Accounting - Edinburgh Business School

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AccountingNiall LothianJohn SmallAC-A4-engb 2/2016 (1001)

This course text is part of the learning content for this Edinburgh Business School course.In addition to this printed course text, you should also have access to the course website in this subject,which will provide you with more learning content, the Profiler software and past examination questionsand answers.The content of this course text is updated from time to time, and all changes are reflected in the versionof the text that appears on the accompanying website at http://coursewebsites.ebsglobal.net/.Most updates are minor, and examination questions will avoid any new or significantly altered material fortwo years following publication of the relevant material on the website.You can check the version of the course text via the version release number to be found on the frontpage of the text, and compare this to the version number of the latest PDF version of the text on thewebsite.If you are studying this course as part of a tutored programme, you should contact your Centre forfurther information on any changes.Full terms and conditions that apply to students on any of the Edinburgh Business School courses areavailable on the website www.ebsglobal.net, and should have been notified to you either by EdinburghBusiness School or by the centre or regional partner through whom you purchased your course. If this isnot the case, please contact Edinburgh Business School at the address below:Edinburgh Business SchoolHeriot-Watt UniversityEdinburghEH14 4ASUnited KingdomTel 44 (0) 131 451 3090Fax 44 (0) 131 451 3002Email [email protected] www.ebsglobal.netThe courses are updated on a regular basis to take account of errors, omissions and recentdevelopments. If you'd like to suggest a change to this course, please contactus: [email protected]

AccountingThe Accounting programme is written by Niall Lothian, formerly Professor at Edinburgh Business School,Heriot-Watt University, and John Small, Professor Emeritus at Heriot-Watt University. Both havepreviously occupied chairs in the University’s Department of Accountancy and Finance.Professor Lothian has taught at IMEDE (now IMD) in Lausanne and is currently a member of thevisiting faculty of INSEAD, Fontainebleau; the European School of Management and Technology, Berlin;and Duke Corporate Education. He has conducted seminars and managerial briefings in Europe, Africaand China, the latter under the auspices of the United Nations Industrial Development Organisation.Professor Lothian has been consultant to British government agencies such as the Ministry of Defenceand the Cabinet Office and to numerous international companies.His current research and consulting interests include the study of managerial controls over R&D expenditure, a field in which he has published widely, and the accounting implications of flexible manufacturingsystems. A chartered accountant by professional training, he is a Past President of the Institute ofChartered Accountants of Scotland. He was the inaugural chairman of the audit advisory board of theScottish Parliamentary Corporate Body and is chairman of Inspiring Scotland, a venture philanthropytrust. Professor Lothian was made an Officer of the Order of the British Empire in the New Year’sHonours 2012.Professor Small was Chairman of the Accounts Commission in Scotland from 1982 to 1991. TheAccounts Commission is responsible for arranging the audit of local government in Scotland and ensuringthe proper steps are taken to achieve economy, efficiency and effectiveness. He has recently served onthe board of Scottish Homes.He is a member of the Council of the Chartered Association of Certified Accountants and was itsPresident in 1982/83. He has been Chairman of the Education Committee of the International Federationof Accountants and a member of the executive Board of the Union Européenne des Experts Comptables,Economiques et Financiers. He is an honorary member of the Arab Society of Certified Accountants. Hehas also held visiting professorships and external examinerships at various universities and businessschools.His special interest is in the use of financial information in decision making for planning and control. In thisarea he is a consultant to a number of organisations and has advised companies and government agenciesin the UK and abroad.Professor Small was made a Commander of the Order of the British Empire in the Queen’s BirthdayHonours, 1991.

First Published in Great Britain in 1991. Niall Lothian and John Small 1991, 1998, 2001, 2003, 2007, 2014.The rights of Niall Lothian and John Small to be identified as Authors of this Work have been asserted inaccordance with the Copyright, Designs and Patents Act 1988.All rights reserved; no part of this publication may be reproduced, stored in a retrieval system, ortransmitted in any form or by any means, electronic, mechanical, photocopying, recording, or otherwisewithout the prior written permission of the Publishers. This book may not be lent, resold, hired out orotherwise disposed of by way of trade in any form of binding or cover other than that in which it ispublished, without the prior consent of the Publishers.

ContentsPART 1FINANCIAL ACCOUNTING FOR MANAGERSModule 1An Introduction to Accounting and the Accounting Equation1/11.1Approaching Accounting1/21.2The Reality of Accounting1/21.3What Accounting Is1/31.4Focus on Profit-Seeking Businesses1/51.5Who Are the Users of a Company’s Accounting Information?1/61.6For What Sort of Decisions Do these Users Value Accounting Information? 1/61.7Common Information Requirements among Users1/81.8The Accounting Equation1/91.9The Accounting Statements1/121.10 Sole Trader versus MBA1/231.11 Accounting: The External and Internal Functions1/241.12 Accounting Principles1/25Review Questions1/26Case Study 1.11/31Module 2The Income Statement2.12.22.32.42.52.62.72.8IntroductionWhat Is Profit?The Measurement of AccomplishmentAnother Reason for Opting for ‘Ship and Invoice’Conventions Underlying Measurement of Sales AccomplishmentThe Measurement of EffortTask One: Determining the Consumption of the Means of ProductionTask Two: Determining the Value of Closing Work-in-Progress andInventories2.9Types of Inventory in a Manufacturing Company2.10 Inventory Valuation Methods2.11 Valuation of Work-in-Progress and Finished Goods2.12 Interpreting ProfitLearning SummaryReview QuestionsCase Study 2.1Case Study 2.2Case Study 2.3Accounting Edinburgh Business 22/272/282/322/322/33v

ContentsModule 3The Balance Sheet3/13.1Introduction3.2The Anatomy of the Balance Sheet3.3Non-Current Assets3.4Current Assets3.5Current Liabilities3.6A Matter of Judgement3.7Gearing (or Leverage)3.8Why Does a Balance Sheet always Balance?Learning SummaryReview QuestionsCase Study 3.1Case Study 3.2Module 43/13/23/33/83/103/113/113/133/153/163/223/22The Cash Flow Statement4/14.1Introduction4.2Why Are Cash Flow Statements Needed?4.3What Is ‘Cash’ in a Cash Flow Statement?4.4Cash: Where Does It Come From? Where Does It Go To?4.5Three Major Categories of Cash FlowLearning SummaryReview QuestionsCase Study 4.1Case Study 4.2Module 5The Framework for Financial The Concept of DisclosureSources of Disclosure RequirementsGovernment LegislationAccounting StandardsStock Exchange RequirementsFinancial Reporting in ActionAn Introductory Note on Groups of CompaniesAbstract of Annual Reports: The MBA Company and the Award CompanyThe Accounting PoliciesThe Consolidated (or Group) Income Statement(or Profit and Loss Account)The Consolidated (or Group) Balance SheetProvisions, Contingent Liabilities and Contingent Edinburgh Business School Accounting

Contents5.14 A Concluding Note on MBA’s Balance Sheet5.15 Group Cash Flow Statement5.16 Detailed Disclosure Requirements for Selected Items5.17 Lessons to Be Learned5.18 Fundamental Accounting Principles5.19 Management Commentary5.20 Reporting on Corporate Social Responsibility5.21 The External AuditorLearning SummaryAppendix 5.1: Extract from MBA Group Annual Report 20x2Appendix 5.2: Extract from Award Group Annual Report 20x2Review QuestionsCase Study 5.1Module 6Interpretation of Financial Statements6.1Introduction6.2Ratio Analysis6.3Group 1: Liquidity Ratios6.4Group 2: Profitability Ratios6.5Group 3: Capital Structure Ratios6.6Group 4: Efficiency Ratios6.7Other Possible Ratios6.8Window Dressing6.9Putting it all Together: The Dupont Chart6.10 A One Hundred Per Cent Statement6.11 Basic Stock Market RatiosLearning SummaryReview QuestionsCase Study 6.1Case Study 6.2Module 96/206/256/27How to Understand and Analyse a Bank’s Annual Financial Statements 7/17.1Introduction7/17.2A Line-by-Line Description of a Bank’s Income Statement and Balance Sheet 7/27.3Additional Information Provided by Banks for the Purposes of Analysis7/67.4Ratio Analysis7/87.5A Few Highlights and Key Topics in the Industry7/14Learning Summary7/42Appendix 7.1: Historical Accounting Data for Bute Bank plc7/42Review Questions7/46Case Study 7.17/50Accounting Edinburgh Business Schoolvii

ContentsPART 2MANAGEMENT ACCOUNTING FOR DECISION MAKINGModule 8An Introduction to Cost and Management Accounting8.1What Accounting Is: A Refresher8.2Management Accounting Looks Forward8.3Where Accounting Fits into a Company8.4A Brief Note on What a Manager Does8.5The Role of Accounting Information8.6Management Accounting in MBA8.7Differences between Management Accounting and Financial Accounting8.8Management Accounting and Cost Accounting8.9Where Costs Come from and an Overview of the Modules to Follow8.10 Process Costing8.11 Costs Relevant to Management Decisions8.12 Other Topics in the Management Accounting CourseLearning SummaryReview QuestionsModule 9Cost Characteristics and 68/178/189/19.1Introduction9.2Cost: A Deceptively Simple Word9.3Variable and Fixed Costs9.4Beware the Unitising of Fixed Costs!9.5Direct and Indirect Costs9.6Traceable and Common Costs9.7Product Costs and Period Costs9.8Controllable and Non-Controllable Costs9.9Standard and Actual Costs9.10 Engineered and Discretionary Costs9.11 Another Look at Variable and Fixed Costs: The Break-Even Chart9.12 Profit from Different Cost Structures9.13 The Break-Even Chart: An Alternative Display9.14 Other Ways of Calculating Break-Even Points9.15 Break-Even Analysis and the Multi-Product Firm9.16 Contribution and Limiting Factors of Production9.17 Assumptions Underpinning Cost–Volume–Profit AnalysisLearning SummaryReview QuestionsCase Study 9.1Case Study /159/179/179/219/239/249/279/279/349/35Edinburgh Business School Accounting

ContentsModule 10Allocating Costs to Jobs and Processes10.1 Introduction10.2 Cost Gathering10.3 Where Do These Costs Come From?10.4 Plantwide versus Departmental Rates10.5 Joint Products and By-Products10.6 Process Costing10.7 Process Costing and the Equivalent Unit10.8 Cost per Equivalent Unit10.9 Activity-Based Costing10.10 Traditional Costing versus ABCLearning SummaryReview QuestionsCase Study 10.1Case Study 10.2Case Study 10.3Module 11Costs for Decision Making11.1 Introduction11.2 The Dilemma of the Denominator11.3 Managerial Implications of Absorption versus Variable Costing11.4 Cost Information for Management Decisions11.5 Routine and Non-Routine Decisions11.6 Developing an Analytical Framework11.7 Finding the Relevant Costs11.8 The Pitfalls of Full Costing11.9 Opportunity Costs11.10 Department versus Company11.11 Sunk Costs11.12 Management Decisions in Action11.13 Closing down a Unit11.14 The Special Sales Order11.15 Should we Process Further?Learning SummaryReview QuestionsCase Study 11.1Case Study 11.2Accounting Edinburgh Business 1/1911/2111/2311/3111/32ix

ContentsModule 12Budgeting12/112.1 Introduction12.2 Why Bother with Budgets?12.3 Why Budgeting Gets a Bad Name12.4 Budgeting in Action: The Go-Straight Trolley Company12.5 Discretionary Expenditure and Zero-Base BudgetingLearning SummaryReview QuestionsCase Study 12.1Module 13Standard Costing13/113.1 Introduction13.2 Setting Standards13.3 A Word about Motivation13.4 Flexible Budgets13.5 The Anatomy of Variances: Materials and Labour13.6 Responsibility for Variances13.7 Variable and Fixed Overhead Analysis13.8 Investigation of Variances13.9 Sales Variances13.10 Pulling It All TogetherLearning SummaryReview QuestionsCase Study 13.1Case Study 13.2Module 14Accounting for /2013/2813/2813/3513/3614/114.1 Introduction14.2 Why Divisionalise?14.3 Types of Divisions14.4 Defining Profits and Investments14.5 Asset Base Valuation14.6 Residual Income: An Alternative to ROI14.7 The Imputed Rate of Interest Does Matter!14.8 A Cautionary Note about Performance Measures14.9 Transfer Pricing14.10 Criteria for Establishing a Transfer Price14.11 The International DimensionLearning SummaryReview 314/24Edinburgh Business School Accounting

ContentsCase Study 14.1Module 15Investment Decisions15.1 Introduction15.2 The Investment Process15.3 Concept of Present Value15.4 Discounted Cash Flow Approach15.5 Net Present Value (NPV)15.6 Discounted Cash Flow (DCF) Rate of Return15.7 Comparison of Net Present Value and DCF Rate of Return15.8 Investment Appraisal in Non-Revenue and Not-for-Profit Situations15.9 Risk and Uncertainty and Inflation15.10 Risk and Uncertainty15.11 Payoff or Payback Period15.12 Sensitivity Analysis15.13 Risk Analysis15.14 The Key Investment Factors15.15 Projected Weighted Average Cost of Capital15.16 Weighted Average Cost of Capital15.17 Opportunity Cost, Risk and the Cost of Capital15.18 Investment Appraisal and Inflation15.19 Post-Assessment/Continuous Post-Audit of Capital Expenditure ProjectsLearning SummaryAppendix 15.1: Present Value TableAppendix 15.2: The Calculation of the Internal Rate of ReturnReview QuestionsCase Study 15.1Module 16Alternative Techniques to Measure Efficiency and Performance16.1 Introduction16.2 Target Costing16.3 Life Cycle Costing16.4 Throughput Accounting16.5 Costing for Competitive Advantage16.6 The Balanced Scorecard16.7 Time-Driven Activity-Based CostingLearning SummaryReview QuestionsCase Study 16.1Case Study 16.2Accounting Edinburgh Business 516/1916/2316/3116/3516/3516/4016/41xi

ContentsAppendix 1Practice Final Examinations and Worked SolutionsPractice Final Examination 1Practice Final Examination 2Appendix 2GlossaryIndexxiiA1/11/11/13Answers to Review QuestionsA2/1Module 1Module 2Module 3Module 4Module 5Module 6Module 7Module 8Module 9Module 10Module 11Module 12Module 13Module 14Module 15Module 952/1022/1082/117G/1I/1Edinburgh Business School Accounting

PART 1Financial Accounting for ManagersModule 1 An Introduction to Accounting and theAccounting EquationModule 2 The Income StatementModule 3 The Balance SheetModule 4 The Cash Flow StatementModule 5 The Framework for Financial ReportingModule 6 Interpretation of Financial StatementsModule 7 How to Understand and Analyse a Bank’sAnnual Financial StatementsAccounting Edinburgh Business School

Module 1An Introduction to Accounting andthe Accounting EquationContents1.11.21.31.41.51.6Approaching Accounting .1/2The Reality of Accounting .1/2What Accounting Is .1/3Focus on Profit-Seeking Businesses .1/5Who Are the Users of a Company’s Accounting Information? .1/6For What Sort of Decisions Do these Users Value AccountingInformation? .1/61.7Common Information Requirements among Users .1/81.8The Accounting Equation .1/91.9The Accounting Statements. 1/121.10 Sole Trader versus MBA . 1/231.11 Accounting: The External and Internal Functions . 1/241.12 Accounting Principles . 1/25Review Questions . 1/26Case Study 1.1. 1/31Learning ObjectivesBy the end of this module you should understand: the value to various groups in society of a knowledge of accounting; the role of accounting in management; the need for, and use of, accounting information in decision making within anyorganisation; the accounting equation; the basic layout of the income statement (sometimes called the profit and lossaccount), the balance sheet and the cash flow statement; the distinction between financial accounting and management accounting.Accounting Edinburgh Business School1/1

Module 1 / An Introduction to Accounting and the Accounting Equation1.1Approaching AccountingFew subjects in a master’s degree course in Business Administration are approachedby students with a greater sense of awe than accounting. Put another way, of all thesubjects typically on offer in an MBA programme, accounting is the one thatstudents would most prefer to avoid! Why should this be? Here are some reasonsthat may reflect the reader’s thinking as he or she embarks on this course. Unlike many other MBA disciplines, such as marketing, economics and organisational behaviour, which are viewed as being intuitive – that is, the reader has afairly good idea of what the subject is about without prior study – accounting isnon-intuitive, requiring the mastery of rules from the outset. Accounting is seen to deal exclusively with numbers; many people prefer to dealwith words and ideas. Because of its concentration on numbers, accounting is considered to beconcerned with precision and accuracy, both of which require a highly developedmathematical mind. Accounting is solely concerned with applying arbitrary rules and conventions,such as International Accounting Standards, and is therefore mechanistic andrequires only good memory. Readers know friends and relatives who have studied for a degree or professionalqualification in accounting; since these people spent many years studying, howcan an MBA course deal with complexities so quickly? Accounting and accountants are treated by society as being dull and boring! Theimage, bolstered by the perceived obsession with numbers and accuracy, ispicked up by TV scriptwriters and producers, who stereotype the accountant asbeing humourless, repetitive, pedantic, unimaginative and incapable of formingclose personal relationships!In an effort to put the reader’s mind at ease at the outset of the course, twopoints should be made.1. Virtually everyone (whether studying for an MBA or not) who is not a trainedaccountant views accounting and accountants as set out above.2. They are all wrong!1.2The Reality of AccountingAll business disciplines, inc

Accounting The Accounting programme is written by Niall Lothian, formerly Professor at Edinburgh Business School, Heriot-Watt University, and John Small, Professor Emeritus at Heriot-Watt University. Both have previously occupied chairs in the University’s Department of Accountancy and Finance.

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