motor vehicles at 20% per annum
on the diminished balance. Furniture and equipment at 15% per
annum on the diminished balance.
Interest on mortgage loan, at 15% per annum, is outstanding for two
months.
Rent was received for one month in advance.
An amount of $100 was paid to an employee, being an advance on his
salary for January 2000.
Prepare the following:
The trading and profit and loss account for the year ended 31 Decem-
ber, 1999, and the balance sheet at 31 December 1999.
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QUESTION 2
The following trial balance was extracted from the accounting records
of Treda Wholesalers on 30 June 2000.
$ $
Advertising 3 000
Bank 400
Capital 73 500
Cash 100
Depreciation at 1 July, 1999 – furniture 1 800
Discount allowed 400
Drawings 10 000
Electricity 3 200
Furniture at cost 12 000
General expenses 28 900
Interest on investments 800
Investments, at cost 5 000
Provision for bad and doubtful debts 2 300
(at 1 July, 1999)
Purchases 645 000
Purchases returns 2000
Rates 6 000
Sales 820 000
Sales returns 4 000
Stock – 1 July, 1999 47 000
Telephone 1 300
Motor vehicles, at cost 35 000
Total 920 900 920 900
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2. Additional information
Stock at 30 June 2000: $50 000.

The provision for doubtful debts is to be made equal to 5% of
trade debtors as at 30 June 2000.
Furniture is to be depreciated at a rate of 15% on cost, and the motor
vehicles at a rate of 20% on a reducing balance basis.
At 30 June 2000 amount owing for electricity, $300; rates paid in
advance, $1000.
Prepare the following:

Tread Wholesalers' trading and profit and loss account for the year ended
30 June, 2000, and Balance sheet as at 30 June 2000.
3.5 Depreciation
Depreciation as used in Accounting, is the allocation of the cost of a
tangible plant asset or other fixed assets to expense in the periods in which
services are received from the asset.
Expenditure on fixed assets is necessary in order to provide a general

service to the enterprise. The benefits received from the purchase of
fixed assets extend beyond, at least, one financial year. The cost of the
said benefit ought to be charged to the financial periods that benefit from
such expenditure. Such a charge is known as depreciation. The basic
purpose of depreciation is, in short, to achieve the matching concept,
that is, to offset the revenue of an accounting period with the costs of
the goods and services being consumed in the effort to generate that rev-
enue.
3.5.1 Causes of depreciation

There are two causes of depreciation namely, physical deterioration
and obsolescence.
The physical deterioration of a plant asset results from use, as well as

from exposure to the sun, wind, and the other climatic factors for exam-
ple, a vehicle starts loosing its colour or a machine wears out due to its
use.
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Obsolescence means the process of becoming out of date or obsolete.

An airline, for example, may become obsolete even though it is in an
excellent physical condition; it becomes obsolete because better planes
of superior design and performance have become available.
3.5.2 Methods of computing depreciation

It must be pointed out that it is not easy to measure the benefit provided
to each financial year. There are a number of methods that may be ap-
plied in the computation of depreciation. In this section, we consider
only three i.e. the straight-line method, the reducing balance method and
the sum of year’s deficits.
Â The straight-line method charges an equal amount of deprecia-

tion to each financial year that benefits from the purchase of a
fixed asset. This is the most commonly used method because it is
easier to apply and it charges equal amounts in each accounting
period, completely eliminating the value at the end of the deprecia-
tion period.
The annual charge is calculated as follows:
Depreciation charge for the year
= Historic cost of the asset – estimated residual value of the

asset Estimated life of the asset (years)
Let us take the example of PAKA CHITOMBO’S car, which has the
following data and estimates needed to calculate the annual depreciation
expense.
Cost $ 17 000,00
Estimated residual value $ 2 000,00
Estimated useful life 5 years
Using the above data, the annual straight-line depreciation is computed

as follows:
Cost – Residual Value = $17 000 - $2 000 = $3 000 per year

Years of Useful life 5years for 5 year
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Â The reducing balances method

This is the second method of computing depreciation. This method is
also referred to as the declining –balance method or the fixed- per-
centage- of -declining balance. It is similar to the straight-line method
in that it is based on the historic cost of the asset. It is however different
in that you apply a depreciation rate to the book value less the residual
value. Estimates of the life of the asset and its residual value are there-
fore required.
The depreciation rate is usually expressed as a percentage and that rate is

subsequently applied to the reducing balance of the asset, i.e. after the
depreciation charge in previous years has been deducted.
The computation may be summarised as follows:
Depreciation = Remaining x Accelerated

Expense book value Depreciated Rate
The accelerated depreciation rate remains constant throughout the life of

the asset. This rate represents the “fixed –percentage “ described in the
name of this depreciation method. The book value (cost minus accumu-
lated depreciation) decreases every year, and represents the declining bal-
ance. Here is an example to illustrate this method:
A motor vehicle costing $700 000, depreciated at 20% per annum on the
reducing balance method will be shown as follows:
Year $
01.07.97 Historic cost 700 000

30.06.98 Depreciation charge for the year (20%) 140 000
Reduced balance 560 000

Â Sum- of -years-digits is the other method of computing deprecia-
tion. This method is also known as the year’s digits method. The
number of years are added up and the depreciation rate for the year
is a fraction in which the denominator is the sum of these digits
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and the numerator is for the first, n; for the second year, n-1; for the third
year, n-2, and so on.
Below is an illustration of this method:
Cost $ 30 000,00
Estimated residual value $ 2 000, 00
Estimated useful life 5 years
If depreciation were based on the sum-of-the years- method, then, using
the above figures, the depreciation would be as follows:
Rate Annual depreciation Net book value
5/15 10 000 20 000

4/15 8 000 12 000
3/15 6 000 6 000
2/15 4 000 4 000
1/15 2 000 0
You should note that the denominator is obtained by adding up the number
of years. In the above example you add the following: 5+4+3+2+1=15.
The depreciation rate for the first year becomes 5/15 and for the second
year becomes 4/15 et-cetera. You apply the depreciation rates to the book
value.
NOTE: Note that the first two methods are by far the most important
methods widely used in practice. This is because they have been widely
accepted and are also easier to calculate.
3.5.3 Treatment of depreciation

The ledger account entries for depreciation appear as shown here below:
Debit: Profit and loss account AND

Credit: Accumulated depreciation account with the depreciation charge
for the year
Each group of fixed assets normally has its own accumulated deprecia-
tion account. For balance sheet purposes, it is customary to disclose the
historic cost, accumulated depreciation and net book value as follows:
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Historic cost of the asset less accumulated depreciation = net book value
(NBV).
3.6 Summary
The preparation of the financial statements is an important part of the
accounting function. The unit dealt with the extraction of information
from the source documents to the books of original entry and then into
the ledgers, preparation of the trial balance, trading, profit and loss ac-
count, including the treatment of depreciation. You should be able to
prepare the financial statements and be able to deal with the various meth-
ods of depreciation from the worked examples give.
Activity 3.3
? *
*
QUESTION 1 Compilation of a Trial Balance
Mpetakamwe commenced business on September 1, 2000.
The following transactions took place during his first month
in business:
* 01.09 Mpetakamwe started business with $12 000 in cash.
* 03.09 He paid $10 000 of the cash into a business bank
account.
* 05.09 He bought office furniture on credit from Jaggers Whole
salers for $3 000.
* 06.09 Edward rented shop premises for $1 000 per quarter; he
paid for the first quarter immediately by cheque.
* 08.09 He bought goods on credit from Station Furnitures for
$4 000.
* 11.09 He paid shop expenses amounting to $1 500 by cheque.
* 13.09 He sold goods on credit to Saratoga Enterprises for
$3 000.
* 25.09 He settled Jaggers Wholesalers' account by cheque.
* 26.09 He received a cheque from Saratoga Enterprises $2 000;
this cheque was paid immediately into the bank
* 27.09 Mpetakamwe sent a cheque to Station Furnitures for
$500.
* 27.10 Goods costing $3 000 were purchased from Station
Furnitures on credit.
* 30.10 Cash sales for the month amounted to $2 000.
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* Required:
* Enter the above transactions in appropriate ledger accounts, bal-
ance/close off each account as at September 30, 2000 and bring
down the balances as at that date; and
* Extract a trial balance as at September 30, 2000.
* QUESTION 2 Compilation of a Trial Balance
* The following balances have been extracted from Fred's ledger ac-
counts as at 31 August 2000.
$
Bank 15 000
Cash 3 000
Capital 18 000
Debtors 10 000
Creditors 4 000
Drawings 5 000
Electricity 4 000
Furniture 7 000
Office expenses 3 000
Purchases 50 000
Sales 100 000
* Required:
* Compile Fred's Trial Balance as at 31 August 2000.
3.7 References
Text and Cases. 9th Edition, 1995. Irwin McGraw-Hill, Boston
Meigs&Meigs, Better and Whittington: Accounting – The Basis for Business
Decisions. 10th Edition, 1996, The Mcgraw-Hill Companies Inc, New
York
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Unit 4 Interpretation of Financial Statements
4
Unit F our
Four
Interpretation of Financial
Statements
4.1 Introduction
A ccounting information, as presented in the financial statements, sum-

marizes the economic performance and situation of an enterprise.
In order to make use of this information, you need to analyse and inter-
pret its meaning. When confronted with such massive information, it is
always useful for you to have a framework of analysis available to make
an attempt to distil what is important from the mass of less important
data. In this unit, we concentrate on the interpretation of financial state-
ments.
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4.2 Objectives
By the end of this Unit, you should be able to:
* Analyse financial statements;
* Extract additional information from a set of financial state-
ments;
* Prepare cash flow statements
* Summarize information contained therein, and
* Prepare reports based on their observations.
4.3 What is Interpretation of Financial Statements?

Interpretation of financial statements may be defined as the “art or sci-
ence of translating the figures in the financial statements, i.e. the
trading and profit and loss account and the balance sheet, in such a
way as to reveal the financial strengths and weaknesses of the busi-
ness and the causes which have contributed thereto”.
It actually involves examining the accounts of an enterprise in some de-

tail so as to be able to explain what has happened and to predict what is
likely to happen in future. In fact, the whole ‘SWOT’ analysis can be
applied in this exercise, instead of looking only at the strengths and weak-
nesses. The ‘SWOT’ analysis involves looking at: S = strengths; W =
weaknesses; O = opportunities, and T = threats. In undertaking this
exercise, therefore, considerable skill and judgment are required to appre-
ciate and unveil the realities underlying a set of financial statements.
4.4 Techniques Used in Interpretation of Financial

Statements:
There are three techniques that are applied in the interpretation of finan-
cial statements and these are:
Â The straightforward analysis;
Â The ratio analysis, and
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Â The cash flow statement (an upgrade of what used to be known

as the statement of source and application of funds or source and
application of funds statement or the movement of funds state-
ment).
The interpretation in applying these techniques takes the form of hori-

zontal, trend or vertical analysis.
4.5 Interested Parties:

Any interpretation of the financial statements should be considered from
the point of view of the party for whom the interpretation is being under-
taken. It must be noted that, for various reasons, many parties (from both
within and outside the enterprise) may be interested in analysing the fi-
nancial statements.
The following are some of the interested parties.
Â The owners/shareholders
Â Debenture holders
Â Bank managers, financial institutions, etc.
Â Prospective investors and their professional advisers
Â Financial journalists and commentators
Â Trade creditors
Â Government (for taxation and statistical purposes)
Â Company management and employees just to mention a few.
4.6 Intended Results From Financial Statements

Analysis
In an attempt to analyse the financial statements, one should always con-
sider and draw conclusions in answering the following questions, inter
alias, on profitability, solvency, ownership market capital and finan-
cial strength.
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4.6.1 Profitability
Â Are profits adequate in relation to the capital employed, or could a
better return be received from another enterprise or from another
industry?
Â Is the capital employed in the right way and in the right place?
Â Can improved management increase profits?
4.6.2 Solvency
Â Can the enterprise pay its creditors?
Â Should they demand payment simultaneously?
Â Is the enterprise operating with sufficient working capital?
Â How liquid are the current assets?
Â Can the enterprise’s profitable activities be halted by a shortage of

working capital?
4.6.3 Ownership
Â Who owns the business, i.e. does one person or a group of persons
(local or foreign) have control?
Â How is ownership divided between the ordinary and preference

shareholders?
4.6.4 The market for the enterprise’s products/services

Â Has the market expanded or contracted in the recent years?
Â How has the business coped with the changes in market condi-
tions?
Â What is the market likely to be like over, say, the next three to five
years?
Â How will the general demographic, economic, political, and social

factors affect it? Does the business seem attuned to these possible
changes?
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4.6.5 Capital investment

Â What capital investment has there been and what is planned?
Â How would future investments be financed?
Â What retained reserves have the enterprise built up?
4.6.6 Financial strength

Â What is the credit position of the enterprise?
Â Has it reached the limit of its borrowing powers, if any?
Â Is it the policy of the enterprise to retain a proportion of its profits

each year?
4.7 Ratio Analysis

By the use of the ratio analysis technique, it is possible to facilitate com-
parison of significant figures by expressing their relationship in the form
of ratios or percentages. It must be pointed right from the onset that
ratios themselves are not particularly useful unless they are incorporated
into an overall analysis. They are only a guide and as such, cannot be
used to form the basis of definitive statements. They should, in fact, be
used to support other information and, in some instances, other ratios.
Comparison may be made with ratios for earlier periods in the same busi-
ness in order to disclose trends. They may also be employed for purposes
of inter-company comparison. Ratios employed to denote past trends
may give an indication as to future trends and thus act as signposts for
plans and policies.
4.7.1 Main ratios:

Please note that it is not possible to show all possibly useful ratios since
these can run to many hundreds. In this regard, therefore, useful com-
mon ratios generally used are discussed. In practice, however, it is advis-
able to compute as many ratios as possible depending on the required
objective. The main ratios we consider in this unit fall under four catego-
ries, i.e. profitability ratios; liquidity ratios; efficiency ratios, and in-
vestment ratios. We shall look at each of these in turn
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4.7.1.1 Profitability ratios:

Profitability ratios help users of financial statements to know how much
profit an enterprise has made, and then to compare it with previous peri-
ods or with other entities. Remember that profitability is the end product
of the policies and decisions made by any business and automatically,
therefore, becomes its most important barometer of success.
There are four main profitability ratios: the return on capital employed,
liquidity, efficiency and investment ratios.
Â Return on capital employed RATIO (ROCE), expressed as

= profit x 100 = X%
Capital
You must know that there is no standard agreement on how the return on
capital employed ratio should be computed, the main problem being the
several different ways in which ‘capital’ and ‘profit’ can be defined. Vari-
ous definitions have been attached to these two items as shown here
below: -
Capital:
Â Shareholders’ funds
Â Shareholders’ funds less preference shares
Â Shareholders’ funds plus long-term borrowings
Â Shareholders’ funds plus total liabilities (i.e. long-term and current)
Â Total assets
Â Total assets less intangible assets
Â Total assets less current liabilities
Profit:
Â Operating profit
Â Net profit before interest and taxation
Â Net profit before taxation
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Â Net profit after taxation
Â Net profit after taxation and preference dividend
As to what definitions you should one use depends entirely upon your
purpose. For example, if you are looking at profit from only an ordinary
shareholder’s point of view, you may define profit as being the net profit
after taxation and preference dividends (i.e. the amount available for dis-
tribution to ordinary shareholders), and capital as shareholders’ funds less
preference shares (i.e. the total amount of capital that the ordinary share-
holders have invested in the business.
Â Gross profit ratio
The gross profit ratio measures how much profit the enterprise has earned
in relation to the amount of sales that it has made. The formula used for
the computation of this ratio is:
Gross profit x 100 = X%

Total sales revenue
Â Mark-up ratio measures the amount of profit, added to the cost

of goods sold. The formula applied to compute it is:
Cost of goods sold x 100 = X%

Gross profit
Â Net profit ratio is generally used to compare net profit with the
sales revenue.
The formula used is:

Net profit before taxation x 100 = X%
Total sales revenue
4.7.1.2 Liquidity ratios

Liquidity ratios measure the extent to which assets can be quickly turned
into cash. The interests of shareholders, debenture holders and credit
suppliers are vested in the current position of the enterprise, i.e. the en-
terprise’s ability to meet its obligations by paying current debts. Liquidity
ratios are, therefore, indicators of short-term ability to pay. There are
basically two liquidity ratios namely the current asset and the quick
asset ratios:
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Â Current assets (working capital) ratio, given by the formula:
Current assets
Current liabilities
and is usually expressed as a factor, e.g. 3: 1. It indicates the number of

times that current liabilities are covered by current assets. A ratio of 2: 1
is generally considered satisfactory, i.e. current assets covering liabilities
twice as much. A current assets ratio of less than 2: 1 is usually an indi-
cation of a serious financial position, especially if the current assets con-
sist of a very high proportion of stock. The next liquidity ratio attempts
to address this problem.
Â Quick assets/(acid test) ratio
The quick asset ratio gauges the enterprise’s ability to meet its creditors
from its liquid resources/assets, i.e. current assets less stock, should they
demand payment simultaneously. The stock figure is subtracted current
assets since it may not be easy to dispose of stocks in the short term as
they cannot always be readily turned into cash, especially in times of
crisis.
The formula used is:
Current assets - stock

Current liabilities
A ratio of 1: 1 is generally considered satisfactory, i.e. current assets cov-

ering Liabilities. Both ratios are good indicators of the company’s liquid-
ity position. However in companies selling slow moving stocks the quick
asset ratio provides a more satisfactory measure of liquidity.
4.7.1.3 Efficiency Ratios

There are quite a number of different ratios, which can be used to meas-
ure the efficiency of an enterprise, but this unit covers only the more
common ones. Efficiency ratios include stock turnover, fixed assets,
trade debtor, trace creditor, etcetera.
Â Stock turnover ratio
The formula used is: Cost of goods sold = X times

Average stock*
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* The average stock is usually calculated as:

½(Opening stock + closing stock)
Where there is no opening stock figure, just use the closing stock figure as
the denominator.
Â Fixed assets turnover ratio, given by the formula
Total sales revenue = X

Fixed assets at net book value
The more times that the fixed assets are covered by the sales revenue, the
greater the recovery of the investment in fixed assets. This ratio is more
useful if it is compared with previous periods or with other entities.
Â Trade debtor collection period
The trade debtor collection period ratio relates to the length of time a
trade debtor takes to pay and the formula applied in its computation is:
Average trade debtors* x 365 = X days

Total credit sales
*Average trade debtors = ½(opening trade debtors + closing trade debt-

ors) The closing trade debtors’ figure is sometimes substituted for aver-
age trade debtors. The les the number of debtor collection days, the more
efficient the debt collection is. It also means the company will be able to
its payment obligations like creditors
Â Trade creditor payment period
Like the trade debtor collection period, the trade creditor payment
period relates to the length of time a trade creditor takes to be paid by
the enterprise.
The formula used to compute this ratio is as follows:
Average trade creditors* x 365 = X days

Total credit purchases
*Average trade creditors = ½(opening trade creditors + closing trade credi-

tors) It is also common to use the closing trade creditors. If it takes your
company longer to pay its creditors it means you are stretching your
creditors and use their money to finance your company’s operations.
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4.7.1.4 Investment ratios

Investment ratios are generally more important to shareholders, pro-
spective investors and the financial director/manager who is interested
in the market prices of shares of the enterprise on the Stock Exchange.
These can be dividend, dividend yield ratio, dividend cover ratio, earn-
ings per ordinary share, price earnings ratio and capital gearing
ratio.
Â Dividend yield ratio applies to ordinary shareholders and is given

by the formula:
Dividend per share x 100 = X%

Market price per share
It measures the real rate of return an investor gets by comparing the cost
of his shares with the dividend receivable and/ or paid
Â Dividend cover ratio shows the number of times that ordinary

dividend could be paid out of current earnings. The dividend is
usually described as being X times covered by earnings.
The formula applied in the computation is:
Net profit for the year after taxation – preference dividend = X times
Dividend on ordinary shares (paid and proposed)
Â Earnings per ordinary share ratio enable a fair comparison to be

made between one year’s earnings and another by relating the earn-
ings to something tangible, i.e. the number of ordinary shares in
issue.
The method of calculation is:
Net profit for the year after taxation – preference dividend = Act/share
Number of ordinary shares in issue during the year
Â Price/Earnings ratio, commonly known as the P/E ratio relates

the earnings per share to the price the shares sell at in the market.
It tells us that the market price is X times the earnings.
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Market price per share =X

Earnings per share
Â Capital gearing ratio discloses the relationship between the ordi-

nary share capital and fixed-interest-bearing securities of an enter
prise.
= Borrowings
Shareholders’ funds
Where the ordinary share capital figure is greater than the total of the
fixed-interest-bearing securities, the company is said to be low geared’.
On the other hand, if the ordinary share capital figure is less than the
total of the fixed-interest-bearing securities, the company is said to be
highly geared’. In a highly geared company, i.e. where there is a high level
of borrowings, there is a higher risk in investing in it, mainly because of
the following two main reasons:
· Firstly, the higher the borrowings, the more interest that a company will
have to pay, and that may affect the company’s ability to pay an ordinary
dividend;
· Secondly the company cannot find the cash to service its borrowings, the
ordinary shareholders may not get any money back if the company goes
into liquidation.
The worked example below illustrates how these ratios are worked out.
You should work through the example and see how the formulae are used
and draw conclusions on each ratio based on what we have discussed
above.
You are provided with the following summarized information relating to

Upper Most Enterprises (Pvt.) Ltd. for the year ended 31 March, 2000:
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UPPER MOST ENTERPRISES (PVT.) LTD.

FOR THE YEAR ENDED 31 MARCH, 2000
$ $
Sales 180 000
Less: Cost of goods sold
Opening stock 14 000
144 000
Less: Closing stock 24 000 120 000
GROSS PROFIT 60 000
Less: Operating expenses:
Administration 24 000
Interest on loan 1 000
Selling and distribution 16 000 41 000
Taxation 6 000
Net profit after taxation 13 000
Dividends – preference (paid) 2 000
- ordinary (proposed) 5 000 7 000
Net profit for the year 6 000
Retained profit brought forward 12 000
Retained profit for the year 18 000
——-
BALANCE SHEET
AS AT 31 MARCH, 2000
EMPLOYMENT OF CAPITAL
Fixed assets:
Freehold property 60 000
Motor vehicles less depreciation 26 000 86 000
Current assets:
Stocks 24 000
Bank 1 000
85 000
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Less: Current liabilities

Trade Creditors 62 000
Taxation 6 000
Proposed dividend 5 000
73 000
Net Current assets 12 000
CAPITAL EMPLOYED 98 000
Share capital
$1 ordinary share issued and fully paid 40 000
Preference shares (10%) 20 000
Retained profit for the year 18 000 78 000
5% Debenture stock 20 000
98 000
2) Additional information
Â Purchases and sales are made evenly throughout the year.
Â All purchases and sales are made on credit terms.
Â You may assume that price levels are stable.
Â The company only sells one product: it sold 60 000 units in the year
under review.
Â There were no sales of fixed assets during the year.
Â The market value of the ordinary shares was estimated to be worth

$1.80 per share at 31 March 2000.
Required
Calculate the significant ratios as discussed above.
Solution:
Profitability ratios:
Â Return on capital employed (ROCE):
Net profit before taxation x 100 = 19 000 x 100

Shareholders’ funds 40 000
= 47.5%
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Â Gross profit ratio:
Gross profit x 100 = 60 000 x 100

Total sales revenue 180 000
= 33.33%
Â Mark-up:
Gross profit x 100 = 60 000 x 100

Cost of goods sold 120 000
= 50.0%
Â Net profit:
Net profit before taxation x 100 = 19 000 x 100

Total sales revenue 180 000
= 10.56%
Liquidity ratios:
Â Current assets:
Current assets = 85 000

Current liabilities 73 000
= 1.16 : 1
Â Acid test:
Current assets – stock = 85 000 – 24 000

Current liabilities 73 000
= 0.84: 1
Efficiency ratios:
Â Stock turnover:
Cost of goods sold = 120 000
Average stock* 24 000
= 5 times
No opening stock has been given, so closing stock is used.
Â Fixed assets turnover:
Total sales revenue = 180 000

Fixed assets at net book value 86 000
= 2.09 times
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Trade debtor collection period:
Closing trade debtors = 60 000 x 365

Total credit sales 180 000
= 122 days
Â Trade creditor payment period:
Closing creditor payment period x 365 = 62 000 x 365

Total credit purchases 130 000
= 175 days
Investment ratios:
Â Dividend per share:
Dividend x 100 = 5 000 x 100

Ordinary share capital 40 000
= 12.50c per share
Â Dividend yield:
Dividend per share x 100 = 12.5 x 100

Market price per share 180
= 6.94%
Â Dividend cover:
Net profit after taxation – pref. dividend = 13 000 – 2 000

Paid & proposed ordinary dividends 5 000
= 2.20 times
Â Earnings per share (EPS):
Net profit after taxation – pref. dividend = 13 000 – 2 000

No. of ordinary share in issue during year 40 000
= 27.50c per share
Â Price/earnings ratio (P/E) ratio:
Market price per share = 1.80

Earnings per share 0.275
= 6.55
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Capital Gearing:
Pref. shares + long-term loans = 20 000+ 20 000

Shareholders’ funds 40 000
= 100%
Activity 4.1
? *
*
Question 1.
You are presented with the following summarised information:
M'KWASHI LTD.
PROFIT AND LOSS ACCOUNT FOR THE YEAR
ENDED 29 FEBRUARY, 2000
$
Sales (all credit) 1 200 000
Less: Cost of sales 600 000
Administrative expenses (500 000)
Debenture interest payable (10 000)
Taxation (30 000)
Net profit after taxation 60 000
Dividends (40 000)
BALANCE SHEET AS AT 29 FEBRUARY 2000

$ $
Fixed assets (net book value) 685 000
Current assets:
Stock 75 000
275 000
Taxation 30 000
240 000
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Net current assets 35 000

720 000
CAPITAL AND RESERVES
Ordinary share capital 600 000
Loans - 10% debentures 100 000
720 000
Calculate the relevant ratios as discussed in paragraph 4.7 above.
* Question 2.
The following information was extracted from the financial statements

of XXX (Pvt.) Ltd. on 31 March 2000.
XXX (PVT.) LTD.

PROFIT AND LOSS ACCOUNT FOR THE YEAR ENDED
31 MARCH, 2000
$
Profit before taxation 55 000
BALANCE SHEET (EXTRACT) AT 31 MARCH 2000

$
Capital and reserves:
Ordinary share capital of $1 each 60 000
Cumulative 15% preference shares of $1 each 10 000
Share premium account 20 000
Profit and loss account 200 000
290 000
Loans - 10% debentures 100 000
390 000
Calculate the following accounting ratios:
Â return on capital employed;
Â and capital gearing.
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4.8 Cash Flow Statements

The objective of financial statements is to provide information about the
financial position, performance and changes in financial position of an
enterprise that is useful to a wide range of users in making economic
decisions. One such statement most commonly used is the cash flow state-
ment.
The purpose of the cash flow statement is to provide information about

the cash flows associated with the period’s operations and also about the
entity’s investing and financing activities. It is prepared just after the bal-
ance sheet and is useful in assessing the ability of an enterprise to gener-
ate cash. It also enables the said users to develop models for assessment
and comparison of the forecast future cash flows of different enterprises.
In addition, comparability of operating performance by different enter-
prises is enhanced because cash flow information eliminates the effects
of using different accounting treatments for the same transactions and
events.
Two similar enterprises, for example, may use different methods to de-
preciate their fixed assets. These enterprises would both report different
earning figures but their choice of depreciation methods has no effect on
their cash flows.
Historical cash flow information is often used as an indicator of the

amount, timing and certainty of future cash flows. It is also useful in
checking the accuracy of past assessment of future cash flows and in
examining the relationship between profitability and net cash flow as well
as the impact of changing prices. Cash flow statements also highlight the
liquidity and working capital management of an enterprise.
4.8.1 Sources and uses of cash

The activities that the cash flow statement describes can be classified
into two categories, which are the sources and the uses.
The sources are the activities that generate cash.
Â Operations
Â Net borrowings
Â Net stock issues

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Â Sale of property, plant and equipment
Â Sale of other non-current assets
The uses are the activities that involve spending the cash.
Â Cash dividends
Â Repayments of borrowings
Â Repurchase of stock
Â Purchase of property, plant, and equipment
Â Purchase of other non-current assets.
The user of a cash flow statement is primarily interested in the net amount
of cash generated by operations rather than the detailed operating cash
inflows and outflows
There are two methods for drawing up a cash flow statement i.e. the
direct and indirect methods.
Â The direct method which shows operating cash receipts and

payments in a gross form,
Â The indirect method which starts with the operating profit and
adjusts it for non-cash charges and credits to reconcile it to the net
cash flow from operating activities.
4.8.2 Importance of cash flow statements.
Â The cash flow statements help you answer the following questions:
Â How much cash was provided by the normal ongoing operations of

the company?
Â In what other ways were significant amounts of cash raised?
Â Is the company reinvesting excess cash in productive assets, or is it

using cash to retire stock?
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Â To what extent are the company’s investments being financed by

internally generated cash and to what extent by borrowing or other
external resources?
Â For the cash obtained externally, what proportion was from debt
and proportion from equity?
Â Is the company having to borrow the cash in order to maintain its

cash dividend payments?
Although the cash flow statement cannot provide complete answers to

all the above questions, it can at least suggest answers and highlight areas
where it would be desirable to gather more information before deciding
for example whether to buy, sell or hold ones’ investment in the compa-
ny’s commons stock.
In drawing up a cash flow statement, the following words are used and
you need to understand them: cash, cash equivalent and cash flows.
Â Cash refers to cash on hand and demand deposits.
Â Cash equivalents refer to short-term, highly liquid investments

that are readily convertible to a known amount of cash, e.g. money
market instruments would be regarded as a cash equivalent.
Â Cash flows refer to inflows and outflows of cash and cash equiva-
lents
The following worked example illustrates how a cash flow statement is

obtained.
The following are the summarized accounts for MHOFU (Pvt.) Ltd.
MHOFU (PVT.) LTD.

31 OCTOBER, 1999
$ 000
Turnover 1 800
Less: Operating expenses 1 680
Operating profit 120
Less: Interest payable 15
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Profit before taxation 105

Less: Taxation 37
Profit after taxation 67
Less: Proposed dividends 45
Retained profit 23
BALANCE SHEET AS AT 31 OCTOBER, 1999
1998 1999
$000 $000
Fixed Assets 775 870
Less: Depreciation 250 270
525 600
Current Assets
Stock 187.5 300
Debtors 225 262.5
Cash/Bank 75.0* 112.5*
487.5 675
Less: Current Liabilities
Creditors 105.0 142.5

Dividends owing 15.0 45.0
Tax owing 22.5 37.5
142.5 225.0
Net: Current Assets 345.0 450.0
Less: Long-term Loans 105.0 150.0
765 900.0
Capital and Reserves
Ordinary share capital 637.5 750.0

Revenue Reserves 127.5 150.0
765.0 900.0
Note: There were no fixed asset disposals in the year ended 31
October 1999
Required.
Prepare the cash flow statement of MHOFU (PVT) LTD for the year
ended 31st October 1999.
Solution
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MHOFU (PVT) LTD

CASH FLOW STATEMENT FOR YEAR ENDED
31st OCTOBER, 1999
$000 $000 $000
Cash generated by operating activities (1) 140.0

Cash utilized to increase working capital (2) (112.5)
NET CASH GENERATED BY
OPERATING ACTIVITIES 27.5
Add: Interest paid (15.0)
Add: Taxation paid (3) (22.5)
CASH AVAILABLE FROM

OPERATING ACTIVITIES (10.00)
Dividends paid (4) (15.0)
CASH RETAINED FROM

OPERATING ACTIVITIES (25.0)
CASH UTILISED IN
INVESTING ACTIVITIES
Acquisition of fixed assets (95.0)
(120.00)
CASH EFFECTS OF
FINANCING ACTIVITIES
Increase in long-term loan 45.0
Proceeds of share issued 112.5
157.5
Increase in cash and cash equivalents 37.5

Cash and cash equivalents at 31 October, 1998 75.0*
Cash and cash equivalents at 31 October, 1999 112.5*
Notes:
1. Profit on ordinary activities before taxation 105.0

Adjustments for – Depreciation 20.0
- Interest paid 15.0
Operating profit before working capital changed 140.0
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2. Cash utilised to increase working capital

Increase in stock (187.5 – 300.0) (112.5)
Increase in debtors (225.0 – 262.5 (37.5)
Increase in creditors (105.0 – 142.5) 37.5
Increase in working Capital (112.5)
3. Taxation paid
Amount due – 31 October, 1998 22.5
Add: Tax for the year 37.5
60.0
Less: Amount due – 31 October, 1999 37.5
Therefore, amount actually paid 22.5
4. Dividends paid
Amount due – 31 October, 1998 15.0
Add: Dividends declared for the year 45.0
60.0
Less: Amount due – 31 October, 1999 45.0
Therefore, amount actually paid 15.0
4.9 Summary
The preparation, analysis and interpretation of financial statements is an
important and integral part of the accounting and decision making proc-
ess. This unit has looked at a number of methods used in the analysis and
interpretation of financial statements including the use of ratio analysis
and the cash flow statements. It has also demonstrated how to summarize
the information and to finally prepare the reports.
Activity 4.2
? * QUESTION 1
Draw up a cash flow statement from the following infor-
mation:
BALANCE SHEET AS AT 30 JUNE 2000
1999 2000
$ 000 $000
Fixed assets at cost 8 650 11 170
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Less: Depreciation 2 890 3 905
5 760 7 265
Current assets
Stock 3 720 3 604
Debtors 4 896 5 001
Cash/Bank 544 0
9 160 8 605
Creditors 2 072 1 854
Bank overdraft - 116
Tax owing 856 620
3 428 3 190
11 492 12 680
Financed by:
Issued share capital 10 000 10 000
Profit and loss account 1 492 2 680
11 492 12 680

30 JUNE, 2000
$000
Profit on ordinary activities before taxation 2 408
Tax on profit on ordinary activities 620
1 788
Retained profit - 30 June, 1999 1 492
3 280
Proposed dividend 600
* QUESTION 2
BALANCE SHEET INFORMATION AT 30 JUNE 2000
1999 2000
$ $
CAPITAL EMPLOYED
Ordinary share capital 375 000 355 000
Retained profit 15 000 8 000
Long-term loan 100 000 70 000
490 000 433 000
==== ====
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$ $
Fixed assets
Land & buildings at cost 260 000 260 000
Machinery & equipment at cost 220 500 177 000
Less: Accumulated depreciation (49 000) (43 000)
431 500 394 000
Investments at cost 50 000 35 000
Current assets
Stock 50 000 31 000
Debtors 35 000 30 000
Bank - 7 000
Prepaid rent 3 000 ______
88 000 68 000
Creditors 25 000 33 000
Bank overdraft 2 000 -
Taxation owing 9 000 11 000
Dividends owing 37 500 15 000
Accrued wages 6 000 5 000
(79 500) (64 000)
Net Current Assets 8 500 4 000
TOTAL EMPLOYMENT
OF CAPITAL 490 000 433 000
====== ======

FOR THE YEAR ENDED 30 JUNE, 2000
$ $
Sales 490 000
Less: Cost of sales
Opening stock 31 000
332 500
Less: Closing stock 50 000
282 500
Add: Dividends received on investment 13 000
Sub-Total carried forward (c/f) 220 500
Sub-Total brought forward (b/f) 220 500
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Less: Operating expenses

Depreciation 19 000
Interest on loans 14 000
Directors' remuneration 24 000
Administrative expenses 56 000
113 000
NET PROFIT BEFORE TAXATION 107 500
Less: Taxation 63 000
NET PROFIT AFTER TAXATION 44 500
Less: Dividends 37 500
During the year obsolete machinery and equipment costing $17 000
and on which depreciation to the amount of $13 000 was written
off, were disposed off at book value.
REQUIRED
Prepare the cash flow statement for the year ended 30 June 2000.
Show all calculations.
4.9 References
R.N. Anthony, J.S. Reece and J.H. Hertenstein. Accounting: Texts and Cases,
9th Edition, 1995. Irwin McGraw-Hill, Boston.
Meigs& Meigs, Bettner and Whittinghton: Accounting-The Basis of Business
Decisions, 10th Edition, 1996. The McGraw -Hill Companies Inc., New
York.
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Unit 5 Management Accounting
5
Unit F ive
Five
Management Accounting
5.1 Introduction
M anagement accounting involves the use of accounting and other

relevant information in the planning and control of the activities
of an enterprise. Management accounting results in specific reports to be
used by decision makers in an enterprise.
This unit looks at some of the aspects of Management Accounting that

are used in decision-making. The aim is to equip you with some knowl-
edge of the methods used in preparing reports that are then used for
decision-making.
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5.2 Objectives
* At the end of this unit, you should be able to:
* State the function of management accounting.
* Describe the environment of management accounting.
* Explain the concepts and give examples of cost-volume–profit
analysis.
* Discuss the pricing decisions in organizations.
* Describe standard costing and variance analysis in manufacturing
environment.
5.3 Definitions of terms

The following are some of the terms you will come across during your
study of this unit
Break- even quantity or volume is the minimum quantity of products

that must be produced and sold in a given period to ensure that all fixed
costs are recovered and that the enterprise does not sustain a loss
Marginal income is the amount remaining after the variable costs have
been subtracted from the sales revenue.
The margin of safety represents the amount by which the sales value
exceed the break- even point
Product life cycle is the time it takes from the approval of the initial
research and development of the product , the designing, manufacturing
and marketing until the product becomes obsolete resulting in the with-
drawal from the market.
Variance or variation refers to the situation when the actual quantity of

material used and the costs incurred differ from the standard quantity and
costs.
5.4. Function and Environment of Management

Accounting
In this section, we discuss the needs and relevance for Accounting Infor-
mation. We also differentiate Financial from Management Accounting.
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We conclude the section by looking at elements of Cost Accounting Sys-

tem.
5.4.1 Need and relevance for accounting information

As said in unit 4, accounting performs a service function of providing
relevant information about the enterprise to a wide variety of interested
parties. The information is particularly required by people like you, man-
agers, in order to make correct and enlightened decisions in the manage-
ment of your enterprises.
Competition is one of the most important reasons for the need of rel-
evant information. Enterprises are increasingly finding themselves under
competitive pressure from both local and international organizations par-
ticularly in relation to prices, quality and customer service. This pressure
impacts on manufacturing and production, local and international mar-
keting and distribution. The above emphasize the need for more accurate
product cost information.
Accurate costing information is also essential element in pricing deci-

sions.
Lastly, the new international economic environment requires that relevant

and timely information be provided.
5.4.2 Differences between financial and management

accounting
The two major users of accounting information are those who manage
the enterprise and those stakeholders in the enterprise, namely the
shareholders, creditors, workers and the government.
The purpose of financial accounting is to provide financial information

about the enterprise by means of financial statements for the use mainly
of interested parties who are themselves primarily out side the enterprise
and do not take part in the day –to-day management of the of the enter-
prise.
Management Accounting embraces the use of accounting and other

information by the management of an enterprise in the planning and con-
trol of the activities of the enterprise. Management accounting provides
specific reports for use by decision makers within an enterprise.
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The important differences between management and financial account-

ing are summarized as follows in Table 5.1.
Financial Accounting Management Accounting
Â Provides information for Â Provides information for internal

external users. users.
Â Generates 'general purpose' Â Generates 'specific purpose
financial statements. statements and reports' for plan-
Â Reports on financial events ning and control purposes
in the past. Â Future orientated reports.
Â Must confirm with standards Â Not subject to external standards.
that are externally imposed. Â Uses subjective data.
Â Emphasizes objective data.
Table 5.1 Differences between Management and Financial Account-

ing
5.4.3 Elements of Cost Accounting Systems

A cost accounting system is a set of systematic processes and procedures
that are used to measure record and report on cost accounting data. Cost
accounting is a process of compiling the costs of producing certain prod-
ucts, providing certain services or undertaking certain activities. It is used
both in manufacturing and non-manufacturing environment such as in
government, hospitals, churches and educational institutions.
There are five distinct activities in a cost accounting system and these are
cost determination, cost recording forms, cost analysis, cost man-
agement and cost reporting.
Cost determination activity where data is collected to determine the

costs of a specific product or activity. Data on such items as hours worked,
material used and units produced must be collected.
Cost recording forms an integral part of the double entry system and
the information is obtained from the company’s records.
Cost analysis.
For the information to be useful, the people who have a thorough knowl-
edge of the cost accounting methods in use must analyze it.
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Cost management.
A cost accounting system uses cost analysis to make recommendations

concerning cost management e.g. savings on costs.
Cost Reporting is the process by which relevant information is given to

the decision makers
Activity 5.1
* Using an example of an enterprise you know of, explain
? *
what is meant by the term break-even quantity
Explain the need for accurate costing information in
decision making
5.5 Cost- Volume-Profit Analysis.

5.5.1 Introduction
The success of an enterprise is generally measured in terms of the profit
that it generates. The management must make choices as to which of the
various alternatives is most advantageous to the enterprise.
The cost –volume- profit analysis has been developed as a basic tool for
short- term analysis. It is based on the underlying relationship between
cost and volume and the eventual profit.
There is a causal relationship between the change that is brought about in

one element and the effect of its influence on the other elements. This
relationship implies that any change in any of the three elements will
have an influence on the other two elements.
Cost- volume- profit analysis (CVP) includes a study of the underlying

relationship and intertwining of the following factors:
Â Price of the product
Â Volume of level of activity
Â Variable cost per unit
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Â Total fixed costs
Â Sales mix
Â Estimated Profit
The technique is used to analyze the influence of volumes on incomes,

costs and profit, and inter alias provide answers to the following ques-
tions:
Â What profit will be a given sales volume yield?
Â How will a change in costs affect the profit?
Â How will a change in the volume of business affect the profit

potential of the enterprise?
Â How many units must be sold to achieve the planned profit?
Â At what volume of production are costs and income equal?
The CVP analysis is an important factor in many management decisions

although it is subject to some limitations explained later in the module .
5.5.2 Cost- Volume-profit analysis using the marginal

income method
The marginal income method distinguishes between fixed and variable
components of all expenses. The total variable costs are deducted from
the sales revenue to determine the marginal income
The following is the budgeted income statement of Tsodzo (Pvt) Limited

a manufacture of product Y. Assume the Company manufactures this
one product.
Tsodzo (Pvt) Limited

Marginal Income Statement for June 2000
Total per unit

$ $
Sales @$30 per unit x30 000 900 000 30
Less: variable cost per unit (@$20 per unit 600 000 20
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Marginal income 300 000 10

Fixed costs 150 000
Net profit 150 000

The marginal income is the amount remaining after variable costs (mar-
ginal costs) have been deducted from the sales revenue. Alternatively,
marginal costs represent the aggregate of the variable costs applied to
produce or market a single product. Economically marginal costs are the
increase in total costs that arises if an additional unit is manufactured.
In practice, the marginal income is first applied to cover the fixed costs
and thereafter to contribute to the net income. Looking at the example
Tsodzo could apply the marginal income first to the fixed costs as shown
below:
Sales (1x$30) -------------------------------------------------------- $30

Less: Variable costs------------------------------------------------- 20
Marginal income ---------------------------------------------------- 10
Less: fixed costs $150 000
Net loss ($149990)
5.5.3 Break- even analysis

Breakeven analysis involves determining the point at which there are suf-
ficient volumes to being produced to pay at least for the fixed costs. This
point can either be obtained using the calculation method or by graphi-
cal method.
The break- even point is the volume (or number of units that must be
sold) or value at which the marginal income is sufficient to pay for the
fixed costs. The break-even quantity is therefore the minimum quantity
of products that must be sold in a given period to ensure that all the fixed
costs are recovered and that the enterprise does not sustain a loss.
5.5.3.1 The calculated method

Using the above figures, the break- even quantity is calculated as
follows, using marginal income per unit method:
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Break-Even Quantity = Total Fixed Cost

Marginal income per unit
= $150 000
$10
= 15 000 units
Break Even value represents the sales value of the break- even quantity
and is calculated as follows.
Break Even Value = break-even quantity x selling price per unit
= 15 000x $30
= $450 000
Break-even point using the marginal income ratio method

The other method of calculating the break-even point besides the ‘on a
per unit basis’ is using the marginal income ratio method.
Using Tsodzo (Pvt) Limited’s volumes above, the marginal income ratio
method is as follows.
Total Per Unit Percentage

$ $ %
Sales (30 000units) 900 000 30 100

Less Variable costs @ $20 600 000 20 66.67
Marginal income 300 000 10 33.33

The percentage of variable costs to total sales is known as the marginal
cost ratio. The percentage of the marginal income to the total sales is
known as the marginal ratio (or the profit /volume ratio).
THE TSODZO (PVT) LIMITED’S marginal income ratio is:
Marginal income ratio = marginal income x 100

Sales 1
= $10 x 100
$30
= 33.33%
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Break even value = total fixed costs

Marginal income ratio
= $150 000
33.33%
= $450 000
Alternative formula for calculating the break-even value is:
Break Even Value = fixed costs

1- Variable cost per unit
Sales per unit
Where 1 - variable costs
Sales is the marginal cost ratio
5.5.3.2 Break- even graphs

Closely related to break-even values we have been calculating above
are break-even graphs, which are drawn to show the relationship between
costs, volume and profit at various sales volumes. The value of a break-
even graph lies in the simple manner in which the profit structure is con-
veyed to management at a glance.
The preparation of the graph using the following simple example:
Expected sales for the period 1000 units

Selling price per unit $10
Variable Costs per unit $6
Total fixed costs for the period $2 000
Procedure for the preparation of the break-even graphs
Â Choose a scale suited to the graph paper available. Use the vertical
or Y-axis to represent monetary values and the horizontal or X-axis
to represent the volume in units. It is important that the scales are
shown clearly on the graph.
Â The fixed cost line is drawn first after drawing both the Y and
X-axis. In the above example, the fixed costs are $2 000 in total and
remain the same for all volumes. Therefore this line is drawn paral-
lel to X axis from the $2000 point on the Y- axis (line FK on the
graph).
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Â From point H on the X-axis we measure the total cost which are
$8 000 [fixed $2000+variable$6000]. The straight line FV
represents the total costs while VK represents the variable costs.
Â Draw a straight line from the origin (point O) of the graph to the
maximum value of the proceeds (point S). This represent the total
value of the proceeds of $10 000 for 1000 units
Break- even graph

Fig 5.1
Y
S
$ 10 000 - Total costs
Sales
$ 8 000 -
Break-even point V
$ 6 000 - W
Profit potential Variable
costs
$ 4 000 -
Loss potential K
$ 2 000 -
Fixed
B H Costs
0 500 1000
Units
Source: M.A. Faul, P.C DU Plessis, S.J. Van Vuuren, A.A Niemand
and E. Koch: Fundamentals of cost and Management Accounting.
3rd Edition, 1997,Butterworths, Durban
Deductions from the graph:
Â The break even point
This is the point at the intersection of the scale line OS and the total cost
line FV. If a line EB is drawn perpendicular to the X-axis and line EW is
drawn perpendicular to the Y-axis, they show the break-even volume (B)
and the break-even value respectively.
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Â Profit/loss
At a given volume the vertical distance between the sales line and the
total cost line shows the profit or loss amount. In this example a profit of
$2 000 is earned (distance VS).
Â Safety margin
This is the distance between the breakeven point and the units sold. The
safety margin is the distance BH on the graph, which amounts to 500units
(1000-500).
Advantages of the cost- volume -profit analysis
The following are some of the advantages of the cost- volume- profit
analysis.
Â By using the cost- volume-profit analysis you are able to see at a

glance the relationship between the units sold (volume or value)
and the costs and hence the profit or loss.
Â Once you draw the graph to scale, you will be able to determine the
volumes you need to sell before you break-even and start making a
profit
Â At any volume of sales, you are able to tell whether you are making
a profit, a loss or you are on the break-even point.
Â The method is easy to follow.
Deficiencies of the cost- volume profit analysis
Â The system however has a number of deficiencies and they are

outlined as follows:
Â Firstly the cost- line is not always a straight line as the costs are
always changing.
Â Secondly, the variable costs do not always change in proportion to

the to the volume of the sales but can do so disproportionately. In
such cases the relationship between the total costs and the volume
of units sold do not always follow a linear relationship.
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Â Lastly the price per unit can also change and therefore the sales can
no longer be expressed as a straight line.
Â Marginal income graph (profit-volume diagram)
The marginal income graph is often used to overcome the deficiencies

of the break- even graph discussed above. It is often referred to as the
profit- volume graph as opposed to the cost -volume -profit analysis
discussed above.
The marginal income graph compares the sales values to the profit and
loss situation depicted by the break-even line and the profit line
Using the same information used to construct the break-even graph above,
we can plot the following profit volume diagram.
The break-even line shown on the X-axis divides the Y-Axis (the Vertical
Axis) into the negative (loss) and the positive (profit) portions. The por-
tions above the break-even line (BY) represents the profit portion while
the portion below the line (OB) represents the losses. The fixed costs are
measured off the Y-axis of the graph at point F.
X
Profit X-ax
Y-ax
V
+ $ 3 000 -
+ $ 2 000 -
Break-even point E
+ $ 1000 - Profit potential
B
0
- $ 1 000 - Break-even line
F
- $ 2 000 -
Loss potential
- $ 3 000 -
Loss I I I I I I I I I
0 $ 5 000 $ 10 0
Value of sales
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Source: M.A. Faul, P.C DU Plessis, S.J. Van Vuuren, A.A Niemand,
E. Koch: Fundamentals of cost and Management Accounting. 3rd
Edition, 1997,Butterworths, Durban
From the graph, it can be seen that the break –even point is point E,
where the profit- line cuts the beak-even line. The safety margin is the
distance EV.
Equation methods of cost- volume- analysis
The relationship between costs, volume and profit can also be expressed
in terms of the following algebraic terms;
Sales(S)-fixed costs(F) -variable costs(V) =Profit(P)
OR
Sales =fixed costs +variable costs +profit
Using simple algebraic equations we can develop the following formu-

lae;
Marginal income ratio (MIR) =S-V or 1-V or MI

S S S
Where MI=marginal income
Break-even quantity (BEQ) = F or F

S-V I- V
S
Break- even value (BEV) =F OR F

MIR I-V
S
Margin of safety (MS) = S-BEV
Margin of safety ratio (MSR) = S-BEV

S
Required minimum turnover on value(RV) = F+TP
MIR
Where TP =planned profit
Required minimum turnover in quantity(RQ) = F+ TP

MI per unit
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Where RQ is a sales quantity
Example
The following information is available:
Sales $10 000

Variable costs $ 6 000
Margin of safety ratio 50%
Profit margin $2 000
Required:
Calculate the following with the aid of algebraic calculations:
a) Marginal income
b) Marginal income ratio
c) Net profit
d) Fixed costs
e) Break-even point
f) Safety margin
Solution
(a) Marginal Income (MI): = S-V

= $10 000 - $6 000
= $4 000
(b) Marginal income ratio (MIR): = S-V

S
= $10 000 - $6 000
$10 000
= 40%
(c) Net profit (P) = S-V-F

= $10 000-$6000-F
= $4 000-F
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(d) Fixed costs (F) = S-V-P

= $10 000-$6 000-$2 000
= $2 000
(e) Break-even point (BEV) = F

MIR
= $2 000
0.40
= $5 000
(f) Margin of safety (MS) = C-BEV

= $10 000-$5 000
= $5 000
5.5.4 Evaluation of cost-volume- profit analysis
The usefulness of the break-even analysis is limited only by the degree of

validity of the following assumptions:
Â Selling price per unit remains constant, irrespective of the sales

volume, hence sales are expressed as a straight line. In practice prices
are not constant.
Â All costs and expenses can be expressed as either fixed or variable

costs.
Â Fixed costs remain constant irrespective of the volume of business

while variable costs vary in direct ratio with volume. These assump-
tions ensure straight- cost lines in the break-even- graph.
Â Sales mixes are constant for all different types of products.
Â Stock levels do not change materially during the a given period.
Â There is no change in the effectiveness of the variable costs in the

production factors. This assumption is also necessary to maintain
the linear relationship of the variable cost functions.
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5.6 Pricing Decisions

The aim of this unit is to consider the effect of an enterprise’s pricing
decisions on profits. Normal prices must be set high enough to cover
total costs and to provide a reasonable profit, otherwise the organization
will not survive.
Two approaches are used to set normal selling prices, namely
Â the market methods and
Â the cost- based method.
Enterprises manufacturing goods according to customer specifications

normally use the cost –based method because no market price exists for
this type of product. Manufacturers making and selling homogeneous
products in a competitive market must use market price.
5.6.1 Cost- based pricing approaches.

There are basically four methods of cost-based pricing approaches, namely
the total cost-plus mark up approach, Product cost-plus mark up pricing
approach; variable cost plus mark up approach and activity based cost-
ing.
5.6.1.1 Total cost-plus mark-up approach

The total cost of the product is determined as accurately as possible after
which a percentage is added to provide for profit.
Profit = cost + mark up
The mark up percentage for the total cost approach is calculated as

follows:
Mark up percentage = Desired profit x100

Total costs
Example:
Chimoto Manufacturing Limited only manufactures one product X.
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The costs are as follows:

Variable costs are per unit $
Direct materials 9.00
Direct labor 30.00
Manufacturing 4.50
Selling and administrative costs 4.50
Selling costs $
Manufacturing overheads 120 000
Selling and administrative costs 80 000
The desired rate of return is 20% and the investment is $2 500 000. The
enterprise budgeted to manufacture and sell 100 000 units.
Required
a) Calculate the cost price per unit
b) Calculate the mark-up percentage.
c) Calculate the selling price.
d) Verify your calculations by the preparing an income statement
Solution
Â Cost price per unit

$
Variable costs ($48x100 000) 4 800 000
Fixed costs
Factory overhead 120 000
Selling and administrative costs 80 000
Total costs 5 000 000
Cost price per unit: = $5 000 000

100 000 units = $50.00
Â Mark up percentage
Mark-up percentage = desired profit x 100

Total costs
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= (20% x $2 500 000) x 100

$5 000 000 1
= 10.0%
Â Selling price $
Cost per unit 50.00

Mark up ($50. 00x 10%) 5.00
Selling price 55.00
Â Income Statement
Sales( $55x100 00) 5 500 000

Less: Variable costs($48 000x100 000) 4 800 000
Less: Fixed cost ($120 000+$80 000) 200 000
Operational profit 500 000
5.6.1.2 Product cost plus mark- up pricing approach

Under the product cost plus mark up pricing approach, all the manufac-
turing costs are included in the cost amount after which a percentage is
added to include a mark up. The selling and administrative expenses and
profit are included in the mark-up.
The mark up percentage is calculated as follows:
Mark up percentage = Desired profit +selling and administrative costs x 100

Total manufacturing costs 1
Example –Question
Using the above data on Chimoto Manufacturing Limited, you are re-
quired to:
Calculate
a) Cost per unit
b) Mark up percentage
c) Selling price
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Solution
Â Cost per unit $

Direct materials ($9x100 000 units) 900 000
Direct labor ($30x 100 000 units) 3 000 000
Variable manufacturing overhead ($4.50X100 000 units) 450 000
Fixed costs 120 000
Total manufacturing costs 4 470 000
Cost price per unit = $4 470 000 = $44.70

100 000 units
Â Mark up percentage =desired profit x selling and administrative

expenses
Total manufacturing costs
Mark up percentage = $500 000 + ($4.50 x 100 000 units)+80 000 x 100
$4 470 000 1
= 23.04%
Â Selling price
Cost price per unit 44.70

Mark-up ($44.70x23.04%) 10.30
Selling price 55.30
5.6.1.3. Variable cost plus mark-up approach.

Under the variable cost plus mark up method of calculating the selling
prices only variable costs are included in the cost amount after which a
percentage is added to include mark-up. The total fixed costs and profit
are included in the mark-up. The mark-up percentage is calculated as
follows:
Mark-up % = desired profit + total costs x 100
Total variable costs 1
The mark up percentage is calculated as follows :
Mark up percentage = Desired profit +selling and administrative costs x 100

Total manufacturing costs
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Using the above data
Solution
Cost per unit $

Direct materials ($9x100 000 units) 900 000
Direct labor ($30x 100 000 units) 3000 000
Variable manufacturing overhead ($4.50X100 000 units) 450 000
Variable selling and administrative costs
($4.50 x 100 000 units 450 000
Total manufacturing costs 4 800 000
Cost price per unit = $4 800 000 = $48.00

100 000 units
Mark up percentage
mark up percentage = $500 000 + $120 000 +$80 000 x 100

$4 800 000 1
= 14.58%
Â Selling price
Cost price per unit 48.00

Mark-up ($48x14.58) 7.00
Selling price 55.00
5.6.1.4 Activity- based costing (ABC)

The aim of ABC costing is to trace costs to the products or services
instead of arbitrarily allocating them. It assumes that activities cause costs
and that products are consuming activities. Activity costs are allocated
to products or services using cost drivers. Therefore, direct materials and
direct labor are directly traced to products because there is a physical
measure of their consumption by a particular product.
In traditional systems for example, engineering costs are often part of

overhead cost pool that is allocated based on direct labor hours. However
in ABC systems such costs are assigned to products in proportion to the
engineering design services received by the product.
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The method therefore provides a more accurate allocation of joint costs

to cost centers than usually result when other overhead rates are used. It
is usually used in assigning any indirect costs to various cost centers that
jointly cause the cost to be incurred.
ABC is a useful tool in the pricing where a diversity of products espe-

cially where the non-unit-based overheads comprise a significant percent-
age of total overheads.
5.6.2 Market-based pricing approach

The market-based pricing approach is also known as the target cost-
ing and is based on the external marketing factors. A target market price
is chosen before the design and introduction of a new product. The mar-
ket price must be sufficient to allow the enterprise to achieve the desired
market share and the sales volumes. The desired profit margin is normally
deducted from the target price to set the maximum allowable cost (called
target cost).
Example:
Dennis Electrical Manufacturing Company is considering introducing a

new 37cm color remote control television set onto the market. A market
has a target price for such a product should be $850. The company has a
target profit of 20% of sales value.
The following estimate cost information is available.

Direct materials $
Cabinet 35
Picture tube 200
Circuit boards 145
Small parts plastics parts 70
Plastic parts 50
Total direct costs 500
Direct labor: 3hours at $40 per hour.
The overhead rate is 150% of direct labor cost.
Required
a) Calculate the target cost of the new television set.
b) Compare the estimated costs with the target cost and comment on
the difference.
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c) Advise the board regarding achieving the target costing level.
Solution
Â Target cost = selling price – desired profit

= $850 –(20% x $850)
= $680
Â Estimated costs
Direct material $500

Direct labor (3hours x $40 per hour) $120
Overheads (150%x $120) $180
Estimated unit cost $800
The estimated cost is $120 ($800-$680) higher than the target cost.
Â To achieve target cost and the desired profit margin, Dennis Elec-
trical Manufacturing Company must attempt to decrease costs by
purchasing cheaper parts and by implementing less expensive proc-
esses.
5.6.3 Product life cycle costing

The product life cycle is the time from the approval of the initial research
and development of the product, the design, manufacturing and market-
ing until the product becomes obsolete resulting in its withdrawal from
the market.
The life –cycle costing is a costing approach that allocates all estimated
costs that will be incurred to over its entire life cycle. The method is
largely used for cost planning and product pricing.
It includes all costs regarding the value chain categories. The value chain
is a set of sequential phases in which value is added to the products or
services, e.g. research and development, design, production, marketing
distribution and customer service.
Life cycle costing is an approach that can be applied in enterprises where

sales and related costs do not fall in the same period. The research and
development and design costs are not normally incurred in the same pe-
riod in which the related income is earned.
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Example
Zwamaida (Pvt) Limited is a company that manufactures and sells three

products A, B and C. The enterprise is currently investigating the profit-
ability and pricing policies of its products. These products have an esti-
mated economic life of two years.
The following budgetary information is available:

Number of units sold
Product selling price year 1 year 2

$
A 50 300 900
B 60 300 450
C 40 750 500
No inventory balances are anticipated at the end of the year 2
A B C
Year 1 Year 2 Year 1 Year 2 Year 1 Year 2
$ $ $ $ $ $
Sales 15 000 45 000 18 000 7 000 30 000 20 000
Costs:
Research and
Development 20 000 0 130 000 0 7 000 0
Design 5 000 1 000 3 000 1 000 2 000 1 000
Production 2 000 5 000 3 000 3 000 5 000 2 000
Marketing 4 000 8 000 4 000 4 000 7 000 7 000
Distribution 1 000 2 000 1 000 1 000 2 000 2 000
Customer 1 000 7 000 1 000 3 000 7 000 13 000
services
Required
a) Prepare a budgeted product life cycle income statement for the three
products.
b) Rank the three products in order of profitability
c) Comment on the difference of the cost structure (% of total costs)

of the three products.
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Solution
a) Product life-cycle income statement

———
A B C
$ $ $
Sales 60 000 45 000 50 000
Less: Total Costs: 56 000 37 000 55 000
Research and development 20 000 13 000 7 000
Design 6 000 4 000 3 000
Production 7 000 6 000 7 000
Marketing 12 000 8 000 14 000
Distribution 3 000 2 000 4 000
Customer services 8 000 4 000 20 000
Profit/(loss) 4 000 8 000 5 000
b) Ranking of the products
Expected income Profit ratio

$ %
B 8 000 B 7.8
A 4 000 A 6.7
C (5 000) C (10.0)
Management should emphasize A and B and product C should be with
drawn from the market.
c) Cost structures
A B C
% % %
Research and development 35,7 35.1 12.7
Design 10.7 10.8 5.5
Production 12.5 16.2 12.7
Marketing 21.4 21.6 25.4
Distribution 5.4 5.5 7.3
Customer service 14.3 10.8 36.4
The poor performance of product C shows that too little was spent on
research and development and design. This results in excessive time and
money being spent on customer services because of poor quality
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The major criticism about this technique is that it ignores the time value
of money. Some adjustment can however be brought in to take into
account the time value of money.. It can be an effective aid for the prod-
ucts with life cycle of more than one year.
Activity 5.2
* Chipangura Limited uses the total cost plus mark-up approach
? to set sales prices The estimated cost of producing and selling
2 000 units of product for year 2000 is as follows:
$ $
Variable cost per unit Fixed costs:
Direct materials 26.00 Factory overhead 39 000
Direct labor 17.68 Selling and administrative
Cost 19 500
Factory overhead 3.12
Total 46.80
The enterprise ‘s desired rate of return is 20% on an investment of
$110 000
Required
* Calculate the amount of the desired profit of the enterprise.
* Calculate the total costs and the price per unit for the production
and sale of 2000 units of product Z.
* Calculate the mark up percentage for the product Z
* Calculate the selling price of product Z
(2) Using the same information as above, the company uses the vari-
able cost plus mark- up approach to calculate the selling prices.
Required
* Calculate the cost price per unit of product Z if 2000 units
are manufactured and sold.
* Calculate the mark up percentages for product Z
* Calculate the selling price of product Z
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5.7 Standard Costing and Variance Analysis

Standard costing is a system of costing whereby a comparison is drawn
between:
Â What should be done at standard costs (pre- calculated costing

method) and
Â What was done at actual cost?
Â The purpose of standard costing is to furnish the relevant informa-

tion to in good time by means of pre-determined cost standards.
Â Standard costing improves cost control in the enterprise by:
Â establishing standards for each cost element
Â determining actual costs for each cost element
Â comparing actual costs with standard costs and determining the

differences (variances)
Â analyzing the variances and facilitating measures to correct them

where these are necessary
5.7.1 Uses of standards and standard costs

Standards and standard costing can be used for several purposes. These
include cost control, stock valuation, planning for budget purposes, fix-
ing prices and for keeping records.
Â For cost control purposes, standards enable management to draw

periodic comparisons between actual and standard costs in order to
measure efficiency.
Â Standard cost help in tock valuation in that it is easy to convert

them to actual costs for balance sheet purposes
Â Planning for budget purposes is made easier by the standard

costing system as it facilitates the preparation of the production
and sales budget.
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Â In fixing of prices, the standard unit costs enable management to

achieve the best combination of prices and volume for a given
period.
Â The keeping of records is facilitated by the use of the standard

costing costs in that the standard costs can be pre recorded.
5.7.2 Advantages of standard costing
The following are some of the advantages brought about by the standard
costing to an organization using the standard costing.
Â Standard costs serve as a systematic standard against which actual

costs can be measured.
Â The analysis of variations necessitates consistent control over the

entire production process
Â The use of standard costs reduces clerical work, since the values
and quantity of the cost elements of each completed product that
must be manufactured are already available on a standard costs
card and production orders need only be recorded on standard forms.
Â The analysis of cost reports by management is simpler and takes

less time.
Â With standard costing, greater control is exercised over costs.
Â If a standard costing system is introduced, it makes the task of

valuing raw materials, half complete products and complete prod-
ucts easier. This is because the pre-determined standards are
applied as values of stocks
Â When standards are first established, they may serve as a stimulus

to further planning, which will lead to greater efficiency.
5.7.3 Materials standards and variances

Standard specifications must be prepared for the establishment of the
standard material quantity according to size mass or any other yardstick.
Attention must be given to quantities, prices rates, quality and grades and
provision must be made for normal scrap, losses, wastage and breakages.
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There are two types of materials standards that are set at a factory:
Â Price and
Â Quantity.
The purchasing department establishes the standard prices of the materi-

als in conjunction with the factory accountant and takes into account
market factors, suppliers’ quotations, and optimum purchase quantities.
The standard material quantity specifications serve as a basis for the

determination of the standard quantities required to manufacture one
unit of each completed product. If the actual quantity of materials quan-
tity of materials used and the costs incurred differ from the standard quan-
tities and costs allowed this is known as a variance or variation
Material variances are calculated in one of the following methods.
5.7.3.1 Materials price variance

Material price variance is the difference between the standard price de-
termined and the actual price of the materials. There are two types of
materials variance and these are the purchase price variances and the
issue price variance.
Purchase price variances method is based on the number of units

purchased. It is determined upon the receipt of the materials and
occurs whenever the actual price differs from the standard price.
The variance is calculated by taking the difference between the
actual cost of the amount purchased and the standard cost thereof.
Formula: (AP x AQ)-(SP x AQ) OR (AP-SP) AQ

Where AP= actual price
SP =standard price
AQ= actual quantity purchased
Issue price variance is determined when the raw materials are is-
sued. It is the difference between the actual quantity issued at ac-
tual cost and the actual quantity issued at the standard price
Formula: (AP x AQ)-(SP x AQ) OR (AP-SP) AQ

Where: AQ = actual quantity issued
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Please note that the purchase price variance is of greater value since it is
known at the time that the goods are received.
Material price variances can be attributed to:
Â Faulty standards (mistakes made when establishing the standard

prices)
Â Price increases or reductions as a result of unforeseen changes in

the market prices, good/poor conditions in the purchase depart-
ment, incorrect calculation of discounts and deliveries costs or bad
timing of purchases.
5.7.3.2 Materials quantity variance

Material Quantity variance , also known as the usage, efficiency or
volume variance is the difference between the actual quantities of
material used at the standard price and the standard quantity of mate-
rial allowed at the standard price.
The concept of standard quantity of materials allowed means the stand-

ard quantity allowed for the actual production and is calculated as fol-
lows.
Formula: (AQ x SP) – (SQ x SP), OR (AQ-SQ) SP

Where: AQ = actual quantity of materials used
SQ=standard quantity of material allowed for actual production
SP= standard price
Material quantity variances can be attributed to:
Â faulty standards (mistakes made when establishing the standard

prices)
Â good/ poor controls over the use of material at the shop floor.
Â better/poor quality material, which results in a better/poor output.
Â efficient/inefficient working conditions, equipment, supervision,

skills of the employees and so forth.
The total of the material price variance and the material quantity vari-
ance is known as the total material variance and can also be calculated
as follows:
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(AQ x AP) - (SQ x SP)
The variances can be favorable (F) or unfavorable (U). If the standard

costs are greater than the actual cost, the variance is favorable because
less actual costs were incurred than the standard requires. If the standard
costs are less than the actual costs the variances are unfavorable because
more actual costs were incurred than the standard requires.
Example:
The standard material costs of finished product Z are as follows:

5 kg of raw materials X @ $10 per kg
Actual information:
Purchase of raw material X: 1000 kg @ $9.00 per kg
Issues of raw material X 700kg
Units of products X manufactured 320 units
Required:
Calculate the following variances in respect of material:
Â Purchase price
Â Material issue price
Â Material Quantity
Â Total material variance, if an issue price variances is used
Solution
i) Material purchase price variance = (AP - SP) AQ
= ($9.00 -$10.00) 1 000
= $1000 (f)
ii) Material issue price variances: = (AP – SP) AQ

= ($9.00 - $10.00) 700
= $700(f)
iii) Material quantity variance = (AQ – SQ) SP

= (700 – 640) $10
= $600.00 (u)
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* standard quantity =320 x 2

640
iv) Total material variance =(AQ x AP) –(SQ x SP)

=(700 x$9.00) – (640 x $10.00)
= 6300- 6400
=100 (f)
Alternatively add (jj) and (iii)
=$700.00 (f) + $600.00 (u)
5.7.4 Labor standards and variances

Labor standards are usually based on the established wage scales paid for
the specified type of labor. Time standards for the manufacture of a product
are determined with the aid of time and motion studies and provision
should be made for idle time, which is unavoidable. The company can for
example determine the labor rates per hour at say $20 per hour and this
becomes the labor rate standard. It can also determine the time it takes
an article to pass through a process as two hours with the aid of time and
motion studies. The time so determined becomes the company’s standard
time.
The two main variances relating to labor are:
Â The labor rate variances. and
Â The labor efficiency variances.
5.7.4.1 Labor rate variance

is the difference between the standard labor rate and the actual labor rate
.It is calculated using the following formula:
(AR x AT) –(SR x AT) or (AR-SR) AT

Where: AR = Actual rate paid
AT = Actual hours worked
SR = Standard rate
The labor rate variance can be caused by
Â the establishment of incorrect labor rates.
Â changes in wage rates

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Â poor scheduling of production which gives rise to overtime (since

the overtime is calculated at a higher rate)
Â the use of better/ poorer qualified personnel with higher/ lower

pay
5.7.4.2. Labor efficiency variance

The labor efficiency variance is related to the amount of time necessary
to manufacture one unit of a product. It is calculated by taking the differ-
ence between the actual hours worked at the standard rate and the stand-
ard time (hours) allowed for the actual production at the standard rate.
Formula: (AT x SR)- (ST x SR) or (AT-ST) SR

Where: AT = actual time worked
ST = standard time allowed for actual production
SR = standard time
The labor efficiency variances show how efficiently is employed.
Variances may be due to:
Â the establishment of standard times (hours) may not be accurate

and need to be revised continuously to ensue they are as close as
possible to the actual times.
Â properly/poorly trained employees who are not meeting the

standard times.
Â good/poor quality material being used in the production process.
Â problems with machinery and equipment that result in longer manu

facturing hours than budgeted for.
The following example will help to illustrate the variance discussed above
The management accountant of Madzorera Limited has provided the fol-

lowing information about the labor in the production department:
Actual hours worked = 510 @ $4.50 per hour.
Units manufactured:
Complete 500 units
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Incomplete 250 units

(100% complete in respect of
material and 25% in respect of
labor and overheads)
Standard labor cost per

unit according to the
standard cost card. 1 hour @ $5.00 per hour
Required
a) Calculate the following.
b) Labor rate variance
d) Labor efficiency variance
e) Total labor variance
Solution
i) Labor rate variance (AR – SR) AT

= ($4.50 – $5.00) 510
= $255.00 (F)
ii) Labor efficiency variance (AT – ST) SR

= (510 – 562.5) $5.00
= $262.5 (f)
*Standard hours allowed for the
actual production = [500 +(25% x 250)] x 1 hour per unit
= 562.5(f)
iii) Total labor variance (AT x AR) – (ST x AT)

= (510 x $4.50)- (562.5 x $5.00)
= $2295 – $2812.5
= $517.5
5.7.5 Manufacturing overhead standards and variances

Manufacturing Overheads can be divided into variable and fixed over-
heads because in some cases, the manufacturing overheads have a direct
connection with the level of business activity.
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Variable costs are constant per unit because they vary in a direct ratio to
the level of business activity while fixed costs are variable per unit. This
attribute of fixed costs hampers the establishment of standard fixed over-
head rate when the level of activity differs from month to month.
In order to overcome the above problem, the fixed overhead rate is

therefore calculated on the basis of the normal level of activity because
this is based on the standard level of activity.
Manufacturing overhead variances maybe due to:
Â The actual level of operations differing from the planned level
Â The actual overheads differing from the budgeted overheads
Â The actual hours worked differing from the standard hours
Overhead costs are usually based on direct labor hours or machine hours,
or are expressed as a percentage of the direct labor costs. For the purpose
of the exercise labor hours will be used.
There are two kinds of manufacturing overhead variances
Â Variable manufacturing overheads variances
Â Fixed manufacturing overheads variances
5.7.5.1 Variable manufacturing overhead variances

There are two types of variable manufacturing variances and these a effi-
ciency and expenditure variances:
Â Efficiency variance (is also called the quantity variance) is

calculated by multiplying the difference between the actual hours
worked and the standard time allowed by the standard rate for
variable overheads.
Formula: (standard time allowed – actual hours worked) x stand-

ard rate
Expenditure variance (is also called the tariff, rate or price variances)
is the difference between the actual and the standard rate for variable
overheads multiplied by the actual hours worked.
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Formula: (standard rate - Actual rate) x Actual hours
Example
The following are the budgeted results at normal capacity of Stratton

Limited for June 2000
Fixed overheads $27 000

Variable overheads $22 500
Labor hours $15 000
According to the standard, it takes 7.5 hours to manufacture one

product.
Actual results:
Fixed overheads $27 000
Variable $22 400
Labor hours worked $16 000
Units manufactured $ 2 100
Required
Calculate the following variances in respect of variable manufacturing

overheads:
i) Efficiency
ii) Expenditure
iii) Total variable overheads
Solution
i) Efficiency (AT – ST) SR or

= (AT x SR) – (ST x SR)
= [16 000-(2100 x 7.5)] x (22 500: - 15 000)
= (16 000 – 15 000) x$1.50
= $375 (U)
ii) Expenditure = (AR –SR) AT

= (AR x AT) – (SR x AT)
= {(22400: -16 000) – 1.50} x 16 000
= $1600 (F)
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iii) Total variable overheads = Actual Amount – Standard Amount

= $22400 – (15750 x 1.50)
= $22 400 – 23 625
= $1125 (f)
5.7.5.2 Fixed manufacturing overheads variances

The total fixed overhead variance is the differences between the standard
fixed overheads allowed and the actual fixed overheads. The two main
variances in fixed manufacturing overheads are the expenditure vari-
ance and the volume variance.
Â The expenditure variance
The expenditure variance is calculated as the difference between the ac-

tual and the budgeted fixed overheads
Â The volume variance
The variance is calculated as the difference between the budgeted and

the standard fixed overhead, and can be divided into:
Â a capacity and
Â An efficiency variance
The capacity variance represent the differences between the budgeted

time and the actual time valued at the standard fixed recovery rate while
the efficiency variance represents the differences between the actual
time and the standard time allowed multiplied by the total standard rate.
Example.
Using the same information in Stratton Limited above, calculate the fol-
lowing overhead variances:
i) Expenditure
ii) Volume
iii) Efficiency
iv) Capacity
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iii) Total variance
iii) Test the correctness of your variances
Solution
i) Expenditure = actual fixed overheads- budgeted fixed overheads

= $27200-$27000
= $200 (U)
ii) Volume = (BT – ST) SR or

= Budgeted overheads – standard overheads
= [15 000 – (7.5 x 2 100)] 1 .80
= (15 000 – 15750) 1.80
= $1350 (F)
iii) Efficiency = (AT – ST) SR

= $16 000 –15 750) 1.80
= $450 (U)
iv) Capacity = (BT – AT) SR

= (15 000 - 16 000) 1.80
= $1 800 .00 (F)
*Where BT = budgeted time

AT = Actual time
ST = standard time
SR = Standard fixed overheads rate
v) Total variance = Actual overheads – standard overheads

= $27 200 - (15750 x $1.80)
= $1150 (f)
vi) Test the correctness of your variances
Test:
Total variance= expenditure variance + volume variance
= $200 (u) + $1350 (f)
= $1150 (f)
Volume variance = Capacity variance + = Efficiency Variance
= 1800 (f) + 450 (u)
= $1350(f)
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There are several causes of manufacturing overheads variances. These

include the following:
Â Equipment standing idle due to the power failures defective

machinery raw material shortages etcetera resulting in more time
being spend on manufacturing a product.
Â Ineffective planning - incorrect scheduling of work or instructions

resulting in delays.
Â Labor problems as a result of unforeseen absents cold cause delays

in the production schedules.
Â Material problem as a result of defective materials could result in

the purchase of more raw materials as some would have to re-pur-
chased.
5.6.5.6 Total overhead variances

The total overhead variances are also known as combined variable
and fixed manufacturing overheads variances.
Under this method, no distinction is made between fixed and the variable
manufacturing overheads. You should notice the difference between this
method and the one using separate fixed and variable overhead variances
The two methods under the total overhead variances are two variances
analysis method and the three variances analysis method
The two variances analysis method is divided into controllable and

non-controllable (or Volume) variances.
Â Controllable variance represents the difference between the

actual total overheads as on the one hand and the standard variable
over heads allowed for actual production time plus budgeted fixed
over head on the other.
Â Non-controllable or volume variance is applicable to fixed costs

only and represents the differences between the budgeted and the
standard amount of fixed overheads allowed for actual production.
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Three variances analysis method is divided into budget variance, vol-

ume variance and efficiency variance
Â Budget Variance represents the differences between the actual

total overheads and the variable cost budget (budgeted fixed and
variable cost for actual production)
Â Volume Variance is the variance is the difference between the budg-

eted and the actual fixed overheads.
Â The Efficiency Variance is the difference between the actual time

and the standard time allowed for the production multiplied by the
standard total overhead rate.
5.7.6 Sales standards and variances

It is important to exercise control over the sales of the enterprise. There
are two types of sales variances and these are price and quantity.
These are calculated in the same way as the materials and labor rates
variances.
The formulae used are as follows:

Price variance = (AP - SP) AQ
Sales quantity variance= (AQ - SQ) SP
* where: AP = Actual selling price

SP = Standard selling price
AQ = Actual quantity sold
SQ = Standard (budgeted) sales
Example
The following illustrate the sales variances:
Sales:
Actual =900 units @ $20.00 each
Budgeted =1100 units
Standard cost per unit = $15.00
Selling price per unit = $18.00
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Required
Calculate the following:
i) Sales price variance

ii) Sales quantity variance
Solution
i) Sales variance = (AR - SP) AQ

= (20 - 18) 900
= $1 800 (f)
ii) Sales quantity variance = (AQ - SQ) SP

= (900 - 1100) 18
= $3600 (u)
5.8 Summary
This unit has looked at the function and environment of management
accounting and compared it with financial accounting. It also dealt with a
number of management accounting issues such as cost-volume analysis,
pricing decisions and standard costing. These are important as they assist
management in decision-making. A number of exercises were carried out
to illustrate to you how management arrives at decisions using the analy-
sis. A number of examples were also given. Work on them as they clarify
the concepts further.
Activity 5.3
? * Standards are often confused with budgets. Explain the

differences between the two concepts.
* Explain how a standard costing system and especially the different
variances that can be calculated can be used as a management tool
to control costs.
* A company manufactures a single type of product and uses a stand-
ard costing system to calculate the cost price. The standard cost
per unit of the product is compiled as follows.
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$
Material (50 kg @$20 per kg) 1 000
Direct labor (20hours @$5 per hour 100
Overheads (30 machine hours @ $1.50 per hour) 45
The following variable budget was used to calculate the overhead rate:
80% 90% 100%

Machine hours 24 000 27 000 30 000
Overheads: Fixed $15 000 $15 000 $15 000
Variable $24 000 $27 000 $30 000
Additional information
Material purchased and issued 52 000kg @$20.10 per kg

Direct labor cost 19 900 hours @$5,10 per hour
Actual overheads $45 500
Finished products completed
and transferred 1 000 units
Opening stock work in progress 20 units (material -100 %
completed; labor and
overheads- 50% completed)
Closing stock work in progress 80 units (material- 100 %
complete; Labor and
overheads -50% complete)
Required
Calculate all the variances in respect of material, labor and manufac-

turing overheads using the Two-Variance method.
* Suni Limited uses a standard costing system in the manufacturing

of a single type of product. The following information shows the
budgeted and actual figures for 2000.
Budgeted Actual
$ $
Turnover
1250 units @ $ 1200each 1 500 000
1180units @$1250 each 475 000
Cost of sales (per unit)
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Material
Budgeted 2,8kg; actual 2,5kg 420 390
Labor
Budgeted 13 hours; Actual 12hours 182 174
Variable overheads 182 192
Fixed overheads 226 224
* There was no opening or closing stock.

* In determining the standards, an assumption was made that the
company operates at full capacity
Required:
* Draft a variable budget for the month

* Calculate all the different variances
Reconcile the standard net profit with the actual net profit.
* A cell phone manufacture uses activity -based accounting .

For simplicity, assume that its accountants have identified only the
following three activities and related cost drivers for the manufac-
turing overhead:
Activity Cost Driver

Materials handling Direct materials cost
Engineering Engineering change notices
Power Kilowatt-hours
Three types of cell phones are produced: CL3, CL6 and CL7. Direct
costs and cost driver activity for each product for a recent month are as
follows:
CL3 CL6 CL7

$ $ $
Direct materials cost 25 000 50 000 125 000
Direct labor cost 4 000 1 000 3 000
Kilowatt hours 50 000 200 000 150 000
Engineering charge notices 13 5 2
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Manufacturing overhead for the month was:
Materials handling $10 000

Engineering 30 000
Power 24 000
Total manufacturing overhead $64 000
Required
* Compute the manufacturing overhead allocated to each product

with the activity- based accounting.
* Suppose all manufacturing overhead costs had been allocated to
products in proportion to their direct to their direct-labor costs.
Compute the manufacturing overhead allocated to each product.
* In which product costs those in requirement 1 or those in require-
ment 2 do you have the most confidence?
* Burke Limited manufactures a single product. The company budg-
ets for its fixed costs on a normal business capacity of 320 000 to
400 000 units per year. The company finds that it seldom has large
changes in its stock.
The following is the budget for the net profit on the lowest and highest
normal operating level.
Low High
Units 320 000 400 000
$ $
Sales 160 000 200 000
Cost of sales and expenses 156 000 180 000

Net profit 4 000 20 000
Required:
* Calculate marginal income per unit

* The fixed costs per hear
* The break- even point in units
* Budgeted profit for 360 000 units
* Mujuru Enterprises is a small trading company, which does busi-

ness from a number of sales outlets. The company also owns fixed
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property, which it rents to other enterprises. The rental agreement

for one of these properties expires on 30 September 2000 and the
company is considering using this property itself for the marketing
of radios.
The company bought the premises 15 years ago for $140 000. It is now
estimated that the property could be sold for $240 000.
The financial manager made the following estimates:
* The company's requirements are such that the site can be equipped
at a cost of $60 000. The amount will be paid by the 30th Septem-
ber 2000. This expense will be written off over the five years on a
straight-line basis.
* All sales will be on a cash basis and the estimated turnover from
October 2000 will be $80 000 per month. The marginal income
will be 20%.
* The amount of operating capital will be invested exclusively in the
trading stock. Enough stock will be held to cover seven weeks'
sales. The opening stock will be purchased and paid for in Septem-
ber 2000 and will be kept at that level throughout the year.
* The annual fixed ruining costs (excluding depreciation) are at
$88000.
* The company's objective is to make an annual profit of 20%(be-
fore tax) on the investments in each of its products.
Required
* Calculate:
* The value of the investment on 30thSeptember 2000.
* The sales level on which the project will break-even.
* The estimated profit for the year.
* The margin of safety ratio
* The sales level necessary to achieve a target of 20% on the
value of the investment
* Give a short discussion of the project based on your
calculations and the other information at your disposal
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5.10 References
Prof.M.A. Faul, P.C. du Plessis, S.J. Vuuren, A Niemand and E. Koch:
Fundamentals of Cost and Management Accounting, Third Edition, 1997.
Butterworths, Durban.
Charles T. Horngreen, Gary L. Sunden and William O. Stratton: Introduc-
tion to Management Accounting, 10th Edition, 1996. Prentice-Hall In-
ternational, London.
Meigs & Meigs, Better and Whittington: Accounting, The Basis for Business
Decisions. 10th Edition, 1996. The Mcgraw-Hill Companies, Inc.
New York
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Unit 6 Planning and Control: The Budgetary Process
6
Unit Six
Planning and Control: The

Budgetary Process
6.1 Introduction
W e now turn to the Planning and Control Process in organizations.

The purpose of management is to implement an organization's
strategies. The process of identifying, evaluating and deciding on these
strategies is called strategy formulation. The process of implementing
the organization's strategies is known as the budgetary process. This unit
examines the budgetary process as a tool for management planning and
control process and looks at different types of budgets and their uses
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6.2 Objectives
At the end of the unit, you should be able to:
* Define the planning and budgetary control process.
Uses of a budget
* Explain the budget making process.
* Define the master budget and other related budgets and explain
their uses.
* Prepare different types of budgets
* Work out some examples
6.3 Definition of Terms

Operating cycle is the average time required for the cash invested in
inventories to be converted into cash, ultimately collected on sales made
to customers. It involves the conversion of cash into inventories and of
inventories into accounts receivables and accounts receivables back into
cash.
Performance Report is a schedule comparing the actual and budgeted

performance of a particular responsibility center.
The budget period is the period covered by a budget and this period
should be long enough to show the effects of managerial policies so that
the estimates can be with reasonable accuracy.
A Master Budget is an overall financial and operating plan, including

the budgets for all aspects of business operations and for all responsibil-
ity centers. It is made up of a number of interrelated budgets that collec-
tively summarize all the planned activities of a business.
A responsibility center is a cost center or revenue centers or profit

center to which the budget refers.
Responsibility budget is a portion of the master budget showing the budg-

eted performance of a particular responsibility center.
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6.4 Budgeting and Budgetary Control

A budget is a comprehensive financial plan setting forth the route for
achieving the financial and operational goals of an organization. It is a
plan expressed in quantitative, usually monetary, terms covering a speci-
fied period of time, usually a year. Even a small business will benefit
from preparing a formal written plan for its future operations including
the expected levels of sales, expenses, net income, and cash receipts and
cash outlays as this helps to set the targets at to set standards against
which performance can be measured.
All economic entities - businesses, churches, universities, government

agencies and even individuals engage in some sort of budgeting. A fac-
tory worker, for example, with limited financial resources may prepare a
list of monthly cash payments to ensure that they do not exceed the ex-
pected monthly salary.
Most business engages in some degree of planning. The extent to which

plans are formalized in written budgets varies from business to business.
Medium to large companies however, have carefully developed budgets
for every aspect of their operations.
The use of a budget is a key element of financial planning and control.

Managers compare the actual costs with the budgeted amounts and take
corrective action as necessary.
Management controls the activities of an organization in a number of

ways including the following:
Â Strategic Planning
Â Budgeting
Â Measurement and
Â Evaluation
Strategic planning is a process of deciding on the programs an organi-

zation undertakes and the approximate amounts of resources to allocated
to each program. Budgeting is also a planning process but the essential
difference between the two is that strategic planning looks forward sev-
eral years into the future whereas budgeting focuses on the next year.
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In preparing a budget, each program is translated into terms that corre-

spond to the responsibility of those managers who have been charged
with executing the program or some part of it. The plans are therefore
translated into responsibility centers and are referred to as the responsi-
bility budgets in the budgeting process.
6.5 Uses and Benefits of Budgets

The following are some of the uses and benefits of preparing the budgets.
6.5.1 Uses of budgets:

The budget is an important planning and control instrument. The follow-
ing are some of the uses derived from the budget:
Â It serves as an aid in making and coordinating short-range

plans. Strategic planning decisions results in major planning
decisions and these decisions are refined through the process of
budgeting.
Â The budget serves as a means for communicating plans to the

various responsibility center managers. For the organizations' plans
to be carried out, they must be understood. Communication is there-
fore required within the organization in order to understand how
the goods or services are to be produced, using what methods,
people and equipment, and materials to be purchased, etcetera.
Examples of information to be communicated include the amounts
that may be spent on wages, advertising, maintenance costs, hours
of work and desired quality levels
Â It serves as a means of educating managers about the detailed

workings of their responsibility centers and the relationships of
their centers with other centers in an organization.
Â It is used as a benchmark for controlling ongoing activities in

an organization since the managements control purpose is to attain
the desired results. A carefully prepared budget is the best possible
standard against which to compare actual performance. A
comparison of actual performance with budgeted performance
provides attention to where action may be needed.
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Â An analysis of the variance between actual and budgeted

results do the following:
Â Help identify a problem area that needs to attention.
Â Reveal any exploitable opportunity not predicted in the budget or
Â Reveal that the original budget was unrealistic in some way.
Â The budget is used as a basis for evaluating the performance of

the responsibility centers and their managers in that monthly
variances from the budgets are used for control purposes during the
year. The comparison of the actual and budgeted results for the
entire year is frequently a major factor in the year-end evaluation
of each responsibility center and its manager.
Â Lastly the budget can be used as a powerful force in motivating

managers to work towards the objectives of their responsibility
centers and hence towards the overall goals of the company.
Motivation will be greatest when these managers have played an
active role in the development of their budgets.
6.5.2 Benefits derived from budgeting

The process of budgeting is often called the financial forecasting. The
budgeting process is therefore a forecast of future financial events and
planning and preparation of a formal budget benefit the company in a
number of ways, including the following:
Â Enhancing managerial perspective.
Managers tend to focus attention on the routine problems of running the

business. By preparing a budget, managers are, however, forced to con-
sider all aspects of a company's internal activities and to make estimates
of future economic conditions, including costs, revenue, interest rates,
demand for the company's products and competition. The budgeting proc-
ess thus, increases the managements' awareness of the company's exter-
nal environment.
Â Advance warning of problems.
The budget provides management with warning of financial problems

since it shows the expected results of future operations. If, for example,
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the budget shows that the company selling cold drinks will run short of
cash during the summer months, management has advance warning to
either borrow or reduce expenditure.
Â Coordination of activities.
The preparation of the budget provides management with an opportunity

to coordinate the activities of the various departments within a business.
For example, the production department should be budgeted to produce
approximately the same quantity of goods as the sales department has
budgeted to sell.
Â Performance Evaluation.
The budget show the expected output, that is, the revenue to be earned
or units to be produced as well as the expected costs and expenses. This is
used as a yardstick with which each department's actual performance
may be measured.
6.6 Budget Making Process

All of you have at one stage or another participated in the preparation of
a budget either for yourself or for your organization. The process can be
a simple exercise of determining how you generate personal income and
how to spend it or it can be a highly complex process involving a group of
people. We will look at the budgetary process in larger organizations.
6.6.1. Budget preparation

The budget preparation is a managerial process. For medium to large com-
panies, the starting point of the budget making process is the creation of
a Budget Committee, consisting of several members of the senior man-
agement group. The Committee prepares the general guidelines that the
organization should follow and resolves any differences amongst the
centers. In some cases the committee is headed by the Budget Director or
one of the finance managers who provides the Committee members with
past performance data useful in preparing the budget, disseminate in-
structions about budget preparation, make computations based on deci-
sions reached by the line managers. The Committee assembles the final
budget.
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6.6.2. Budget timetable

Most organizations prepare their budgets once a year with separate budget
estimates for each month or each quarter. Others have what is known as
the rolling budget where the organization prepares a new budget every
quarter but have a budget with a full year ahead.
There has to be a carefully worked out timetable specifying the order in

which several parts of the operating budget are developed and the time
when each must be completed and the budget is submitted to the board
for final approval.
In general, the timetable covers the following steps and these are: the
setting of planning guidelines, preparing the sales budget , negotiating an
agreement on final plans, negotiating to agree on final plans, coordina-
tion and review of the components, final approval and distribution of the
approved budget.
Â Setting Planning Guidelines. Guidelines on how the budgets are

going to be prepared are set by the Budget Committee to assist the
managers with the budget preparation.
Â Preparing the sales budget. This budget must be made early as it

affects most other budgets.
Â Negotiating to agree on final plans. This is the crucial stage of

the process where negotiations are carried out between managers
and their superiors. The value of the budget as a plan of what is to
happen, as a motivating device and as a standard against which
actual performance are to be measured depends on whether the
budget is skillfully negotiated. The end product of the negotiation
process is an agreement that is a commitment by each party, that is
both the subordinate and the superior.
Â Coordination and review of the components of a budget is a

continuous process during the budgeting process when the budget
move up and down the organizations' hierarchy. During this
process, there may be need to change some aspects of the budget
so that it is in line with the rest of the budget.
Â Final approval of the budget by the senior management signifies

the official agreement of senior management to the proposed plans
for the year.
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Â Distribution of the approved budget

The components of the approved budget are transmitted down to
the appropriate responsibility centers. In a large organization the
whole budget preparation process may take up to three months
whilst in a small organization it may take only up to a month.
Activity 6.1
* Briefly explain three ways in which a business may expect
?
to benefit from preparing a budget
* List in a logical sequence and explain the major steps in
the preparation of a master budget
* What is a flexible budget? Explain how the a flexible budget in-
creases the usefulness of budgeting as a means of evaluating per-
formance
* Explain the relationship between the managerial functions
of planning and controlling costs
6.7 Master budgets

A master budget is a complete budget package of an organization con-
sisting of a number of interrelated budgets that collectively summarize
all the planned activities of the business. It is not a single document but a
number of related budgets, which are put together to form a " master
budget".
The elements of a typical master budget vary according to the size and
nature of the business. A typical master budget for a manufacturing com-
pany includes the following elements: operating, capital and the budg-
eted financial.
Operating budgets, include a number of center budgets related to pro-

duction and sales. These include the following budgets: sales forecast,
production schedule, manufacturing cost budget, cost of goods sold
budget and operational expense budget.
Capital budget shows planned changes in property, plant and equip-

ment.
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Budgeted financial Statements shows the cash budget, budgeted income

statement and budgeted Balance Sheet.
The above operational budgets are segmented by responsibility centers

and the extent of the details included in the budget depends on nature of
the business and the size of the organization. Bigger companies prepare a
master budget which includes all the above operational budgets whilst
smaller companies amalgamate some of the different into single budgets.
Smaller companies would usually have only the operating budget, the
capital budget and the cash budget. The income statement and the budg-
eted balance sheet in smaller companies are included in the operating
budget.
Non- manufacturing companies will only have budgeted sales, cash in-
come statement and balance sheet and will not include such budgets as
production schedules and manufacturing cost budgets
The budgets and schedules comprising the master budget are closely in-
terrelated as illustrated in Fig. 6.1 below.
ELEMENTS OF THE MASTER BUDGET

Operating
expense budget
Cash budget Sales forecast Budgeted

Income
statement
Production
schedule
(in units)
Manufacturing
cost budget
Capital Budgeted
expenditures balance sheet
budget
Fig. 6.1
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(Source: Meigs & Meigs, Better and Whittington: Accounting, The

Basis for Business Decisions. 10th Edition, 1996.The Mcgraw-Hill Com-
panies, Inc. New York)
As you can see from the above, all the budgetary elements are interre-
lated and affect one another. All budgets, for example, affect the cash
budget. The sales forecast affect the production schedules, manufactur-
ing expenses, operating expense budget and income statement. All these
elements, including the capital budget affect the budgeted balance sheet.
6.7.1 Steps in the preparation of a master budget

Several steps in preparing a master budget are identifiable. A logical se-
quence of preparing the annual elements of the master budget include
the preparation of sales forecast, sales revenues, production, manu-
facturing costs and operating expenses, the income statements, cash
budgets and the budgeted balance sheet.
Â Preparation a sales forecast.
The starting point in the preparation of a master budget is to include the

preparation of sales forecast, sales revenue etcetera. Such forecast will
be based upon past experience, estimate of general business perform-
ance, economic conditions and levels of expected competition. A sales
forecast plays a central role in the budgetary process. A forecast of the
expected levels of sales is a pre- requisite to scheduling production, budg-
eting revenue and variable costs.
Â The second step is to prepare the operating budgets.
These budgets are made up of sales revenues, production, manufacturing

costs and operating expenses. These elements of a master budget depend
upon the level of sales and cost- volume relationships. The operating
budget provides an excellent control device because comparing it with
actual performance can provide a basis for assessment.
Â Thirdly, you need to prepare a budgeted income statement. This

statement is based on the successful conclusion of the two items
above.
Â Fourthly, you prepare a cash budget. The cash budget is affected

by many other budget estimates.
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Â Finally, you have to prepare a budgeted balance sheet. This is

the last budget to be prepared. It is also affected by the capital
expenditure and budgeted income statement.
6.8 Sales Budget

Sales budgets reflect a commitment by management to take the neces-
sary actions to achieve or attain the desired results. The amount of ex-
pected sales and the product mix govern the level and the general charac-
ter of the company's operations. Sales estimates are based on the statisti-
cal forecast, on the basis of mathematical analysis of general business
conditions and market conditions etcetera and judgmental estimate by
collecting opinions of executives and sales persons
Example.
Mr. J . Chirenga, a marketing director for Better Results Services (Pvt)

Limited is optimistic that demand for the company's product of exercise
books will continue to grow in the year 2001. He estimates that sales will
increase to 5000 units in the first half of the year and 8000 units in the
second half. In order to keep their products affordable to a wide range of
users, the company is committed to holding the selling price at $50.00 per
unit.
Required:
Prepare a sales budget for the company for the year 2000.
Solution
Sales budget for the year 2000
Forecast 1st Half-year 2nd half-year
Budgeted Sales (in units) 5 000 8 000

Selling Price per unit $ 50 $ 50
Budgeted Sales $250 000 $400 000
(Note: The budget figures are arrived at through both judgmental and
statistical forecast.)
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6.9 Production Budget

A production budget is a budget that forecast the production and the
operating used in the production process so that the estimated units re-
quired for sale can be produced.
Production budgets depend on the sales forecast and production costs

and expenses.
Example
Simbarashe Enteprises (Pvt) Limited's production policy is that the

number of finished goods inventory to be held is to be 20% of the sales
units volume anticipated in the following year. In the last quarter of 1999
the company sold 14500 units.
It is anticipated that the sales forecast for the 1st half-year is 15000 and
the 2nd - year is 18000.
Required
Prepare a production schedule for Simbarashe Enterprises for the year

2000.
Solution
SIMBARASHE ENTERPRISES (PVT) LIMITED
Production Schedule (in Units) for the year 2000
Production schedule (in Units) 1st half year 2nd half year
Budgeted unit sales 15 000 18 000

Add:
Desired ending inventory of finished goods 3 000 3 600
Units budgeted to be available for sale 18 000 21 600
Less: Beginning inventory of finished goods 2 900 3 020

Planned production for finished goods 15 100 18 580
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6.10 Cash Budgets

A cash budget is a forecast of the cash receipts and cash payments for the
budget period. The budgeted levels of cash receipts depends upon a
number of factors including the sales forecast, credit terms offered by the
company and the company's experience in cash collection from its cli-
ents.
The budgeted cash payments depend upon the forecast of manufacturing

costs, operating expenses and capital expenditures as well as the credit
terms offered by the suppliers, debt repayment and anticipated borrow-
ings.
Example
Simbarashe Enterprises (Pvt) Limited, sells all its products on account.

Assume that payment for 80% of all sales is made during the half- year
period and 20% is paid for during the next half-year period. Also assume
that there are no bad debts and that all creditors are paid when due during
the period.
The following information is provided Mr. Lawrence, the finance man-

ager of Simbarashe Enterprises (Pvt) Limited.
Previous half year sales=$281250.

Total current sales: 1st half =$250 000: 2nd half=$375 000
Cash in the bank at beginning of period= $45 500
Required:
Prepare a cash budget for the company
Solution
SIMBARASHE ENTERPRISES (PVT) LIMITED
Cash budget for the year 2000
1st Half Year 2nd Half Year
Cash at the beginning of each half year 45 500 55 500

Cash receipts from current sales 200 000 300 000
Cash from sales of previous period 56 250 50 000
Total cash available 301 750 405 500
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Cash payments
Payment of current payables 156 000 187 000
Prepayments 8 000 11 250
Other payments (tax, interest, etc) 85 250 95 750
Total disbursement 246 250 294 000
6.11 Capital Budgeting.

A capital budget is essentially a list of what management believes to be
the worthwhile projects for the acquisitions of plant assets, develop new
product lines or acquire subsidiary companies. It reflects the short and
long term planning for changes and of all fixed assets and is known as
capital investment. Since capital investments are usually relatively large,
this budget is just as important as the sales budget during the compilation
of the master budget.
Uncertainty of the future makes all investment decisions extremely im-

portant. Capital investments involve large risks and obligations of a per-
manent nature and must be financed from profits, long-term loans or the
issue of shares or working capital.
The proposals for capital expenditures come up from all sections of the
organization and they are screened at various levels. Only the sufficiently
attractive ones flow up to the top and appear in the final capital expendi-
ture budget. The estimated cash out flows are shown by quarters or by
years so that the cash required in each period can be determined.
The capital budget process can be divided into the following three phases:
planning, evaluation and control
The first phase is that of planning. A well-prepared budget must be backed

by a thorough research analysis of every possibility that may exist.
The second phase is that of evaluation. Capital budget are evaluated by

applying the various techniques such as the discounted cash flows using
the net present value and the required rate of return, the pay back period
and the return on average investments (ROI).
Finally, the control phase in which the procedures necessary to control

the approved budget's performance until it is accomplished are estab-
lished.
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Approval of the capital budget usually means approval of the project in

principle. However, it does not mean the final authority to proceed with
the purchase. Specific authorization for the project to go ahead has to be
requested, spelling out the proposal in detail together with price quota-
tions. Only then is the final approval be granted and the project go ahead.
6.12 Flexible (Variable) Budgets

In the actual environment, the sales or production activity may be differ-
ent from the budgeted figures. If the actual level of activity is substan-
tially different from the original level budgeted, then performance may be
difficult to evaluate. A flexible budget is the answer to this problem.
A flexible budget shows the planned behavior of costs at various vol-

ume levels. It is usually expressed in terms of a cost volume relationship
and can be adjusted easily to show the budgeted revenue, costs and cash
flows at different level of activity. If, for example, a change in volume
lessens the usefulness of the original budget, a new budget may be pre-
pared quickly to reflect the actual level of activity for the period.
Example
The production manager of Better Results Services (Pvt) Limited is pre-

sented with the performance report shown below:
Better Results Services (Pvt) Limited

Performance Report of the Production Department
For the Half-Year Period Ended 30th June 2000.
Amount Actual Over Budget or

(Under) budgeted
Manufacturing Costs
$ $ $
Direct materials used 45 000 52 000 7 000
Direct Labor 10 000 13 000 3 000
Variable overheads 15 000 18 000 3 000
Fixed costs 25 000 26 500 1 500
Total manufacturing costs 95 000 109 500 14 500
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The table compares the manufacturing cost originally budgeted for the
period with the actual performance. The figures show that the all the
actual costs exceed the budget and this could reflect the company's poor
performance. However, exceeding the budget could have been as a result
of increased production to meet the increased demand from 4500 units
of the previous period. To meet a higher than expected demand of the
company's products, the production department produced 5000 units in-
stead of 4500. This means that management has to re-evaluate its con-
clusions to concerning the company's ability to control costs.
Using the estimated costs above, the manufacturing cost budget for Bet-
ter Results Services may be revised to reflect any level of production.
These costs may be used to forecast half yearly manufacturing cost at
three levels of production as shown below.
Level of Production
(In Units)
4 500 5 000 5 500
Manufacturing costs (estimates
from above schedule)
Variable costs:
Direct materials ($10 per unit) 45 000 52 000 59 000
Direct labour ($2.2 per unit) 10 000 13 000 16 000
Manufacturing overheads
($3.3 per unit) 15 000 18 000 21 000
Fixed costs
Manufacturing overhead
($25 000 per half year) 25 000 25 000 25 000
Total Manufacturing Costs 95 000 108 000 121 000
Notice that the budgeted variable costs change as the level of production
changes whereas the budgeted fixed costs remain unchanged.
For the purposes of the master budget, one level of the flexible budget is
included in the master budget. That volume becomes the planned level
of the operations for the budget period.
With flexible budgets, it is easy to evaluate the budgets performance be-

cause the actual costs can be compared with those budgeted at different
levels of production.
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6.13 Zero Based Budgets

The zero based budgeting process is a process where in deciding the rev-
enue and costs associated with a budget, the costs estimates are built
from scratch i.e. from zero. Starting from a zero base means the process
does not take into account the current levels of costs as a starting point
for the purposes as is customary with the normal budgetary process.
An effective zero based review involves thoroughly reviewing each part

of the whole organization every two to three years.
Making a zero based review of an expense center involves asking basic

questions about each significant activity of the center such as:
Â Should this activity continue to be performed?
Â Is too much/too little being done?
Â Should it be done internally, or should it be contracted to an out

side (or make- or -buy question?
Â There is a more efficient way of obtaining the desired results?
Â How much should it cost?
Zero based budgets are appropriate in governmental and non- govern-

mental agencies, which tend to have high discretional costs. They are also
useful for expense centers having a high proportion of discretional costs.
The zero based activity has been popularized under a number of names
such as process analysis, process re-engineering activity based manage-
ment.
6.14 Incremental Budgeting.

Incremental budgeting is the opposite of the zero based process and is
widely used by companies. The budget committee focuses on how the
coming year's activities will differ from this year's and then adjusts the
current year's budget amounts for these differences including increased
salaries and other inflationary impacts. This method of budgeting has an
advantage of taking into performance of the current budget.
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Its major advantage is that you use the current performance as starting
point and then analyze the expected performance for the coming year.
You thus save costs because you take your current performance into ac-
count.
6.15 Continuous Budgeting

Continuous budgeting policy requires the company to add a new month
to the end of the budget as the current month draws to a close. The
budget will thus always cover the upcoming 12 months.
The major advantage of the continuous budget is that it stabilizes the

planning horizon at one year ahead. This removes the problem created by
other fiscal approaches of budgeting whereby the planning period be-
comes shorter as the year progress.
Continuous budgeting forces managers into a continuous review and re-

assessment of the budget estimates and the company's current progress.
An increasing number of companies follow this policy of budgeting.
6.16 Summary
This Unit looked at the budgeting and budgetary process as a tool for
planning and controlling. We defined the budgetary process and outlined
the budget making process. A master budget and its related budgets were
explained and a number of examples of budget preparation were worked
out. Below are a number of exercises, which you should work through.
These assist you to understand principles behind the preparation of budg-
ets.
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Activity 6.2
* Question 1
? * The following information is from the manufacturing account
of Zuma Manufacturing (Pvt) Limited's manufacturing budget
and the budgeted financial statements:
Direct materials inventory Jan. 1 $75 000

Direct materials inventory, Dec.31 85 000
materials budgeted for the use during the year 350 000
Accounts payable to suppliers of materials, Jan.1 45 000
Accounts payable to suppliers of materials, Dec.31 65 000.
Compute the budgeted amounts for:
i) Purchases of direct materials during the year.

ii) Cash payments during the year to the suppliers of materials
* Question 2
* Christopher Chidhumo Enterprises' sales of oranges on account
for the two months of June and July are budgeted as follows:
June…………………………………………….……...$500 000
July………………………………………….………... $750 000
All sales were made on terms and collections on accounts receivable

are typically made as follows:
Collections within the month of sale.

Within the period………………………………………..….60%
After discount period………………………………… ……15%
Collections within the month following the sale.
Within the discount period………………………………...15%

After the discount period. ………………………………….5%
Returns, allowances and uncollectables…………………….5%
Total ……………………………………………………….100%
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REQUIRED:
To compute the estimated cash collections on accounts receivable for

the month of February.
* Question 3
* John Mawere of Chiutsi (Pvt) Limited is negotiating with a bank
for a $200 000, 90 days, 12% loan effective July 1. of the current
year. If the bank grants the loan, the proceeds will be $194
000;which Mawere intends to use on 1st July as follows: Pay ac-
counts payable, $150 000; purchase equipment, $16 000; add to
the bank balance, $28 000.
* The current working capital position of the company, according

financial statements is as follows:
Cash in the Bank $ 20 000

Receivables (net of allowance for doubtful accounts) 160 000
Merchandise inventory 90 000
Total current assets 270 000
Accounts payable (including accrued operating expenses) 150 000
Working Capital 120 000
* The bank loan offer asks John to prepare a forecast of his compa-
ny's cash receipts and payments for the next three months to dem-
onstrate that the loan can be repaid at the end of September .
* The company has made the following estimates, which are to be
used in preparing. A three- month cash budget: Sales (all on ac-
count) for July, $300 000; August, $360 000;September, $270 000;
and October, $200 000. Past experience indicates that that 80%
of the receivables generated in any month will be collected in the
month following the sale, and 1% will prove uncollectable. John
expects to collect $120 000 of the June receivables in July, and the
remaining $40 000 in August.
* Cost of the goods sold consistently has averaged about 65% of
sales. Operating expenses are budgeted at $36 000 per month plus
8% of sales. With the exception of $4 400 per month depreciation
expense, all operating expenses and purchases are on account and
are paid in the month following their incurrence.
* Merchandise inventory at the end of each month should be differ-
ent to cover the following months' sales:
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Required
* Prepare a monthly cash budget showing estimated cash receipts
and cash payment for July, August, and September, and the cash
balance at the end of each month. Supporting schedules should be
prepared for estimated collections on receivables, estimated mer-
chandise purchases and estimated payments for operating expenses
and of accounts payable for the merchandise purchases.
* On the basis of this cash forecast, write a brief to the company
explaining whether it will be able to repay the $200 000 bank loan
at the end of September.
* Question 4
* Zwenhamo Investments (Pvt) Limited uses the departmental budg-
ets and performance reports in planning and controlling its manu-
facturing operations. The following annual performance report for
the custom made saddle production department was presented to
the Chief Executive Officer of the company.
Budget costs Over or

For 5 000 units Actual Costs (under budget)
per unit total r units per unit
Variable manufacturing costs:
Direct materials $30.00 $150 000 $171 000 $21 000
Direct labor 48.00 240 000 261 500 21 500
Indirect labor 15.00 75 000 95 500 20 500
Indirect materials, 9.00 45 000 48 400 3 400
supplies, etc
Total Variable
Manufacturing $102 000 $510 000 576 400 $66 400
Costs
Fixed manufacturing costs
Lease rental $9.00 $ 45 000 45 000 none

Salaries of foreman 24.00 120 000 125 000 5 000
Depreciation and other 15.00 75 000 78 600 3 600
Total fixed
Manufacturing costs 48.00 240 000 248 600 8 600
Total manufacturing costs $150.00 $750 000 $825 000 $75 000
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Although a production volume of 5 000 saddles was originally budg-

eted for the year, the actual volume of production achieved for the
year was 6000 saddles. Direct materials and direct labor are charged to
production at actual cost. Factory overheads are applied to production
at the pre-determined rate of 150% of the actual direct labor cost.
After a quick glance at the performance report showing an unfavorable

manufacturing cost variance of $75 000, the C.E.O. said to the
accountant: "Fix this thing so that it makes sense. It looks as though
our production people are really blew the budget. Remember that we
exceeded our budgeted production schedule by a significant margin. I
want this performance report to show a better picture of our ability to
control costs."
Required
Prepare a revised performance report for the year on a flexible budget
basis. Use the same format as the production report above, but revise
the budgeted cost figures to reflect the actual production level of
6 000 saddles.
Briefly comment upon Zwenhamo Investments (Pvt) Limiter's ability

to control its variable manufacturing costs.
What is the amount of over or under applied manufacturing overheads

for the year?
(Note that a standard cost system is not used)
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6.18 References
Meigs & Meigs, Better and Whittington: Accounting, The Basis for Business
Decisions. 10th Edition, 1996. The Mcgraw-Hill Companies, Inc.
New York. Chapters 25 and 26
R.N. Anthony, J.S. Reece and J. Hertenstein. Accounting: Text and Cases,
(9th Edition, 1995, Irwin McGraw-Hill, Boston. Read Chapter 24
Prof.M.A. Faul, P.C. du Plessis, S.J. Vuuren, A Niemand and E. Koch:
Fundamentals of Cost and Management Accounting, Third Edition, 1997.
Butterworths, Durban.
Charles T. Horngreen, Gary L. Sunden and William O. Stratton: Introduc-
tion to Management Accounting, 10th Edition, 1996.Prentice-Hall In-
ternational, London.
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Mbaz502 Accounting For Manager

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ZIMBABWE OPEN UNIVERSITY

Accounting For Managers

Module (MBA 502)

P.O. Box MP1119

The Zimbabwe Open University is a distance teaching and

Year: 2001, Reprinted 2004

Cover design: B. Pillay

Layout and Design :S. Mapfumo

Printed by: Benaby Printing and Publishing (Pvt) Ltd

Typeset in Garamond, 12 point on auto leading

Content Reviews: J. Mujuru

As a progressive university that is forward

Unit One: Background Information to Accounting

1.1 _______ Introduction ____________________________________________________ 5

Unit Two: Principles and Concepts of Accounts

2.1 _______ Introduction __________________________________________________ 15

Unit Three: Fundamentals of Accounting Transactions

3.1 _______ Introduction __________________________________________________ 31

Unit Four: Interpretation of Financial Statements

4.1 _______ Introduction __________________________________________________ 57

Unit Five: Management Accounting

5.1 _______ Introduction __________________________________________________ 8 3

Unit Six: Planning and Control: The Budgetary Process

6.1 _______ Introduction _________________________________________________ 129

W elcome to the MBA 502: Accounting for Managers a core

It is not necessary for a professional manager to be an expert in account-

A synopsis of the broad areas covered by this accounting course is given

Â Define accounting and outline the various branches of accounting;

Â Describe the basic accounting concepts and list organizations that

Â Draw up the traditional financial statements such as the income

Â Conduct an analysis and interpretation of financial statements as

Â Outline some basic management accounting concepts;

Â Explaining the concepts.

Â Describing how they are used in practice in the formulation of both

Â Giving some illustrative examples of the practical application of

Unit three deals with drawing up of the traditional financial statements

Â The preparation and presentation of financial statements, includ-

Â Gives practical examples of the treatment of assets, profit or losses,

Unit 4 deals with conduct an analysis and interpretation of the financial

Unit 5 covers the basic management accounting. It gives the back-ground

Â Background to management accounting.

Â Cost-volume- profit analysis.

Â Standard costing and variance analysis.

Unit 6 dwells on understanding, preparing and interpreting of the budg-

T he purpose of this unit is to give you the background information

* Define accounting accurately;

1.3 What is Accounting?

The purpose of accounting is to provide decision makers with informa-

Accounting is often called the language of business because it is widely

Accounting information is a tool, which should be used by managers to

In the modern business environment, you need to be familiar with ac-

As you already aware, accounting is a practical subject, which requires a

1.3.1 Branches of accounting

We discuss each of these branches below:

1.3.1.1 Financial accounting

Financial Accounting is a more specific term applied to the preparation

Financial accounting is usually referred to as the general-purpose infor-

1.3.1.2 Financial management

Financial managers are much more involved in the management of an

1.1 _ Introduction ______________________________________________ 5

2.1 _ Introduction ____________________________________________ 15

3.1 _ Introduction ____________________________________________ 31

4.1 _ Introduction ____________________________________________ 57

5.1 _ Introduction ____________________________________________ 8 3

6.1 _ Introduction ___________________________________________ 129