CMA Part 1
Volume 1: Sections A – C
Financial Planning,
Performance, and Analytics
Version 20.02
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2020 Edition
CMA
Preparatory Program
Part 1
Volume 1: Sections A – C
Financial Planning,
Performance, and Analytics
Brian Hock, CMA, CIA
and
Lynn Roden, CMA
HOCK international, LLC
P.O. Box 204
Oxford, Ohio 45056
(866) 807-HOCK or (866) 807-4625
(281) 652-5768
www.hockinternational.com
cma@hockinternational.com
Published August 2019
Acknowledgements
Acknowledgement is due to the Institute of Certified Management Accountants for
permission to use questions and problems from past CMA Exams. The questions and
unofficial answers are copyrighted by the Certified Institute of Management Accountants
and have been used here with their permission.
The authors would also like to thank the Institute of Internal Auditors for permission to
use copyrighted questions and problems from the Certified Internal Auditor Examinations
by The Institute of Internal Auditors, Inc., 247 Maitland Avenue, Altamonte Springs,
Florida 32701 USA. Reprinted with permission.
The authors also wish to thank the IT Governance Institute for permission to make use
of concepts from the publication Control Objectives for Information and related
Technology (COBIT) 3rd Edition, © 2000, IT Governance Institute, www.itgi.org.
Reproduction without permission is not permitted.
© 2019 HOCK international, LLC
No part of this work may be used, transmitted, reproduced or sold in any form or by any
means without prior written permission from HOCK international, LLC.
ISBN: 978-1-934494-70-7
Thanks
The authors would like to thank the following people for their assistance in the
production of this material:
§
§
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Kekoa Kaluhiokalani for his assistance with copyediting the material,
All of the staff of HOCK Training and HOCK international for their patience in the
multiple revisions of the material,
The students of HOCK Training in all of our classrooms and the students of HOCK
international in our Distance Learning Program who have made suggestions,
comments and recommendations for the material,
Most importantly, to our families and spouses, for their patience in the long hours
and travel that have gone into these materials.
Editorial Notes
Throughout these materials, we have chosen particular language, spellings, structures
and grammar in order to be consistent and comprehensible for all readers. HOCK study
materials are used by candidates from countries throughout the world, and for many,
English is a second language. We are aware that our choices may not always adhere to
“formal” standards, but our efforts are focused on making the study process easy for all
of our candidates. Nonetheless, we continue to welcome your meaningful corrections and
ideas for creating better materials.
This material is designed exclusively to assist people in their exam preparation. No
information in the material should be construed as authoritative business, accounting or
consulting advice. Appropriate professionals should be consulted for such advice and
consulting.
Dear Future CMA:
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Sincerely,
Brian Hock, CMA, CIA
President and CEO
CMA Part 1
Table of Contents
Table of Contents
Introduction to CMA Part 1 ............................................................................................... 1
Section A – External Financial Reporting Decisions ...................................................... 3
A.1. Financial Statements ................................................................................................. 3
Users of Financial Information
The Financial Statements
Differences Between IFRS and U.S. GAAP
1) The Balance Sheet (Statement of Financial Position)
2) The Income Statement
3) Introduction to the Statement of Cash Flows (SCF)
4) Statement of Comprehensive Income
5) Statement of Changes in Stockholders’ Equity
Notes to the Financial Statements
Preparation of the Statement of Cash Flows
3
4
4
5
13
18
19
23
24
26
A.1.5 Integrated Reporting .............................................................................................. 43
Introduction to Integrated Reporting
The International <IR> Framework
Sustainability Accounting Standards Board (SASB)
43
45
55
A.2. Recognition, Measurement, Valuation, and Disclosure ........................................ 56
1) Asset Valuation............................................................................................................ 56
1a) Cash and Cash Equivalents...................................................................................... 56
Cash
Cash Equivalents
56
57
1b) Accounts Receivable ................................................................................................ 58
Valuing Accounts Receivable
Discounts and Initial Recording of the Account Receivable
Credit Losses on Receivables
Sales Returns and Allowances
Factoring: Using Receivables as an Immediate Source of Cash
58
58
61
71
71
1c) Inventory .................................................................................................................... 72
Valuing the Inventory When It Is Purchased
Which Goods Are Included in Inventory?
Costs Included in Inventory
Determining Which Item Is Sold: Cost Flow Assumptions
Effect of the Different Methods
The Frequency of Determining Inventory Balances
The Physical Inventory Count
Errors in Inventory
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73
74
75
79
79
85
86
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Recognizing Permanent Declines in Inventory Values
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88
1d) Investments ............................................................................................................... 93
Investments in Debt Securities – Methods 1, 2, and 3
The Fair Value Option for Investments in Debt Securities
Investments in Equity Securities – Methods 3, 4, 5, and 6
Investments Where the Investor Does Not Have Significant Influence
Long-Term Investments Where the Investor Has Significant Influence or Control
Changes in Level of Ownership or Degree of Influence
Consolidated Financial Statements – Method 6
95
96
97
97
100
103
103
1e) Property, Plant, and Equipment ............................................................................. 107
Initial Recording of the Fixed Asset
Depreciation
Net Book Value of Fixed Assets
Calculation of Depreciation
Depreciation Methods
Depreciation for Tax Purposes
Which Method of Depreciation is Best?
Impairment of Long-Lived Assets to be Held and Used
107
108
108
108
109
112
114
114
1f) Intangible Assets ..................................................................................................... 116
Initial Recording of Intangible Assets
Amortization and Accounting Treatment of Intangibles
Impairment of Limited-Life Intangible Assets
Impairment of Indefinite-Lived Intangible Assets Other Than Goodwill
Goodwill and the Impairment of Goodwill
116
117
118
118
119
2) Valuation of Liabilities .............................................................................................. 120
2a) Reclassification of Short-term Debt ...................................................................... 120
2b) Warranty Liabilities ................................................................................................. 121
1) Accounting for Assurance-Type Warranties
2) Accounting for Service-Type Warranties
122
124
2c) Accounting for Income Taxes ................................................................................ 126
Book Income, Taxable Income, and Deferred Taxes
Temporary Timing Differences
Permanent Timing Differences
128
130
132
2d) Accounting for Leases ........................................................................................... 133
Definition of a Lease
The Two Categories of Leases
134
134
3) Equity Transactions .................................................................................................. 137
Corporate Shareholders’ Equity
Retained Earnings
Treasury Stock
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138
145
145
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CMA Part 1
Table of Contents
Classification of Shares
145
4) Income Statement...................................................................................................... 147
4a) Revenue Recognition .............................................................................................. 147
Contract Assets and Liabilities
Five Steps to Revenue Recognition
Special Revenue Recognition Issues
Disclosures for Revenue Recognition
147
149
153
163
4b) Income Measurement .............................................................................................. 165
Expense Recognition
Gains and Losses
Gains and Losses on the Disposal of Fixed Assets
Presentation of Gains and Losses on the Income Statement
Involuntary Disposals
Comprehensive Income
165
166
166
168
168
169
Section B – Planning, Budgeting and Forecasting ..................................................... 170
B.1. Strategic Planning .................................................................................................. 171
Planning in Order to Achieve Superior Performance
Types of Plans and General Principles
The Strategic Planning Process
Other Planning Tools and Techniques
Characteristics of Successful Strategic Plans
171
173
176
195
199
B.2. Budgeting Concepts .............................................................................................. 202
The Relationship Among Planning, Budgeting, and Performance Evaluation
Advantages of Budgets
Time Frames for Budgets
Methods of Developing the Budget
Who Should Participate in the Budgeting Process?
The Budget Development Process
Budgetary Slack and Its Impact on Goal Congruence
Responsibility Centers and Controllable Costs
Standard Costs Used in Budgeting
202
203
205
206
208
208
210
210
211
B.3. Forecasting Techniques ........................................................................................ 221
Using Linear Regression Analysis in Forecasting
Using Learning Curves in Forecasting
Using Probability Concepts in Forecasting
221
228
236
B.4. Budget Methodologies .......................................................................................... 241
The Annual/Master Budget
Static Budgets and Flexible Budgets
Project Budgeting
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242
245
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Activity-Based Budgeting (ABB)
Zero-Based Budgeting versus Incremental Budgeting
Continuous (Rolling) Budgets
CMA Part 1
246
248
248
B.5. Annual Profit Plan and Supporting Schedules.................................................... 249
The Budgeting Cycle
Development of the Annual/Master Budget or Profit Plan
Development of the Master Budget
The Master Budget Financial Statements
Ongoing Budget Reports
249
250
251
262
264
Answering Budgeting Exam Questions ...................................................................... 265
Flexible Budgeting Questions
Units to Produce / Purchase Questions
Cash Budget Questions
267
269
273
B.6. Top-Level Planning and Analysis ......................................................................... 275
Pro Forma Financial Statements
Analysis of Pro Forma Financial Statements
Other Uses of Pro Forma Financial Statements
275
286
288
Section C – Performance Management ....................................................................... 289
C.1. Cost and Variance Measures ................................................................................ 290
Determining the Level of Activity for Standard Costs
Sources of Standards
291
292
Variance Analysis Concepts ........................................................................................ 294
“Levels” in Variance Analysis
Static Budget Variances vs. Flexible Budget Variances
294
294
Manufacturing Input Variances .................................................................................... 301
The Difference Between Sales Variances and Production Variances
What Causes Manufacturing Input Variances?
Direct Materials Variances
Direct Labor Variances
More Than One Material Input or One Labor Class
Factory Overhead Variances
301
302
303
309
312
325
Sales Variances ............................................................................................................. 349
Sales Variances for a Single-Product Company
Sales Variances When More than One Product is Sold
Variances Example for a Multiple-Product Company Using Contribution Margin
350
356
364
Variance Analysis for a Service Company .................................................................. 368
Market Variances ........................................................................................................... 376
C.2. Responsibility Centers and Reporting Segments ............................................... 378
Evaluating the Manager vs. Evaluating the Business Unit
iv
379
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CMA Part 1
Table of Contents
Allocation of Common Costs
The Contribution Income Statement Approach to Evaluation
Transfer Pricing
380
382
386
C.3. Performance Measures .......................................................................................... 395
Strategic Issues in Performance Measurement
Performance Measurement
Balanced Scorecard
Customer and Product Profitability Analysis
395
396
407
414
Appendix A – Time Value of Money Concepts (Present/Future Value)..................... 417
Simple Interest
Compound Interest
Present Value
Future Value
417
418
419
425
Appendix B: Variance Report for a Company Selling Two Products ........................ 434
Answers to Questions ................................................................................................... 438
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CMA Part 1
Introduction to CMA Part 1
Introduction to CMA Part 1
The CMA Part 1 Exam has six sections in the ICMA’s Learning Outcome Statements:1
1)
External Financial Reporting Decisions: 15%
2)
Planning, Budgeting and Forecasting: 20%
3)
Performance Management: 20%
4)
Cost Management: 15%
5)
Internal Controls: 15%
6)
Technology and Analytics: 15%
The Learning Outcome Statements (LOS) for both exam parts are available to download on the IMA’s website at www.imanet.org.
The questions on the exams focus on understanding, in-depth thinking on business strategy, and problemsolving ability, not just number crunching. In order to be able to think through the questions on the exam,
candidates will need to understand the concepts and be able to apply the concepts to new situations. These
study materials provide the tools for understanding the concepts, but they cannot teach in-depth thinking
and problem solving. Your ability to put the knowledge you gain into practice to pass the CMA exam will
depend on you and the effort you put into preparing for the exam.
Section A, External Financial Reporting Decisions, represents 15% of the exam. Section A covers external
financial reporting from the perspective of its use in decision-making only, which is what is tested on the
Part 1 exam. A knowledge of external financial reporting is assumed as a prerequisite to preparing for the
CMA exams.
Section B, Planning, Budgeting and Forecasting, represents 20% of the exam and includes strategic planning, budgeting, forecasting, and top-level planning and analysis.
Section C, Performance Management, is 20% of the exam. Section C covers variance analysis and responsibility accounting as well as financial performance measures. For variances, it is important to be able to
calculate the variances and interpret the information provided by variance analysis. Therefore, in addition
to memorizing the variance formulas, candidates will need to be able to understand and interpret the results
of each variance calculation.
Section D, Cost Management, is 15% of the exam. Section D focuses on costing systems and covers a
number of methods of allocating costs and overheads. It also covers supply chain management and business process improvement.
Section E, Internal Controls, represents 15% of the exam. The technicalities of internal controls are important to know, especially the relevant laws businesses are subject to and the related guidance that has
been published. The Sarbanes-Oxley Act has had far-reaching effects and candidates should be familiar
with its requirements.
Section F, Technology and Analytics, is 15% of the exam and covers information systems including accounting information systems, data governance, technology, and data analytics.
The exam will consist of 100 multiple-choice questions and 2 essay scenarios, each with several questions.
The multiple-choice questions will not be presented in order according to sections. Thus, an exam might
begin with a sales variance question, then follow that with an inventory question, and so forth.
Only candidates who score a minimum of 50% correct on the multiple-choice portion of the exam will be
eligible to take the essay section of the exam.
1
The Learning Outcome Statements are published by the Institute of Certified Management Accountants (ICMA), the
examining body for the CMA exams. The Learning Outcome Statements provide in detail the information candidates need
to know and things they need to be able to do in order to pass the CMA exams.
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Introduction to CMA Part 1
CMA Part 1
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Section A
Section A – External Financial Reporting Decisions
Section A – External Financial Reporting Decisions
A.1. Financial Statements
Note: References to the relevant sections of the FASB’s Accounting Standards Codification® and to other
publications of the FASB are provided throughout Section A. The references are supplied for candidates
who wish to do further research on the topics. Candidates are not expected to memorize the relevant
reference numbers.
Financial accounting is the process of reporting the results and effects of the financial transactions a business undertakes. The objective of financial reporting is to provide useful financial information about the
entity for decision-making. Those using the financial information to make decisions include present and
potential equity investors, lenders, and other creditors who need to make decisions about providing resources to the entity. The decisions relate to buying, selling, or holding debt or equity instruments and
providing credit. In order to make these decisions, investors, lenders, and other creditors need information
to help them assess the amount of, timing of, and prospects for future net cash inflows to the entity. 2
Other users who may or may not be providing capital to the firm—such as management, employees, financial analysts and regulators—may also find financial statements useful as well.
The types of decisions potential investors, lenders, and other creditors are making are numerous and varied.
It is not possible for accounting information to provide all of the information that all users need to make
their decisions. Users need to access information from other sources as well, such as economic forecasts,
the political climate, and industry outlooks.3 However, the financial statements do attempt to provide as
much useful information as possible.
Users of Financial Information
Published financial information must comply with the established accounting standards because outside
users will rely on it to make a variety of decisions. Accounting standards are in place to protect outside
users by ensuring that the information is accurate and useful and can be understood by everyone.
Because so many people are using financial information for so many diverse purposes, the reasons people
need the financial information are also diverse, such as:
•
Making investment decisions.
•
Extending or withholding credit.
•
Assessing areas of strength and weakness within the company.
•
Evaluating management performance.
•
Determining whether or not the company is complying with regulatory requirements.
Users of financial information can be classified by various distinctions:
Direct and Indirect Users. Direct users are directly affected by the results of a company. Direct users
include investors and potential investors, employees, management, suppliers, and creditors. Direct users
stand to lose money if the company has financial problems.
Indirect users are people or groups who represent direct users. They include financial analysts and advisors,
stock markets, and regulatory bodies.
2
FASB Statement of Financial Accounting Concepts No. 8, Conceptual Framework for Financial Reporting, September
2010, Chapter 1, paragraph OB3.
3
Ibid.
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A.1. Financial Statements
CMA Part 1
Internal and External Users. Internal users make decisions within the firm. External users make decisions from outside of the firm about whether or not to begin a relationship, continue a relationship, or
change their relationship with the firm.
Note: Users of financial statements are assumed to have a reasonable knowledge of business and
economic activities and to be willing to study the information with reasonable diligence. Those assumptions are important because they mean that, in the preparation of financial statements, a
reasonable level of competence on the part of users can be assumed. Someone who has a “reasonable
understanding” of business, accounting, and economic activities should be able to read the financial
information and understand it.
The Financial Statements
The five financial statements used by business entities under U.S. Generally Accepted Accounting Principles
(GAAP) are:
1)
Balance sheet (also called the statement of financial position)
2)
Income statement
3)
Statement of cash flows
4)
Statement of comprehensive income
5)
Statement of changes in stockholders’ equity
Note: The notes to the financial statements are also considered an integral part of the financial statements but are not an actual financial statement. The purpose of the notes is to provide informative
disclosures required by U.S. GAAP.
Note: A company can also prepare prospective financial statements. Prospective financial statements are financial statements based on a set of assumptions that present projected information about
a future period. Whenever prospective financial statements are prepared, the significant accounting
policies and significant assumptions used need to be disclosed.
Differences Between IFRS and U.S. GAAP
IFRS stands for “International Financial Reporting Standards,” a widely accepted set of accounting
principles used in many countries around the world. IFRS is primarily a principles-based set of accounting
standards with few practical examples and limited interpretative guidance. Neither acting as a tax standard
nor applying to government organizations, IFRS is intended for multiple countries with different cultural,
legal, and commercial standards.
IFRS’s main objective is to be more open and flexible; therefore, the standard-setters leave interpretation
to companies and their auditors, resulting in greater flexibility. As a result, companies and their auditors
can interpret IFRS differently. The significance of these differences in interpretation will vary from company
to company, depending on factors such as the nature of the company’s operations, the industry in which it
operates, and the accounting policies it chooses.
U.S. GAAP, on the other hand, is largely a rules-based body of standards with extensive interpretive
guidance for individual industries and specific examples for auditors and practitioners. It applies to United
States-based entities and foreign companies that participate in the U.S. financial markets. In addition, the
standard-setters actively interpret the standards. This active participation often results in a proscriptive
approach in U.S. GAAP that reflects the strong regulatory environment in the United States.
4
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Section A
A.1. Financial Statements
Because many of the countries in the world have adopted IFRS, think of IFRS as “International” GAAP
compared to “U.S.” GAAP. Despite their differences, the general principles, conceptual framework, and
accounting results between U.S. GAAP and IFRS are often very similar, if not the same, because the two
standards are more alike than different for most common transactions.
For the exam, candidates need to know what IFRS is and some specific differences between U.S. GAAP and
IFRS. These specific differences appear in orange boxes following the related U.S. GAAP coverage
of the topic.
1) The Balance Sheet (Statement of Financial Position)
Note: Guidance in the Accounting Standards Codification® on presentation of the balance sheet is in
ASC 210.
The balance sheet, also called a statement of financial position, provides information about an entity’s
assets, liabilities, and owners’ equity at a point in time (usually the end of a reporting period). The balance
sheet shows the entity’s resource structure, or the major classes and amounts of its assets, and its financing
structure, or the major classes and amounts of its liabilities and equity.
A balance sheet is not intended to show the value of a business. However, along with other financial statements and other information, a balance sheet should provide information that will be useful to someone
who wants to make his or her own estimate of the business’s value.4
Balance sheet accounts are permanent accounts. Balance sheet accounts are not closed out at the end
of each accounting period as income statement accounts are, but rather their balances are cumulative.
They keep accumulating transactions and changing with each transaction, year after year.
Elements of the Balance Sheet
Elements of the balance sheet include assets, liabilities, and stockholders’ (or owners’) equity.
Assets are probable future economic benefits that have been obtained or are controlled by an entity as a
result of past transactions or events. Thus, an asset:
•
Arose from a past transaction
•
Is presently owned by the company
•
Will provide a probable future economic benefit to the company
Note that the preceding definition encompasses three time periods: the past, the present owned, and the
future.
Liabilities are probable future sacrifices of economic benefits due to present obligations of an entity to
transfer assets or provide services in the future, resulting from past transactions or events. 5 Thus, a liability:
•
Arose from a past transaction
•
Is presently owed by the company
•
Will lead to a probable future sacrifice of economic benefits by the company
As with the definition of an asset, the definition of a liability encompasses the past, the present and the
future.
4
FASB Statement of Financial Accounting Concepts No. 5, Recognition and Measurement in Financial Statements of
Business Enterprises, December 1984, paragraph 27.
5
FASB Statement of Financial Accounting Concepts No. 6, Elements of Financial Statements of Business Enterprises,
December 1985, paragraph 35.
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A.1. Financial Statements
CMA Part 1
Equity represents the entity’s net assets, or the residual (remaining) interest in the assets of the entity
after deducting its liabilities from its assets. For a business entity, equity is the ownership interest.
Current and Non-Current Classification of Assets and Liabilities
On the balance sheet, assets and liabilities are classified as either current or non-current. Generally,
current assets and liabilities are short-term and non-current assets and liabilities are long-term, but the
more correct terminology for both assets and liabilities is “current” and “non-current.” Whether an asset or
liability is classified as current or non-current depends on the time frame in which the entity expects an
asset to be converted into cash or a liability to be settled.
Current Assets
Current assets are cash and other assets or resources that are reasonably expected to be realized in cash
or sold or consumed during the normal operating cycle of the business.
Note: The operating cycle is defined in the Master Glossary in the FASB’s Accounting Standards Codification® as the average time between the acquisition of materials or services and their final cash
realization.
Per ASC 210-10-45-3, a one-year time period is to be used as the basis for the segregation of current
assets when an entity has several operating cycles occurring within a year. However, if the period of an
entity’s operating cycle is greater than twelve months, for example as in the tobacco, distillery, and
lumber businesses, the longer period is used as the entity’s operating cycle. If an entity has no clearly
defined operating cycle, the one-year rule governs.
Current assets are perhaps the easiest of the various sections of the balance sheet to identify. They include:
6
•
Cash available for current operations, including coins, currency, undeposited checks (checks that
have been received but have not yet been deposited in the bank), money orders and drafts, and
demand deposits.
•
Cash equivalents. Short-term, highly liquid investments that are convertible to known amounts
of cash without a significant loss in value and have maturities of 3 months or less from the date of
purchase.
•
Marketable securities representing the investment of cash that is available for current operations. Marketable securities classified as trading securities are always current assets.
•
Receivables. Trade accounts receivable, notes receivable, and acceptances receivable. Receivables from officers, employees, affiliates and others are also current assets if they are collectible in
the ordinary course of business within one year.
•
Contract assets classified as current assets. Under the revenue recognition standard in ASC
606, contract assets represent an entity’s right to consideration in exchange for goods or services
that the entity has transferred to a customer when that right is conditional on something other
than the passage of time, for example the entity’s future performance. Contract assets may be
current assets or non-current assets or both, depending on the facts and circumstances such as
when payment is due, based on the agreement with the customer.
•
Installment or deferred accounts and notes receivable if they conform generally to normal
trade practices and terms within the business.
•
Inventories. Merchandise on hand and available for sale and, for a manufacturer, raw materials,
work-in-process, and finished goods. Operating supplies and ordinary maintenance material and
parts are also inventories.
•
Prepaid expenses. Amounts paid in advance such as an insurance premium paid at the beginning
of a policy period for insurance coverage to be received during the portion of the future policy
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Section A
A.1. Financial Statements
period that will occur during the coming operating cycle. Prepaid expenses are not convertible to
cash, but they are classified as current assets because they would have required the use of current
assets during the coming operating cycle if the expenses had not been prepaid.
•
Funds that are restricted for current purposes. If cash or cash equivalents are being held for
a current purpose, such as for payment of existing obligations due within a year or the operating
cycle, whichever is longer, or as a compensating balance to support short-term borrowing, the
cash should be reported on a separate line in the current assets section of the balance sheet. More
information is below under Restricted Cash: An Asset That Could be Either Current or Non-Current.
Non-Current Assets
Non-current assets are assets or resources other than those that are reasonably expected to be realized
in cash or sold or consumed during the normal operating cycle of the business.
Non-current assets include:
•
Cash and claims to cash that are restricted as to withdrawal or use for other than current operations, are designated for the acquisition or construction of non-current assets, or are segregated
for the liquidation of long-term debts. The restricted cash should be reported on a separate line in
the investments or other assets section as non-current assets.
•
Marketable securities that do not represent the investment of cash available for current operations.
Held-to-maturity debt securities are normally classified as non-current assets.
•
Investments or advances, whether marketable or not, made for the purpose of obtaining control,
for affiliation, or other continuing business advantage.
•
Property, plant, and equipment.
•
Right-of-use assets obtained under lease agreements.
Note: The FASB has not specified whether right-of-use assets obtained under lease agreements
are to be considered tangible or intangible assets.
•
Intangible long-term assets.
•
Other long-term assets such as long-term prepaid expenses, prepaid pension cost, and receivables
arising from unusual transactions not expected to be collected within twelve months.
•
Contract assets that are classified as non-current assets.
•
Deferred tax assets.
•
The cash surrender value of life insurance policies on the lives of key employees.
Property, Plant, and Equipment (Fixed Assets)
Property, plant, and equipment (PP&E) are tangible assets used in operations that will continue to be used
beyond the end of the current period. When the fixed assets are purchased, they are recorded at their cost,
including shipping-in and installation costs needed to bring the asset to usable condition. The cost is then
expensed over the life of the asset through depreciation, amortization, or depletion (except for land, which
is not depreciated).
Examples of property, plant, and equipment are:
•
Land, buildings, machinery, furniture, equipment, and vehicles
•
Leasehold improvements, or improvements made to leased property at the lessee’s expense
•
Natural resources, such as gas, minerals, or timber
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7
A.1. Financial Statements
CMA Part 1
Natural resources other than land are depleted, while property, plant, and equipment other than land are
depreciated or amortized. Land is not depreciated, amortized, or depleted.
Intangible Assets
Intangible assets do not have physical substance but they provide benefit to the firm over a period of time.
Intangible assets may be either purchased or developed internally. However, because an asset recorded on
the balance sheet comes about only as a result of a prior transaction, internally-generated intangible assets
are not recorded on the balance sheet.6
Examples of intangible assets are copyrights, patents, goodwill, trademarks, and franchises. An intangible
asset with a limited life is amortized over its useful life. An intangible asset with an indefinite life, such as
goodwill, is assessed periodically for impairment.
Restricted Cash: An Asset That Could be Either Current or Non-Current
Cash could be restricted for a number of reasons:
•
Petty cash and payroll funds or funds to be paid in dividends
•
Cash in accounts outside the United States may be restricted by country regulations against exportation of money
•
Cash set aside for plant expansion, retirement of a long-term debt, or for other purposes
•
Compensating balances required to be maintained by a bank or other lending institution to support
existing borrowing arrangements with the institution
Material amounts of restricted cash should be segregated from cash on the balance sheet. The restricted
cash should be classified as a current or a non-current asset depending on the date the cash will be available
for disbursement. If the cash is being held for payment of existing obligations or obligations due within the
operating cycle, the cash should be reported on a separate line in the current assets section of the balance
sheet. If the restricted cash is to be held for a longer period of time, it should be reported on a separate
line in the non-current assets section of the balance sheet.
Deposits held as compensating balances to support borrowing arrangements should be reported separately
within the cash and cash equivalents area of the balance sheet as current assets if they support short-term
borrowing arrangements. They should be reported as non-current assets if they support long-term borrowing arrangements.
Companies should describe the arrangements and the amounts involved in the notes to the financial statements.
Current Liabilities
Current liabilities are obligations that will be settled through the use of current assets or by the creation of
other current liabilities.
Examples of current liabilities include:
•
Accounts payable and trade notes payable due to suppliers for purchase of goods and services.
•
Short-term payables (for example, taxes payable, wages payable, and other accruals).
•
Dividends payable.
•
Contract liabilities representing an entity’s obligation under the new revenue recognition standard,
ASC 606, to transfer goods or services to a customer for which the entity has received consideration (or the amount is due) from the customer. Contract liabilities may be current liabilities or non-
6
For an internally-developed patent, the costs of registration fees and legal fees for filing the patent (only) may be
capitalized and amortized because the costs of research and development are expensed as they are incurred.
8
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Section A
A.1. Financial Statements
current liabilities or both, depending on the facts and circumstances such as when the entity expects to satisfy its performance obligations and how it satisfies its performance obligations—over
time or at a point in time.
•
Agency collections such as employee tax withholdings and sales taxes, where the company acts
as agent for another party (the government) and is obligated to remit the payments.
•
Obligations due on demand according to their terms, such as demand notes.
•
Short-term (30-, 60-, 90-day) notes.
•
Current portions of long-term debt and lease liabilities (the portions of the principal due within the
operating cycle, usually twelve months).
•
Taxes payable, wages payable, and other accruals.
•
Long-term obligations callable at the balance sheet date due to some violation by the company
such as a violation of a loan covenant.7
•
Assurance-type warranties8 for which the term of the warranty extends only into the next accounting period or the portion of a longer-term warranty that extends only into the next accounting
period.
Current liabilities do not include:
•
Debts to be paid by funds in accounts classified as non-current.
•
The portion of a short-term obligation intended to be refinanced by a long-term obligation, subject
to fulfilling requirements as noted below.
Note: If the company is able to demonstrate that it has the intent and the ability to refinance an
obligation that is coming due in the next twelve months, it may reclassify that obligation on the
balance sheet as a non-current liability. Having a commitment from a bank for long-term financing
of the obligation is an example of a way to demonstrate the ability to refinance it. When a company is
able to show that it has the intent and the ability to refinance an obligation coming due in the next twelve
months, on its balance sheet it will show an obligation that is due in nine months, for example, as a noncurrent liability. The company can show the obligation as a non-current liability because management
knows it will use the funds received from the future long-term borrowing from the bank to settle the
existing debt. The company is replacing one kind of debt with another kind of debt.
7
A covenant is a condition or a requirement in a loan agreement or in a bond indenture. (A bond indenture is the legal,
binding contract between a bond issuer, the borrower, and the bondholders, who are the lenders.) Covenants may
restrict the actions of the borrower or require that the borrower meet certain requirements such as maintaining certain
financial statement ratios. If the borrower fails to meet the requirements of the loan agreement, the loan becomes in
default, just as if the borrower had failed to make scheduled loan payments, and the full principal and any accrued
interest becomes immediately due and payable.
8
An assurance-type warranty is a manufacturer’s warranty given along with the sale of the product that provides assurance only that the product meets agreed-upon specifications in the contract at the time it is sold, without any additional
payment being required from the customer.
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9
A.1. Financial Statements
CMA Part 1
Bank Overdrafts: An Item That Could Be Reported by Netting Against the Current Asset “Cash” or by
Adding to the Current Liability “Accounts Payable”
Bank overdrafts, or amounts by which a company’s checking account is in a negative position due to checks
written that exceed the amount in the account, should be added to accounts payable and reported as a
current liability, unless cash in an amount that covers the overdraft is present in another account
in the same bank. If enough cash is present in another account in the same bank, the net amount of
cash available (the positive balance minus the negative balance) in that bank should be reported as part of
cash, a current asset.
Non-current Liabilities
Non-current liabilities are liabilities that will not be settled within one year or the operating cycle if the
operating cycle is longer than one year.
Examples of non-current liabilities are:
•
Contract liabilities classified as non-current liabilities.
•
Long-term notes or bonds payable.
•
The principal portions of long-term debt and lease liabilities (the portions of the principal due after
the operating cycle (usually twelve months).
•
Pension obligations.
•
Deferred tax liabilities.
•
The non-current portion of assurance-type warranties for which the term of the warranty extends
beyond the next accounting period.
Note: Most long-term debt is subject to various covenants and restrictions, requiring a great deal of
disclosure in the financial statements.
Question 1: Long-term debt should be included in the current section of the statement of financial
position if
a)
it is to be converted into common stock before maturity.
b)
it matures within the year and will be retired through the use of current assets.
c)
management plans to refinance it within the year.
d)
a bond retirement fund has been set up for use in its scheduled retirement during the next year.
(CMA Adapted)
Equity
Equity is the remaining balance of assets after the subtraction of all liabilities. Equity is the portion of the
company’s assets owned by and owed to the owners. If the company were to be liquidated, equity represents the amount that would theoretically be distributable to the owners.
All business enterprises have owners’ equity, but the types of accounts in owners’ equity will differ depending on the type of the entity. The following discussion focuses on corporations, so the elements of owners’
equity discussed here are the elements of a corporation’s equity.
10
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Section A
A.1. Financial Statements
Owners’ equity for corporations is split into six different categories:
•
Capital stock. The par or stated value of the shares issued.
•
Additional paid-in capital. The excess of amounts contributed by owners from the sale of shares
over and above the par or stated value of the shares issued.
•
Retained earnings. Net income of the company that has not been distributed as dividends.
•
Accumulated other comprehensive income items. Specific items that are not included in the
income statement but are included in equity and adjust the balance of equity, even though they
do not flow to equity by means of the income statement as retained earnings do.
•
Treasury stock. Either the amount paid for shares that have been repurchased or the par value
of shares that have been repurchased.9 Treasury stock is a contra-equity account that reduces
equity on the balance sheet.
•
Non-controlling interest. A portion of the equity of subsidiaries that the reporting entity owns
but does not own wholly. (Formerly known as “minority interest”).
Note: When a corporation repurchases shares of its own stock from the market, the repurchased shares
are called treasury shares or treasury stock. Treasury shares purchased reduce owners’ equity,
because those shares are no longer outstanding.
Benefits of the Balance Sheet
•
Because the balance sheet provides information on assets, liabilities, and stockholders’ equity, it provides a basis for computing rates of return, evaluating the capital structure of the business, and
predicting a company’s future cash flows.
•
The balance sheet helps users to assess the company’s liquidity, financial flexibility, solvency, and
risk. The statement of financial position can also be used in financial statement analysis to assess the
company’s ability to pay its debts when due and its ability to distribute cash to its investors to provide
them an adequate rate of return.
•
Liquidity refers to the time expected to elapse until an asset is converted into cash or until a
liability needs to be paid. The greater a company’s liquidity is, the lower its risk of failure.
•
Solvency refers to the company’s ability to pay its obligations when due. A company with a high
level of long-term debt relative to its assets has lower solvency than a company with a lower level
of long-term debt.
•
Financial flexibility is the ability of a business to take actions to alter the amounts and timing of
its cash flows that enable the business to respond to unexpected needs and take advantage of
opportunities.
•
Risk refers to the unpredictability of future events, transactions, and circumstances that can affect
the company’s cash flows and financial results.
9
Treasury stock can be accounted for under the cost method, the par value method, or the constructive retirement
method. Under the cost method, the full amount paid to repurchase the treasury stock is debited to the treasury stock
account. Under the par value method, the par value of the repurchased shares is debited to the treasury stock account
and the remaining purchase price is debited to the additional paid-in capital account. Under the constructive retirement
method, the par value of the repurchased shares is debited directly to the common stock account and the remaining
purchase price is debited to the additional paid-in capital account. The methods of accounting for treasury stock are
covered in more in any accounting textbook.
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11
A.1. Financial Statements
CMA Part 1
Limitations of the Balance Sheet
•
A statement of financial position provides only a partial picture of liquidity or financial flexibility unless
it is used in conjunction with at least a statement of cash flows.10
•
A balance sheet reports a company’s financial position at one point in time, but it does not report the
company’s true value, for the following reasons:
•
Many assets are not reported on the balance sheet, even though they have value and will
generate future cash flows, such as employees, human resources, internally generated intangible
assets, processes and procedures, and competitive advantages.
•
Values of certain assets are measured at historical cost, or the price the company paid to
acquire the asset—not the asset’s market value, replacement cost, or value to the firm. For example, property, plant, and equipment (PP&E) are reported on the balance sheet at historical cost
minus accumulated depreciation, although the assets’ value may be significantly greater.
•
Judgments and estimates determine the value of many items reported in the balance
sheet. For example, estimates of the balance of receivables the company will collect are used to
value accounts receivable; the expected useful life of fixed assets is used to determine the amount
of depreciation; and the company’s liability for future warranty claims is estimated by projecting
the number and the cost of the future claims.
•
Most liabilities are valued at the present value11 of cash flows discounted at the rate
that was current when the liability was incurred, not at the present value of cash flows
discounted at the current market interest rate. If market interest rates increase, a liability with a
fixed interest rate that is below the market rate increases in its value to the company. If market
rates decrease, a liability with a fixed interest rate that is higher than the market interest rate
sustains a loss in value. Neither of these changes in values is recognized on the balance sheet.
Note: To counter the limitations related to valuation, fair value is increasingly being used to measure
items presented on the balance sheet. “Fair value” is the price that would be received to sell an asset or
paid to transfer a liability in an orderly transaction between market participants at the measurement
date. U.S. GAAP has increasingly called for the use of fair value to measure financial instruments. For
example, many items such as derivatives, which previously were not reported on the balance sheet at
all, are now being reported at fair value. Entities have an option to measure most financial assets and
liabilities at fair value.
Question 2: A statement of financial position provides a basis for all of the following except
a)
computing rates of return.
b)
evaluating capital structure.
c)
assessing liquidity and financial flexibility.
d)
determining profitability and assessing past performance for a specific period.
(ICMA 2014)
10
FASB Statement of Financial Accounting Concepts No. 5, Recognition and Measurement in Financial Statements of
Business Enterprises, paragraph 24.a.
11
Present value is a time value of money concept. For information on time value of money concepts, please see Appendix
A in this volume.
12
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Section A
A.1. Financial Statements
efham CMA
2) The Income Statement
Guidance in the Accounting Standards Codification® on presentation of the income statement is in ASC
225.
The income statement reports the results of a company’s operations during a given period of time. The
income statement provides users with information to help them predict the amounts, timing, and uncertainty of (or prospects for) future cash flows.
The income statement is created using the accrual method of accounting as applied to historical transactions. The income statement gives the results of operations for a period of time and is like a movie,
recording the monetary effect of business transactions for that period of time. The income statement is
different from the balance sheet because the balance sheet provides information specific to one moment
in time, like a photograph.
The accounts used to record revenues, expenses, gains, and losses are temporary accounts. They are
closed to retained earnings, a permanent account on the balance sheet at the end of each fiscal
year. At the beginning of each fiscal year, the balances in the income statement accounts are zero.
Certain types of events are classified and reported separately on the income statement. The standard
multiple-step income statement format includes the following sections:
Sales or service revenues
−
Cost of goods sold (COGS)
=
Gross profit
−
Selling, general, and administrative expenses
=
Operating income
+
Interest and dividend income
−
Interest expense
+/− Non-operating gains/(losses)
=
Income from continuing operations before income tax
−
Provision for income taxes on continuing operations
=
Income from continuing operations
+/− Gain/(loss) from operations of discontinued Component X
including gain/(loss) on disposal of $XXXX
+/− Income tax benefit or (income tax expense) on discontinued
Component X
Net Income
Note: In addition to income information, information regarding Earnings per Share (EPS) must also
be disclosed on the face of the income statement.
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13
A.1. Financial Statements
CMA Part 1
Note: “Income from continuing operations” on a multi-step income statement is not the same as “operating income.”
Operating income includes revenues and expenses generated by the company’s core business. Operating
income does not include financial income (that is, interest and dividend income) or financial expense
(that is, interest expense, also called provision for income taxes), nor does it include non-operating gains
and losses or gains and losses on discontinued operations.
Income from continuing operations, on the other hand, does include financial income and financial expense and non-operating gains and losses in addition to revenues and expenses generated by the
company’s core business.
Income from continuing operations refers to gain or loss that the company generated on all of its activities that are expected to continue in the future. It is called income from continuing operations to
distinguish it from gains and losses on discontinued operations. Income from continuing operations does
not include income from discontinued operations because income from discontinued operations represents income or loss that is not expected to continue in the future. The potential buyer of a company
should look at income from continuing operations instead of net income because income from continuing
operations will continue in the future.
The line “Income from continuing operations” appears on an income statement only if the firm
is reporting results of discontinued operations.
A single-step income statement that has only two groupings, revenues and expenses, may also be used.
Total expenses are subtracted from total revenues to determine the net income or loss. The single-step
form of income statement is simpler and eliminates potential classification problems.
Elements of the Income Statement
The income statement is made up of four elements: revenues, gains, expenses, and losses.
•
Revenues represent inflows or other enhancements to assets or settlements of liabilities12 (or a
combination of both) as a result of delivering or producing goods, rendering services, or other
activities that constitute the entity’s ongoing major or central operations. Under ASC 606, revenue
is to be recognized in the accounting period in which the performance obligation is satisfied, that
is, when the customer obtains control of the asset, which is the good or service that is transferred
to the customer. Revenue is recognized to depict the transfer of goods or services to customers in
an amount that reflects the consideration the company expects to be entitled to in exchange for
the goods or services.
Note: The revenue recognition principle requires revenues to be recognized in the accounting period in which the performance obligation is satisfied.
•
Gains are increases in equity as a result of transactions that are not part of the company’s main
or central operations and do not result from revenues or investments by the owners of the entity.
•
Expenses are outflows or other using-up of assets or the incurrence of liabilities as a result of
delivering goods or providing services that are the entity’s main or central operations.
Note: The expense recognition principle, or the matching principle, states that recognition of expenses is related to net changes in assets and the earning of revenues. Expenses
should be recognized when the work or product contributes to revenue.
12
Settlement of a liability creates revenue, for example, when the company has received a deposit from a customer for
an order to be delivered in the future. The deposit is a contract liability when received. When the performance obligation
in the contract has been satisfied, the contract liability is debited to reduce it by the amount of the deposit, and the
amount of the deposit is credited to revenue.
14
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Section A
•
A.1. Financial Statements
Losses are decreases in equity as a result of transactions that are not part of the company’s main
or central operations and that do not result from expenses or distributions made to owners of the
entity.
The difference between revenues and gains and between expenses and losses depends on what the company’s typical activities are. For example, the sale of a product as part of a company’s normal operations
constitutes revenue. However, the sale of a fixed asset is not part of the company’s regular operations, so
the excess of the amount received for the asset over its net book value is a gain, not revenue.
Other Income Statement Items
Unusual Gains and Losses
Unusual gains and losses are gains and losses the firm considers to be of an unusual nature or of a type
that indicates infrequency of occurrence or both. Some examples of unusual losses are losses on inventory
or other assets damaged in a fire and restructuring charges. They may need separate disclosure on the
income statement in order to help users to predict the amounts, timing and uncertainty of future cash
flows.
Per ASC 220-20-45-1, unusual gains and losses are part of income from continuing operations (in contrast
to discontinued operations). Unusual gains and losses are generally reported as non-operating gains and
losses within income from continuing operations. Unusual gains or losses of a similar nature that are not
individually material should be aggregated, that is, combined on one line. Unusual gains or losses that are
material should be reported as separate line items or, alternatively, disclosed in the notes to the financial
statements.
Discontinued Operations
Guidance in the Accounting Standards Codification® on presentation of discontinued operations in financial statements is in ASC 205-20.
A discontinued operation is any component 13 of an entity that has been or will be eliminated from the
operations of the company. A discontinued operation is defined as a disposal of a component or group of
components either disposed of or held for sale that represents a strategic shift that has or will have a
major effect on the entity’s operations and financial results. A strategic shift that has or will have a major
effect on operations and financial results could include disposing of operations in a major geographical area
or disposing of a major line of business, a major equity investment, or other major parts of the entity.
All gains or losses incurred by the discontinued component are reported in the period in which the gain
or loss occurred. The gain or loss from operations of the discontinued component and the gain or loss
from the disposal, when the disposal takes place, are combined and reported on one line, followed by the
income tax effect on the next line, either a tax benefit (for a loss) or a tax expense (for a gain). The
gain/loss and the tax expense or tax benefit associated with the gain or loss of the discontinued component
should be reported below income from continuing operations, as follows.
Income from continuing operations
+/−
Gain/(loss) from operations of discontinued Component X
including gain/(loss) on disposal of $XXXX
+/−
Income tax benefit or (income tax expense) on discontinued Component X
Net Income
13
A component is defined as operations and cash flows that can be clearly distinguished from the rest of the entity
both operationally and for financial reporting purposes.
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15
A.1. Financial Statements
CMA Part 1
Disposal of a component or group of components that represent a strategic shift must be reported as
discontinued operations when any of the following three items occurs:
1)
The component or group of components meets the criteria in ASC 205-20-45-1E to be classified
as held for sale. ASC 205-20-45-1E requires the held-for-sale classification in the period in which
all of the following criteria are met:
•
Management commits to a plan to sell the entity.
•
The entity to be sold is available for immediate sale.
•
An active program to locate a buyer or buyers and other actions required to complete the plan
to sell the entity have been initiated.
•
The sale is probable within one year, unless events beyond the entity’s control occur.
•
The entity is being actively marketed at a reasonable price in relation to its fair value.
•
Actions required to complete the plan to sell the entity make it unlikely that the plan will be
withdrawn or significantly changed.
2)
The component or group of components is sold.
3)
The component or group of components is disposed of in a manner other than by sale, such as by
abandonment or by distribution to owners in a spinoff.14
In addition to reporting the discontinued entity’s results of operations in the current period, the company
should also reclassify to discontinued operations the net income or loss from the discontinued
operations in the prior period income statements presented as comparisons. Reclassification of prior
period operating results is done so that the prior period financial statements are comparable to the current
period financial statements.
In other words, all gains and losses from the component to be discontinued should be removed from income
from continuing operations so users of the financial statements can see what income from continuing operations is without the operations of the component disposed of or to be disposed of.
Companies use the line “Income from continuing operations” on the income statement only when gains
or losses on discontinued operations occur.
Intra-period Tax Allocation
The income tax effect of discontinued operations needs to be reported on the income statement separately
from income taxes applicable to continuing operations, and discontinued operations are reported on the
income statement net of their applicable taxes. Therefore, taxes must be allocated between income
from continuing operations and income from discontinued operations on the income statement.
In addition, any items reported on the balance sheet in accumulated other comprehensive income are to
be reported net of tax. Allocation of tax among income from continuing operations, discontinued operations,
and accumulated other comprehensive income is called intra-period tax allocation (allocation within one
period).
The income tax due should be allocated first to income from continuing operations. The remaining tax due
should be allocated to gains/losses from discontinued operations and items reported in accumulated other
comprehensive income according to each one’s proportion of the total other taxable items.
14
A spinoff is a form of corporate divestiture. It results in a subsidiary or a division of the company becoming an
independent company. Usually, shares in the new company are distributed to the shareholders of the parent company
on a pro-rata basis.
16
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Section A
A.1. Financial Statements
Benefits of the Income Statement
The income statement helps to predict future cash flows, as follows:
•
It helps users to evaluate the company’s past performance and to compare it to the performance of
its competitors.
•
It provides a basis for predicting future performance.
•
It helps users assess the risk or uncertainty of achieving future cash flows.
Limitations of the Income Statement
Most of the limitations of the income statement are caused by the periodic nature of the income statement. At any particular financial statement date, buying and selling will be in process and some
transactions will be incomplete. Therefore, net income for a period necessarily involves estimates that
affect the company’s performance for the period.
Limitations that reduce the usefulness of the income statement for predicting amounts, timing, and uncertainty of cash flows include:
•
Net income is an estimate that reflects a number of assumptions.
•
Income numbers are affected by the accounting methods used. For example, differences in methods
of depreciation can cause differences in the amount of depreciation expense during each year of an
asset’s life. A lack of comparability between and among companies results from these differences in
accounting methods.
•
Income measurement requires judgment. For example, the amount of depreciation expense recognized during a period is dependent on estimates regarding the useful lives of the assets being
depreciated.
•
Items that cannot be measured reliably are not reported in the income statement. For instance,
increases in value due to brand recognition, customer service, and product quality are not reflected
in net income.
•
The income statement is limited to reporting events that produce reportable revenues and expenses.
Some transactions are not reported immediately on the income statement.
Question 3: The financial statement that provides a summary of the firm’s operations for a period of
time is the
a)
income statement.
b)
statement of financial position.
c)
statement of shareholders’ equity.
d)
statement of retained earnings.
(ICMA 2014)
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17
A.1. Financial Statements
CMA Part 1
3) Introduction to the Statement of Cash Flows (SCF)
Guidance in the Accounting Standards Codification® on preparation of the Statement of Cash Flows is in
ASC 230.
Note: The following is an overview of the statement of cash flows. Specific information on how to prepare
a statement of cash flows is included later in this volume.
The statement of cash flows is one of the three main financial statements presented by companies (the
other two are the balance sheet and income statement). The statement of cash flows must be presented
by all businesses, for-profit and non-profit, public and private, whenever the company presents either a
balance sheet and income statement or just an income statement. Thus, if a company presents income
statements only and no balance sheets for prior periods, it must also present the statement of cash flows
for each of the prior periods.
The primary purpose of the statement of cash flows is to provide information regarding receipts and uses
of cash, cash equivalents, restricted cash, and restricted cash equivalents for the company during
a period of time.
Classification Within the Statement of Cash Flows
Note: The term “cash” is used in the context of the statement of cash flows to refer to the total of cash,
cash equivalents, restricted cash, and restricted cash equivalents. The four classifications are combined
for purposes of reporting activities on the statement of cash flows.
The statement of cash flows presents all of the receipts and uses of cash of the company during the period.
For the purposes of presentation and usefulness, the cash activities are broken down into three categories
of activities in the statement of cash flows. These three categories are:
1)
Operating activities
2)
Investing activities
3)
Financing activities
Benefits of the Statement of Cash Flows
•
The statement of cash flows provides the most information about cash and how the company receives
and spends cash. It helps users to assess the ability of the company to generate positive future cash
flows to meet its obligations as they come due and to pay dividends.
•
It helps users to assess the reasons for differences between net income and net cash inflows and
outflows.
•
It helps users to assess the effect of investing and financing transactions on the company’s financial
position.
•
It helps users to assess the company’s need for external financing. A negative operating cash flow
and a positive financing cash flow indicate the company is financing its operations with either debt or
equity. An examination of the financing section of the statement will reveal whether debt or equity is
being used.
•
Lenders can use it to assess the ability of a company to repay a loan.
•
Investors can use it to determine if the company will be able to continue to pay its current level of
dividends in the future or whether it might even be able to increase its dividend.
18
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Section A
A.1. Financial Statements
Limitations of the Statement of Cash Flows
•
The statement of cash flows shows only how much cash was received and paid out for operating,
investing, and financing activities. In order for the information on a statement of cash flows to be fully
utilized, it often needs to be interpreted in the context of other information in the other financial
statements. For example, a positive operating cash flow may have been achieved by not paying the
payables when due. In order to recognize past due payables, the balance sheet and income statement
are also needed.
•
The indirect method15 of preparing the operating cash flows section of the SCF does not show the
sources and uses of operating cash individually but shows only adjustments to accrual-basis net income, a limitation that can cause a user to have difficulty in using the information presented
4) Statement of Comprehensive Income
Guidance in the Accounting Standards Codification® on presentation of the statement of comprehensive
income is in ASC 220.
U.S. Generally Accepted Accounting Principles (GAAP) are based on comprehensive income. Comprehensive
income includes all transactions of the company except for transactions made with the owners of the
company (such as distribution of dividends or the sale or repurchase of shares).
Thus, comprehensive income is the change in equity (net assets) of an entity from non-owner sources that
arise during a period from transactions and other events. It includes all changes in equity during a period
except those resulting from investments by owners and distributions to owners.
Comprehensive income includes everything on the income statement plus some specific items that do not
appear on the income statement. Therefore, it is more inclusive than traditional net income. In other words,
net income is a part of comprehensive income, but it is not all of comprehensive income.
Net income flows to retained earnings in equity when the year-end close is performed, so net income ends
up in equity. However, certain specific items are not presented on the income statement. Instead, they go
straight to equity by means of the accumulated other comprehensive income account. Accumulated
other comprehensive income is a line in the equity section of the balance sheet that includes these items
that are not reflected on the income statement.
The “other” in accumulated other comprehensive income refers to the specific items that are other than
income statement transactions, so they flow to equity by means of the accumulated other comprehensive
income account. These specific items are called other comprehensive income items.
Of these specific items, those that would increase net income if they were reported on the income statement
are credited to accumulated other comprehensive income, and those that would decrease net income if
they were reported on the income statement are debited to accumulated other comprehensive income.
The “accumulated” in accumulated other comprehensive income means that the balance in the account
keeps accumulating. Since accumulated other comprehensive income is a balance sheet account, it is a
permanent account. It is never closed out, and the balance in it keeps accumulating just like any other
balance sheet account. Therefore, the amount of change in the account from the beginning of the year
to the end of the year is the net amount of other comprehensive income items that were recorded during
15
The indirect method of preparing the operating activities section of the statement of cash flows will be explained in
detail later. Briefly, cash flows from operating activities can be presented on the statement of cash flows in two ways,
and both ways are acceptable under U.S. GAAP. The direct method adjusts each line of the income statement to express
it as a cash amount instead of an accrual amount. For example, revenue is adjusted to become cash received. The
indirect method begins with net income and adjusts the net income figure to remove any income or expense items that
are investing or financing activities and to present the cash flows from operations instead of accrual-basis net income.
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19
A.1. Financial Statements
CMA Part 1
the year. The accumulated other comprehensive income account is also referred to as simply other comprehensive income, or OCI.
Total comprehensive income for a year includes net income for the year plus the transactions for the year
in the accumulated other comprehensive income account. Thus, total comprehensive income for a year is
net income plus the amount of change during the year in the accumulated other comprehensive income
account.
According to ASC 220-10-45-1, a company has the option to report comprehensive income (that is, net
income and the transactions for the year in the accumulated other comprehensive income account) either
in a single continuous financial statement or in two separate but consecutive financial statements.
•
•
If the company chooses to present a single continuous financial statement, it must present it in
two sections: net income and other comprehensive income. It must present
o
Total net income along with the components that make up net income; and
o
A total amount for the other comprehensive income along with the components that make up
other comprehensive income.
If the company chooses to present two separate but consecutive financial statements, it must
present
o
Total net income and the components of net income in the statement of net income; and
o
Total other comprehensive income and the components of other comprehensive income in a
statement of other comprehensive income that immediately follows the statement of net income. The statement of other comprehensive income must begin with net income.
The items that are considered other comprehensive income items are not reported on the income statement
but instead are reported as a component of equity in the accumulated other comprehensive income account.
They are expressly stated in the standards (ASC 220-10-45-10A). The items currently in this group include:
1)
Foreign currency translation adjustments.
2)
Gains and losses on foreign currency transactions that are designated as, and are effective as,
economic hedges of a net investment in a foreign entity, commencing as of the designation date.
3)
Gains and losses on intra-entity foreign currency transactions that are of a long-term investment
nature (that is, settlement is not planned or anticipated in the foreseeable future), when the entities to the transaction are consolidated, combined, or accounted for by the equity method in the
reporting entity’s financial statements.
4)
Gains and losses on derivative instruments that are designated as, and qualify as, cash flow
hedges.
5)
For derivatives that are designated in qualifying hedging relationships, the difference between
changes in fair value of the excluded components and the initial value of the excluded components
recognized in earnings under a systematic and rational method.
6)
Unrealized holding gains and losses on available-for-sale debt securities.
7)
Unrealized holding gains and losses that result from a debt security being transferred into the
available-for-sale category from the held-to-maturity category.
8)
Amounts recognized in other comprehensive income for debt securities classified as available-forsale and held-to-maturity related to an “other-than-temporary” impairment recognized in accordance with ASC Section 320-10-35 if a portion of the impairment was not recognized in earnings.
9)
Subsequent decreases (if not an “other-than-temporary” impairment) or increases in the fair value
of available-for-sale debt securities previously written down as impaired.
10)
Gains or losses associated with pension or other postretirement benefits that are not recognized
immediately as a component of net periodic benefit cost.
20
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Section A
A.1. Financial Statements
11)
Prior service costs or credits associated with pension or other postretirement benefits.
12)
Transition assets or obligations associated with pension or other postretirement benefits that are
not recognized immediately as a component of net periodic benefit cost.
13)
Changes in fair value attributable to instrument-specific credit risk of liabilities for which the fair
value option is elected.16
The items above may each be shown as either net of tax or before related tax effects with one amount
shown for the aggregate income tax expense or benefit related to the total of other comprehensive income.
If a company does not have any items of other comprehensive income in any period presented, it is not
required to prepare a statement of other comprehensive income.
A company must report the accumulated balance of the items of other comprehensive income on the
balance sheet as an element of owners’ equity. Accumulated other comprehensive income should be
reported separately from stock, additional-paid-in-capital (APIC), and retained earnings.
However, the components of accumulated other comprehensive income may not be presented only as part
of the statement of changes in stockholders’ equity. They must also be reported as described above in a
separate statement of comprehensive income.
Exam Tip: It is possible for a company to have none of these items. However, candidates need to be
able to identify the items that are included as accumulated other comprehensive income items.
An example of a single continuous financial statement presenting net income followed by other comprehensive income follows.
16
If the creditworthiness of the issuer declines and a default on the bonds by the issuer becomes more likely, the fair
value of the bonds on the secondary market will decline because investors will demand a higher rate of return to invest
in the bonds. The decline in the fair value of the bond will lead to an unrealized gain for the issuer if the issuer has
elected to report the instrument at fair value. It would not be appropriate for the issuer to be able to report increased
net income because of its own decreased creditworthiness. Therefore, when the fair value option has been elected for a
particular debt instrument, the portion of any change in its fair value attributable to changes in the issuer’s or the
instrument’s level of credit risk (called “instrument-specific credit risk” in the FASB’s Accounting Standards Codification®)
must be reported in accumulated other comprehensive income, not on the income statement. See ASC 825-10-45-5.
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21
A.1. Financial Statements
CMA Part 1
STATEMENTS OF INCOME AND COMPREHENSIVE INCOME
In thousands, except per share amounts
Year Ended
Dec. 31,
20X3
Revenues:
Net revenues
Cost of goods sold
Gross profit
$10,400
3,200
$ 7,200
$11,100
3,400
$ 7,700
Operating expenses:
Research and development
Selling, general and administrative
Total operating expenses
Operating income
$ 3,000
1,500
$ 4,500
$ 2,700
$ 1,800
1,700
$ 3,500
$ 4,200
Non-operating gains/(losses):
Realized gains/(losses) - equity securities
Unrealized gains/(losses) - equity securities
Realized gains/(losses) – available-for-sale debt securities
(
300
100
44)
Financial income and expense:
Interest and dividend income
Interest expense
(
177
400)
Income before income taxes
Provision for income taxes
Net income
500
200
290
(
129
400)
$ 2,833
( 708)
$ 4,919
( 1,230)
$ 2,125
$ 3,689
97
211
Other comprehensive income/(loss) net of tax:
Unrealized gains/(losses) on available-for-sale debt securities
(net of income taxes of $52 in 20X3 and $114 in 20X2)
Unrealized gain on debt securities reclassified from held-to-maturity to
available-for-sale preparatory to selling (net of income tax of $153)1
283
Reclassification adjustment for gains included in net income
(net of income tax of $153)1
97
(
$
283)
211
Other comprehensive income/(loss) net of income tax
$
Comprehensive income
$ 2,222
$ 3,900
Basic earnings per common share
Diluted earnings per common share
Weighted average common shares outstanding
Weighted average common shares outstanding assuming dilution
Cash dividends paid per common share
$
$
$
$
1
22
Year Ended
Dec. 31,
20X2
1.26
1.26
1,680
1,680
$ 0.30
2.21
2.20
1,667
1,672
$ 0.60
Gross amount included in net security gains on the income statement for
20X2 was $436.
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Section A
A.1. Financial Statements
Question 4: Comprehensive income is best defined as
a)
Net income excluding income from discontinued operations.
b)
The change in net assets for the period including contributions by owners and distributions to
owners.
c)
Total revenues minus total expenses.
d)
The change in net assets for the period excluding owner transactions.
(CMA Adapted)
5) Statement of Changes in Stockholders’ Equity
The statement of changes in stockholders’ equity reports the changes in each account in the stockholders’
equity section of the balance sheet and in total stockholders’ equity during the year and reconciles the
beginning balance in each account with the ending balance. Since stockholders’ equity accounts are permanent accounts that keep on accumulating their balances from year to year, information about the sources
of changes in the separate accounts is required to make the financial statements sufficiently informative.
The statement of changes in stockholders’ equity is prepared in columnar form, with a column for each
individual account and a column for total stockholders’ equity. The first line contains the beginning balances;
the sources of the changes are on lines below and identified in the leftmost column; and the final line
contains the ending balances in each account. A statement of changes in stockholders’ equity should be
prepared for every year that comparative financial statements are presented. One statement can be prepared for all the years to be presented, showing beginning balances, activity, and ending balances for each
year. The ending balance for each year becomes the beginning balance for the subsequent year.
Following is an example of a statement of changes in stockholders’ equity.
Statement of Changes in Stockholders’ Equity
Balance, December 31, 20X1
Preferred
Stock
100
Common
Stock
1,650
Additional
Paid-in
Capital
5,310
Net income
Retained
Earnings
3,540
Accumulated Other
Comprehensive Income
0
3,689
Total
10,600
3,689
Preferred dividends declared
(5)
(5)
Common dividends declared
(1,023)
(1,023)
Issuance of common stock
20
260
Other comprehensive income
___
_____
______
_____
325
325
Balance, December 31, 20X2
100
1,670
5,570
6,201
325
13,866
Net income
280
2,125
Preferred dividends declared
Common dividends declared
Issuance of common stock
15
210
2,125
(5)
(5)
(528)
(528)
225
Other comprehensive income
___
_____
______
_____
149
149
Balance, December 31, 20X3
100
1,685
5,780
7,793
474
15,832
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23
A.1. Financial Statements
CMA Part 1
Notes to the Financial Statements
Note: Guidance in the Accounting Standards Codification® on presentation of notes to the financial
statements is in ASC 235.
In order for an item to be recognized in the main body of an entity’s financial statements, it must meet the
definition of a basic element, be measurable with sufficient certainty, and be relevant and reliable, per SFAC
5. Items that do not meet those four criteria but are nevertheless integral to the financial statements and
essential to a user’s understanding of items presented within the main body of the financial statements are
presented in the notes to the financial statements. Notes are used to amplify or explain the items presented
in the main body of the financial statements.
A complete set of financial statements requires notes to the financial statements in order to present a
thorough picture of a company’s financial position and the results of its operations. The notes are used to
explain the items presented in the main body of the financial statements and the methods used to determine
the amounts reported. For example, if a company recognized a loss in the income statement due to impairment of a fixed asset, a note is a way to explain how the asset became impaired. The notes can also provide
further breakdown and analysis of certain accounts that are deemed important, such as an analysis of
depreciation recorded for the period. Disclosures in the notes can provide additional relevant information
that can be important to fully understanding the financial statements.
Accounting Policies
The first note is a summary of significant accounting policies, such as what method of depreciation is being
used or how inventories are valued and what cost flow assumption is being used. Accounting policies are
the principles a company uses and considers appropriate to present fairly its financial statements. Disclosure of accounting policies is used to identify and describe the principles of accounting being followed by
the reporting entity and the methods used for applying the principles that materially affect the determination of the company’s financial position, cash flows, or results of operations.
Companies should present a disclosure of significant accounting policies used as the first note to the financial statements or in a separate summary of significant accounting policies section preceding the notes to
the financial statements. The disclosure needs to include important judgments regarding the principles and
methods that involve any of the following:
•
A selection from acceptable alternatives available
•
Any principles or methods that are unique to the industry in which the company operates, even if
those principles and methods are commonly followed in that industry
•
Any unusual or innovative applications of generally accepted accounting principles.
Specific disclosures are addressed in the FASB’s Accounting Standards Codification® within the appropriate
topics. However, ASC 235-10-50-4 does include examples of accounting policy disclosures that are commonly required, as follows:
24
•
The basis of consolidation used,
•
Depreciation method(s) used,
•
Information on amortization of intangibles,
•
Inventory pricing,
•
Recognition of revenue from contracts with customers, and
•
Recognition of revenue from leasing operations.
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Section A
A.1. Financial Statements
The summary of significant accounting policies can suggest to the user whether the company is using liberal
or conservative accounting policies. Liberal accounting policies are policies that lead to higher current income, such as longer-then-usual estimated lives for depreciable assets. Conservative accounting policies
lead to lower current income, for example the use of the LIFO inventory cost flow assumption when prices
are rising.
Limitations of Financial Statements in General
•
Measurements are made in terms of money, so qualitative aspects of a firm are not included. Only
transactions recorded in the accounting records are in the financial statements.
•
Information supplied by financial reporting involves estimation, classification, summarization, judgment, and allocation.
•
Financial statements primarily reflect transactions that have already occurred; consequently, many
aspects of them are based on historical cost.
•
Only transactions involving the entity being reported on are reflected in that entity’s financial reports.
However, transactions of other entities, such as competitors, may be very important.
•
Financial statements are based on the going-concern assumption.17 If the going-concern assumption
is invalid and the business is facing liquidation, the appropriate attribute for measuring financial statement items is liquidation value. If a business will be liquidated, it is not appropriate to use historical
cost, fair value, net realizable value, or any other valuation measure for a going-concern’s financial
statements.
HOCK international books are licensed only for individual use and may not be lent,
copied, sold, or otherwise distributed without permission directly from HOCK
international.
If you did not download this book directly from HOCK international, it is not a
genuine HOCK book. Using genuine HOCK books assures that you have complete, accurate,
and up-to-date materials. Books from unauthorized sources are likely outdated and will not
include access to our online study materials or access to HOCK teachers.
Hard copy books purchased from HOCK international or from an authorized training
center should have an individually numbered orange hologram with the HOCK globe
logo on a color cover. If your book does not have a color cover or does not have this
hologram, it is not a genuine HOCK book.
17
The going-concern assumption is an assumption that the entity will continue in operational existence for the foreseeable future.
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25
A.1. Financial Statements
CMA Part 1
Preparation of the Statement of Cash Flows
Overview of the Preparation of the Statement of Cash Flows
One of the good things about the SCF is that the net cash flow from all three sources combined—operating
activities, investing activities, and financing activities—is known before the statement is prepared. The total
of the net cash flows from operating, investing, and financing activities must be equal to the amount of
change in the balance of cash from the beginning of the year to the end of the year. Because the cash
balances for the prior period and the current period are on the balance sheets, the total increase or decrease
in cash for the period can be easily calculated.
What Is “Cash” on the Statement of Cash Flows?
On the statement of cash flows, “cash” is the total of cash, cash equivalents, restricted cash, and
restricted cash equivalents, even though some or all of those four classifications of cash may be reported
on separate lines on the balance sheet. The amount of change in “cash” is the amount of change in the
total of the four classifications.
A cash equivalent is a highly liquid, short-term investment that is easily converted into a known amount
of cash without significant loss in value. Common examples of cash equivalents are money market funds,
commercial paper and Treasury Bills. The definition usually includes only those investments that have a
maturity of 3 months or less from the date the company acquires the investment.
Note: Cash or cash equivalents could be restricted for a number of reasons, such as cash that has been
set aside for future capital investment, retirement of a long-term debt, or compensating balances required by a lender to support existing borrowing arrangements. “Restricted cash” and “restricted cash
equivalents” are specifically not defined in the Accounting Standards Codification®.
Example: A company purchases a 20-year Treasury bond two months before it matures. That Treasury
bond will be classified as a cash equivalent on the company’s balance sheet.
However, if the company had instead acquired the same 20-year Treasury bond two years before its
maturity date, that Treasury bond would never be classified as a cash equivalent on the company’s
balance sheet, even when the financial statement date is 3 months before the Treasury bond’s maturity
date. The Treasury bond’s maturity date was not within 3 months of the date it was acquired, so that
Treasury bond will be classified as an investment on the company’s balance sheet until it matures.
In the preparation of the statement of cash flows, cash equivalents, restricted cash, and restricted cash
equivalents are all considered to be cash. The statement of cash flows must explain the amount of
change during the period in the total of the four classifications of cash. The total of the four classifications
should be used when reconciling the beginning-of-period and end-of-period total amounts shown on the
statement of cash flows.
Note: Movements of cash between and among the cash, cash equivalents, restricted cash, and restricted
cash equivalents classifications are not considered cash flows from operating activities, investing activities, or financing activities, since those transactions simply exchange one form of “cash” (as cash is
defined for the SCF) for another form of “cash.”
The individual line items and amounts of cash, cash equivalents, restricted cash, and restricted cash equivalents are to be presented on the face of the statement of cash flows or disclosed in the notes to the
financial statements. The disclosure may be in either narrative form or tabular form.
Furthermore, in the statement of cash flows, the four classifications of cash are to be described specifically
using descriptive terms such as cash, cash equivalents, and restricted cash, not using ambiguous terms
such as “funds.”
26
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Section A
A.1. Financial Statements
Format of the Statement of Cash Flows
An exam question may require the preparation of a complete SCF. The following format should be followed
in putting a statement together:
Name of Company
Statement of Cash Flows
For the Year Ended XXXX XX, 20XX
Cash flows from operating activities
……
$XXXX
……
XXXX
……
XXXX
Net cash provided by operating activities
$XXXXX
Cash flows from investing activities
……
$XXXX
……
XXXX
Net cash provided by investing activities
$XXXXX
Cash flows from financing activities
……
$XXXX
……
XXXX
Net cash provided by financing activities
$XXXXX
Net increase in cash, cash equivalents, and restricted cash
$ XXXX
Cash, cash equivalents, and restricted cash at beginning of year
$XXXXX
Cash, cash equivalents, and restricted cash at end of year
$XXXXX
Supplemental schedule of noncash investing and financing activities:
•
XXXXX
•
XXXXX
Note: Noncash investing or financing transactions must be presented separately in a schedule at
the end of the statement of cash flows. Noncash investing or financing transactions are transactions that
are either investing or financing in nature but that did not involve cash in the transaction. Noncash
investing and financing transactions are explained in more detail later in this topic and examples are
presented.
Classification of Items within the Statement of Cash Flows
The SCF presents all of the company’s receipts of cash and uses of cash during the period. For the
purposes of presentation and usefulness, the cash activities are broken down into three main categories
of activities:
1)
Operating activities
2)
Investing activities
3)
Financing activities
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27
A.1. Financial Statements
CMA Part 1
The sum of the cash flows from the three categories above must equal the net increase or decrease in cash
during the period. The net increase or decrease in cash is also reported in the SCF.
Note: Candidates should know the specific items listed under each of the three categories.
A discussion of each of the three categories of activities follows.
Cash Flows from Operating Activities
Cash flows from operating activities are cash inflows and cash outflows that result from the company’s main
business activities and central operations. In general, any item not classified as either an investing or a
financing activity is an operating activity.
Transactions that cause gains or losses are generally not considered operating activities. Gains and losses
arise from events that do not involve the main business operations of the company. There are a few exceptions to this rule, but they are outside the scope of the exam.
The following specific items are classified as operating activities according to the FASB’s Accounting Standards Codification®:
•
Cash received from customers and cash paid to suppliers in the course of the company’s primary
business activity. Cash paid to suppliers includes principal payments on accounts and on both
short- and long-term notes payable to suppliers.
•
Interest paid on bonds and other debt such as loans, finance leases, and mortgages, net of any
amounts capitalized.
•
Interest received and dividends received from investments in debt and equity investments.
•
Cash paid to governments for taxes, duties, fines, and other fees or penalties and cash
received back from governments as refunds.
•
Payments for the settlement of interest on zero-coupon debt instruments.
•
Cash paid to settle an asset retirement obligation.18
•
Cash payments made by an acquirer to settle a contingent consideration liability that are not
made soon after a business combination and that are in excess of the amount of the liability
recognized at the acquisition date.
•
Other cash receipts and cash payments that do not stem from transactions defined as investing or financing activities.19
•
A lessee classifies cash paid for operating lease payments, variable lease payments, and
payments on short-term leases not reported on the balance sheet within operating activities. However, if any portion of operating lease payments represents costs to bring another asset
to the condition and location necessary for its intended use, that portion of the payments should
be classified within investing activities.20
•
Cash receipts and cash payments resulting from purchases and sales of securities classified as
trading securities (debt and equity) are to be classified based on the nature and purpose for
which the securities were acquired.21 Usually, such securities are classified as operating activities.
18
An asset retirement obligation (ARO) is a liability that is established to cover future costs associated with the dismantling of an asset when the asset is taken out of production.
19
Per ASC 230-10-45-16 and 45-17.
20
Per ASC 842-20-45-5c and 45-5d.
21
Per ASC 230-10-45-19. Trading securities are defined in the Accounting Standards Codification® as “securities that
are bought and held principally for the purpose of selling them in the near term and therefore held for only a short period
of time. Trading generally reflects active and frequent buying and selling, and trading securities are generally used with
the objective of generating profits on short-term differences in price.” Trading securities may be either debt securities
28
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Section A
A.1. Financial Statements
Cash flows from operating activities may be calculated and presented in two ways, and both ways are
acceptable under U.S. GAAP. The two acceptable methods are called the direct method and the indirect
method.
•
The direct method essentially adjusts each line of the income statement to make it a cash number
instead of an accrual number. For example, revenue is adjusted to become cash received.
•
The indirect method begins with net income and adjusts the net income figure to remove any
income or expense items that are investing or financing activities and to present the cash flows
from operations instead of the accrual-basis net income.
The two methods will be explained in more detail in the pages that follow.
Cash Flows from Investing Activities
Investing activities are the company undertakes to generate a future profit from investments. Common
events that are classified as investing activities in the Codification® are:
•
Purchasing and selling property, plant, and equipment (fixed assets).
•
Making and collecting loans to other parties or the sale of loans acquired as investments.
•
Acquiring and disposing of available-for-sale or held-to-maturity debt securities.
•
Acquiring and disposing of equity instruments other than certain equity instruments carried in a
trading account.
•
Payments made by an acquirer to settle a contingent consideration liability that are made soon
after a business combination.
•
Cash proceeds from the settlement of corporate-owned life insurance policies and other insurance settlements that are directly related to investments such as the proceeds of insurance
on a building that was damaged or destroyed are investing cash inflows.
Cash Flows from Financing Activities
Financing activities are activities a company undertakes to raise capital to finance the business and the
repayment of same. Common events that are financing activities according to the Codification® include:
•
Proceeds from issuance of stock.
•
Treasury stock transactions.
•
Paying cash dividends (note that dividends paid are a financing activity, but dividends received
are an operating activity).
•
Proceeds from issuing debt such as bonds, mortgages, notes, and payments for debt issuance
costs and repayment of principal on debt obligations.
•
Obtaining a loan and repaying the principal of the loan.
•
Debt prepayment or debt extinguishment costs, including call premiums paid and fees paid
to lenders or third parties that are directly related to the debt prepayment or debt extinguishment,
excluding accrued interest.
•
Payments not made soon after the acquisition date of a business combination by an acquirer to
settle a contingent consideration liability, up to the amount of liability recognized at the
acquisition date.
or equity securities. Trading securities will generally be reported only by entities whose primary business is trading, such
as broker-dealers making trades for their own direct market gain, called “proprietary trading.” According to ASC 940320-45-7, broker-dealers are required to report their trading securities activities in the operating section of the statement of cash flows.
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29
A.1. Financial Statements
CMA Part 1
•
Payments for the settlement of the principal of zero-coupon debt instruments.22
•
A lessee classifies repayment of the principal portion (lease liability) of finance lease payments
for fixed assets as a financing activity. (The interest portion of payments on finance leases is
classified within operating activities.)23
Question 5: Dividends paid to company shareholders would be shown on the statement of cash flows
as
a)
Operating cash inflows.
b)
Operating cash outflows.
c)
Cash flows from investing activities.
d)
Cash flows from financing activities.
(ICMA 2014)
Cash Inflows and Cash Outflows Presented Separately
Cash inflows and cash outflows are to be presented separately from each other for each activity. For example, cash used for the purchase of fixed assets (cash outflows) should be reported on a separate line
from cash received from the sale of fixed assets (cash inflows), although both are reported as cash flows
from investing activities.
However, if a question asks for net cash flows from a particular activity or for a particular category of
activities, both the inflows and the outflows for that activity must be netted together. If outflows are greater
than inflows, then the net amount will be negative.
Two Methods of Preparing Net Cash Provided by Operating Activities
The direct method and the indirect method are both acceptable for preparing the net cash flows from
operating activities section of the statement of cash flows, but a company must consistently use the same
method each period.
Note: The direct and indirect methods differ only in their presentation of cash flows from operating activities. Despite the difference in presentation, the end total of net cash flows from operating
activities will be exactly the same under both methods. The difference between the two methods relates
only to the presentation of the information, not to the results.
Overview of the Two Methods
Note: The ICMA’s Learning Outcome Statements for the CMA exams state that candidates need to be
able to prepare a statement of cash flows using the indirect method of determining cash flow from
operating activities. Therefore, preparation of the operating activities section under the indirect method
only will be covered in detail. Preparation of the operating activities section under the direct method will
be described briefly, however, so that candidates can understand how it differs from the indirect method.
22
Per ASC 230-10-45-14 and 45-15.
23
Per ASC 842-20-45-5a and 45-5b.
30
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Section A
A.1. Financial Statements
The Direct Method
The direct method shows separately each operating activity that caused cash to be spent or received,
such as cash paid for payables or cash collected from customers. The direct method presentation is very
similar to the income statement in the lines in the presentation. Three sets of adjustments need to be made
to the income statement line items.
1)
Each line on the income statement that represents an operating activity is adjusted to reflect the
cash flows of that item, instead of the accrual accounting amount. For example, revenue is adjusted
to be cash received from customers and cost of goods sold is adjusted to be cash paid to suppliers.
Example: Sales revenue for the year 20X5 was $1,500,000. Beginning accounts receivable (at
year-end 20X4) on the balance sheet was $100,000. Ending accounts receivable (at year-end
20X5) was $125,000.
Cash received from customers during 20X5 was $1,500,000 + $100,000 − $125,000 =
$1,475,000.
The beginning A/R balance is added to the sales revenue for the period because it is assumed
that the amount outstanding in A/R at the beginning of the current period (from sales made
during the previous period) was collected during the current period. The ending A/R balance is
subtracted because that represents sales made during the current period for which the amount
receivable was not collected during the current period.
2)
Some income statement items are noncash revenues or expenses, and these items are eliminated.
Depreciation expense is an example of a noncash income statement item. Even though depreciation expense is reported on the income statement, the expense does not represent cash that was
paid out during the current period.
3)
Some lines on the income statement represent transactions for activities other than operating
activities. For example, the gain or loss on the sale of fixed assets is related to an investing activity.
The cash received from the sale, which includes any gain or loss on the sale, will be shown on the
SCF as part of cash flow from investing activities. The gain or loss on the sale is eliminated from
the income statement in calculating the net cash flow from operating activities using the direct
method so it is not included twice on the SCF.
The actual process for preparing the statement of cash flows using the direct method to develop the net
cash flows from operating activities section is outside the scope of the exam and so is not presented here.
The Indirect Method
Under the indirect method of preparing the cash flows from operating activities section of the SCF, all
adjustments are made to the net income figure from the income statement. The adjustments for the
indirect method are the same as those for the direct method, with adjustments for changes in balance sheet
accounts and the elimination of noncash and non-operating activity transactions. However, the adjustments
are made to the figure on the net income line instead of to the figures on the various individual lines on the
income statement.
Question 6: A statement of cash flows would have cash activities listed in which of the following orders?
a)
Financing, investing, operating.
b)
Investing, financing, operating.
c)
Operating, financing, investing.
d)
Operating, investing, financing.
(ICMA 2014)
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31
A.1. Financial Statements
CMA Part 1
Preparation of a Statement of Cash Flows Using the Indirect Method
The CMA Part 1 exam requires candidates to be able to prepare a statement of cash flows using the indirect
method for cash flows from operating activities.
Cash Flows from Operating Activities Under the Indirect Method
Under the indirect method of preparing the cash flows from operating activities section of the SCF, begin
with net income as the top line of the operating activities section of the SCF and then adjust net income
by reversing noncash and non-operating items that are included in net income.
Net income is adjusted for four types of items as follows:
1)
Eliminate noncash income and expense items such as depreciation expense that are included in
the income statement. Add items that reduced net income and deduct items that increased net
income.
2)
Eliminate investing and financing activity events whose results are included in the income statement, for example gains and losses on the income statement.
3)
Include the effect of any operating activities that were not included in net income but that did have
a cash effect. Exclude (eliminate) the effect of any events that are included in net income but that
did not have a cash effect. Examples of these adjustments are those that must be made for
changes in receivables, payables, inventory, and other assets and liabilities.
4)
Cash flows from the purchase or sale of trading securities (either debt or equity) will usually be
classified as operating activities, not investing activities. If those cash flows are classified as operating activities on the SCF, those cash flows must be included as an adjustment to reconcile net
income to net cash from operating activities.
1) Eliminate Noncash Income Statement Items
Perhaps the most obvious example of the required adjustments, and one of the easiest, is the elimination
of depreciation and amortization that has been expensed. Net income will have been reduced by
depreciation and amortization expense, but the company did not pay out any cash related to those expenses. Therefore, the amount of depreciation and amortization expense charged against net income will
need to be added back to net income in order to determine the net cash from operating activities.
Any other noncash items on the income statement must be eliminated as well. Another type of non-cash
adjustment to net income that needs to be reversed is unrealized gains and losses on securities that have
been recognized in net income. Unrealized gains and losses on securities arise because of changes in the
fair value of the securities, and unrealized gains and losses on those securities are charged to net income
in the period in which they occur. However, the unrealized gains and losses do not represent any cash
activity and therefore they need to be reversed. Unrealized gains that increase net income should be deducted from net income and unrealized losses that decrease net income should be added back to net
income.
2) Eliminate Investing and Financing Activity Events Included in the Income Statement
The income statement reports the results of all income-generating and expense-generating transactions
the company entered into during the period. However, some of those events are not operating activities.
In calculating cash flows from operating activities using the indirect method, eliminate all the items in the
income statement that do not relate to operating activities. The events that need to be eliminated as nonoperating activities are usually identified on the income statement as gains and losses. Gains and losses
arise from secondary business activities and are therefore not operating activities.
32
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Section A
A.1. Financial Statements
The most common realized gains and losses on the income statement that are eliminated in determining
cash flow from operating activities are:
•
Realized gains or losses from the sale of equipment or other fixed assets
•
Realized gains or losses on the sale of securities
Note: Unrealized investment holding gains and losses reported on the income statement also need to
be eliminated from net income, as referenced in item 1) above. Since they are noncash transactions,
though, they are not investing or financing activities.
To eliminate realized gains and losses on the income statement from cash flows from operating activities
in the preparation of cash flows from operating activities using the indirect method, gains are subtracted
from net income and losses are added back to net income.
Each investing or financing activity event that gave rise to a realized gain or loss must be included in the
SCF in either the investing or financing activities section. However, each event will be included at the cash
amount of the transaction, not at the amount of the gain or loss from the transaction.
3) Individual Account Adjustments
After taking out the noncash items and investing and financing activity items, the company next needs to
adjust net income for changes in individual asset and liability accounts that are related to operating activities. The following adjustments are all made to net income.
Net Accounts Receivable
An adjustment needs to be made to net income for the change in the net accounts receivable24 balance
over the period.
If net accounts receivable increases during the period, it means that customers bought a greater value
of goods that they have not yet paid for than customers who bought goods in the previous year and paid
for them in the current period. Therefore, the increase in net accounts receivable means that cash collections during the year were lower than the revenue recognized during the year. The amount of the increase
in net accounts receivable will need to be subtracted from net income because not all of the cash corresponding to the amount of revenue recognized during the period was received during the period.
On the other hand, if the net accounts receivable balance decreases during the period, it means that
the company collected more cash from the previous period’s sales (for example, sales made in December
of last year) than it failed to collect from the current period’s sales (for example, sales made this December).
The decrease in net accounts receivable over the period will therefore need to be added to net income in
order to properly calculate the cash received from operating activities during the period.
Note: When the operating activities section is being prepared according to the indirect method, always
use the amount of change in net accounts receivable, not the amount of change in gross accounts
receivable.
Note: Any other receivable account that affected net income will need a similar adjustment made for it.
24
Net accounts receivable is gross accounts receivable less the balance in the allowance for credit losses on receivables
account, since the allowance for credit losses account is a valuation account that decreases the balance in accounts
receivable to a level the company thinks is collectible.
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33
A.1. Financial Statements
CMA Part 1
Inventory
An increase in inventory during the period indicates that the company has paid cash for inventory items
that have not yet been expensed as cost of goods sold. Therefore, the amount of increase in the inventory account needs to be subtracted from net income.
Similarly, a decrease in the inventory account needs to be added to net income.
Note: Just because the inventory account has increased, that does not mean cash was paid for the
purchased inventory. However, if the company did not yet pay for some of the purchased inventory, the
company will have an increase in payables that will also be an adjustment in calculating net cash flows
from operating activities, as covered in the next topic.
Accounts Payable
As with accounts receivable, an adjustment will also need to be made to reflect the change in the accounts
payable balance during the period.
Accounts payable are related to the “cost of goods sold” line on the income statement because cost of
goods sold on the income statement is calculated using, among other things, the amount of inventory
purchased during the year. If the company purchased inventory but did not pay for it during the year, its
accounts payable balance will be higher at the end of the year. The company has recognized an increase in
an asset account (inventory), which is considered a decrease in cash, but the company has not yet actually
paid for some of it. Similarly, if the company has made other purchases that are period costs such as
selling, general and administrative items that it has not yet paid for but has recognized as expenses, the
income statement will include expenses that have not yet actually been paid for.
Therefore, any increase in accounts payable must be added back to net income because it represents
increases in assets and expenses for which the cash has not yet been paid.
On the other hand, a decrease in accounts payable means that the company paid for items this year that
it did not purchased during the previous year and thus were expensed during the previous year. In order
to create the equivalent of a cash basis net income, the amount of the decrease in accounts payable
will need to be subtracted from net income.
Example: If a company started in business on December 30 and its only activity during the year was to
buy $100 of inventory on credit, the cash flows for the year would be $0. Also, the company’s net income
would be $0. Additionally, the company’s inventory account will have increased by $100 and accounts
payable will have increased by $100.
Based on the needed adjustments above, a deduction of $100 would need to be made from net income
because of the increase in inventory. An addition of $100 would also need to be made to net income
because of the increase in accounts payable. These two adjustments net to $0, which would be the net
cash from operating activities for the company.
Note: Any other payable (for example, salaries payable) or other liability account that affected net
income will need a similar adjustment made for it.
34
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Section A
A.1. Financial Statements
General Rules for Operating Activity Asset and Liability Accounts
The following rules should be used to adjust net income by the amount of change in operating activity asset
and liability accounts when calculating net cash flows from operating activities using the indirect method.
Operating Asset Accounts

The amount of an increase in an asset account should be deducted from net income.

The amount of a decrease in an asset account should be added to net income.
Operating Liability Accounts

The amount of an increase in a liability account should be added to net income.

The amount of a decrease in a liability account should be deducted from net income.
The rule is that assets adjust net income to cash flow in the opposite direction from the direction of
change in the account balance. Liabilities adjust net income to cash flow in the same direction as the
account balance changes.
Bond Discount or Premium Adjustments25
A bond discount decreases the valuation of the related bond on the balance sheet, whether the bond
discount is a contra-asset (that is, contra to a bond carried as an investment asset) or a contra-liability
(that is, contra to a bond issued by the company as debt and carried as a liability). Regular amortization
of the discount increases the valuation of the related asset or liability and increases the reported
interest income (for an investor) or interest expense (for an issuer). The amortization results in an
increase to the net carrying value of the asset or liability.
A bond premium works in the opposite way. The premium increases the valuation of the bond on the
balance sheet. As the premium is amortized, the amortization results in a decrease to the net carrying value of the asset or liability and a decrease in the reported interest income (for an investor)
or interest expense (for an issuer).
Thus, transactions recorded in bond discount and premium accounts to amortize the discount or premium
represent noncash transactions that nonetheless affect the income statement. Changes in bond discount
and premium accounts require adjustments to the net income figure just as changes to other assets and
liabilities do.
The required adjustments to net income for amortization of bond discounts and premiums when calculating
net cash flow from operating activities are as follows:
For a bond that is held as an investment:
•
Amortization of a discount increases the asset and the amount of interest income reported
(and thus increases net income) and so the amount of the amortization—the amount of change in
the bond discount account on the balance sheet—is deducted from net income.
•
Amortization of a premium decreases the asset and the amount of interest income reported
(and thus decreases net income) and so the amount of the amortization—the amount of change in
the bond premium account on the balance sheet—is added to net income.
25
For full information on the process of accounting for debt securities and amortization of discounts and premiums by
both the issuer and the investor, please see any intermediate accounting textbook.
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35
A.1. Financial Statements
CMA Part 1
For a bond that has been issued as debt:
•
Amortization of a discount increases the liability and increases the amount of interest expense reported (and thus decreases net income) and so the amount of the amortization—the
amount of change in the bond discount account on the balance sheet—is added to net income.
•
Amortization of a premium decreases the liability and decreases the amount of interest
expense reported (and thus increases net income) and so the amount of the amortization—the
amount of change in the bond premium account on the balance sheet—is deducted from net
income.
4) Cash Flows from the Purchase and Sale of Trading Securities
Trading securities may be either debt securities or equity securities. Trading securities are defined in the
Accounting Standards Codification® as “securities that are bought and held principally for the purpose of
selling them in the near term and therefore held for only a short period of time. Trading generally reflects
active and frequent buying and selling, and trading securities are generally used with the objective of
generating profits on short-term differences in price.”
Cash flows from the purchase and sale of trading securities are classified based on the nature and purpose
for which the securities were acquired.26
Trading securities will generally be reported only by entities whose primary business is securities trading,
such as broker-dealers making trades for their own direct market gain, called “proprietary trading.” According to ASC 940-320-45-7, broker-dealers are required to report their trading securities activities in
the operating section of the statement of cash flows. Other entities that carry securities in a trading account
should classify them as either operating activities or as investment activities, according to management’s
judgment as to the nature and purpose for which the securities were acquired.
If cash received from the sale of trading securities or cash paid for the purchase of trading securities is
classified on the SCF within operating activities, those cash flows will be another adjustment to reconcile
net income to net cash from operating activities.
Remember that in calculating cash flows from operating activities under the indirect method, realized gains
or losses on the sale of all securities (including trading securities) are backed out of net income in Item 2,
Eliminate Investing and Financing Activity Events Included in the Income Statement. The entire cash inflow
from any sale of trading securities (not just the gain) and the entire cash outflow for any purchases of the
same need to be included in cash flows from operating activities (not investment activities) if it is appropriate to report cash flows from trading securities activities as operating activities.
Disclosures
When the indirect method is used to prepare the SCF, two items must be disclosed:
1)
the amount of cash paid for interest (net of amounts capitalized), including the portion of the
payments made to settle zero-coupon debt instruments attributable to accreted interest related to
the debt discount or the portion of payments made to settle other debt instruments with coupon
interest rates that are insignificant in relation to the effective interest rate attributable to accreted
interest related to the debt discount, and
2)
the amount of cash paid for income taxes during the period.
The disclosures are required because the cash paid for interest and income taxes will have been included
in the calculation of net cash provided by operating activities line on the SCF, and users need to know the
individual item amounts. These disclosures will be made at the end of the SCF as a supplemental schedule.
26
Trading securities will generally be reported only by entities whose primary business is trading, such as broker-dealers
making proprietary trades. Trading securities are securities bought and held principally for the purpose of selling them
in the near term with the objective of generating profits on short-term differences in price. Trading securities are therefore held for only a short period of time, sometimes only minutes or seconds.
36
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Section A
A.1. Financial Statements
Summary: The Indirect Method
Below is a summary of the steps to prepare the operating activities section under the indirect method. They
are presented to show how all of the items discussed above fit together.
1)
Add all depreciation and amortization expense back to net income.
2)
Add all non-operating losses on the income statement back to net income.
3)
Subtract all non-operating gains on the income statement from net income.
4)
Add and subtract the changes in balance sheet accounts that are related to operating
activities: net accounts receivable, accounts payable, inventory, other payables and receivables,
bond discount or premium amortization, and other assets and liabilities. All of these items are
adjustments to net income in accordance with the rules set out in the General Rules for Operating
Activity Asset and Liability Accounts above.
5)
If purchases and sales of trading securities are to be classified as operating activities, subtract
cash used for purchasing trading securities and add cash received for trading securities that were
sold.
6)
In addition to the above adjustments, the cash amounts for income taxes paid and interest
paid need to be disclosed in a supplemental schedule.
Exam Tip: If an exam problem requires the use of the indirect method and does not give the amount
of net income for the period, net income can usually be calculated by analyzing the amount of change
in retained earnings from one year end to the next year end. Retained earnings are increased by net
income and reduced by any dividends declared during the period. Therefore, by using the beginning and
ending retained earnings balances and the total dividends declared, if any, the amount of net income for
the period can be calculated.
Example: Beginning retained earnings equal $200,000. Ending retained earnings equal $350,000. Dividends were declared in the amount of $60,000 during the period. What was net income during the
period?
Beginning retained earnings + Net income – Dividends declared = Ending retained earnings
$200,000 + Net income – $60,000 = $350,000
Net income = $210,000
Question 7: For the fiscal year just ended, Doran Electronics had the following results.
Net income
Depreciation expense
Increase in accounts payable
Increase in accounts receivable
Increase in deferred income tax liability
$920,000
110,000
45,000
73,000
16,000
Doran’s net cash flow from operating activities is
a)
$928,000
b)
$986,000
c)
$1,018,000
d)
$1,074,000
(ICMA 2014)
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37
A.1. Financial Statements
CMA Part 1
efham CMA
The Two Methods Compared and Contrasted
Both methods of preparing the operating activities produce the same result for net cash provided by operating activities because the same adjustments are made under both methods to the amounts on the income
statement. The difference is that under the direct method each individual line on the income statement
is adjusted and each individual type of operating cash flow is presented, whereas under the indirect method
the net income figure is adjusted and only the net operating cash flow is presented.
Interest and Income Taxes Paid Disclosure
•
When the operating activities section of the SCF is prepared using the indirect method, amounts
of interest paid net of amounts capitalized—including the portion of payments made to settle zerocoupon debt instruments attributable to accreted interest—and income taxes paid during the period
must be separately disclosed.
•
When the direct method is used, those amounts are reported within the statement of cash flows
and need not be separately disclosed.
Reconciliation of Net Income to Net Cash Flow from Operating Activities Required
•
When the operating activities section of the SCF is prepared using the direct method, a reconciliation between net income and net cash flows from operating activities must be provided in a
separate schedule.
•
When the indirect method is used, the reconciliation may be reported within the statement of
cash flows, or it may be provided in a separate schedule with the statement of cash flows reporting only the net cash flow from operating activities.
Note: The FASB prefers the direct method to the indirect method. Because the separate reconciliation
of net income to net cash flow from operating activities prepared under the direct method reports the
same information as would be reported by the cash flows from operating activities section prepared
using the indirect method, a company that chooses to prepare the cash flow from operating activities
section of its SCF using the direct method will effectively need to prepare its SCF according to both the
direct and the indirect methods. The indirect method is used more extensively in practice.
Question 8: The presentation of the major classes of operating cash receipts (such as receipts from
customers) less the major classes of operating cash disbursements (such as cash paid for merchandise)
is best described as the
a)
Direct method of calculating net cash provided or used by operating activities.
b)
Cash method of determining income in conformity with generally accepted accounting principles.
c)
Format of the statement of cash flows.
d)
Indirect method of calculating net cash provided or used by operating activities.
(ICMA 2014)
Question 9: The most commonly used method for calculating and reporting a company’s net cash flow
from operating activities on its statement of cash flows is the
a)
Direct method.
b)
Indirect method.
c)
Single-step method.
d)
Multiple-step method.
(ICMA 2014)
38
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Section A
A.1. Financial Statements
Cash Flows from Investing Activities
The cash inflows and outflows from investing activities are those related to the items included in investing
activities.
Exam Tip: Exam questions on the statement of cash flows often center on the sale of fixed assets.
Usually, some of the information needed to answer the question will be provided as “Other Additional
Information.”
The main issue in calculating net cash provided by investing activities will probably be the purchase or sale
of property, plant, or equipment. Remember that the amount reported in the investing activities section of
the statement of cash flows is the amount of cash received or paid.
•
For an asset purchase, the amount paid for the asset is reported in the SCF.
•
For the sale of an asset, the amount of cash received for the asset is reported in the SCF.
Information regarding the gain or loss on the sale of the asset is not the amount that is used in calculating
cash flows from investing activities, nor is the book value of the asset sold used, although the book value
of the asset and the gain or loss on the sale are used to calculate the amount of cash received from the
sale. However, neither the book value nor the gain or loss are used individually and they should not be
included in the statement of cash flows.
Note: Any gain or loss on the sale of fixed assets included in net income needs to be eliminated from
net income when calculating net cash flows from operating activities using the indirect method.
An exam question may not directly give the amount received for the sale of an asset. Instead, the amount
received may need to be calculated using the book value and gain or loss on the sale.
Example: Knox Co. sold a fixed asset that had an original cost of $20,000 and accumulated depreciation
of $12,000 at the time of the sale. Knox realized a gain of $5,000 on the sale.
Although the amount of cash received on the sale is not provided, it can be calculated from the information that is provided, as follows.
At the time of the sale, the asset had a net book value of $8,000: $20,000 cost less $12,000 accumulated
depreciation. Since the asset was sold at a $5,000 gain, Knox must have received $5,000 more than the
book value of $8,000, or $13,000, for the sale. The $13,000 cash received from the sale of the equipment
is presented on the statement of cash flows as a cash inflow from investing activities.
In addition, the $5,000 gain will be an adjustment to net income in calculating net cash flows from
operating activities when the statement of cash flows is prepared using the indirect method, which begins
with net income. The gain is included in net income, but it is not an operating cash flow. Therefore, the
$5,000 gain must be deducted from net income when calculating net cash flow from operating activities
because it is included instead in investing activities in the $13,000 cash received from the sale of the
fixed asset.
Note: In reporting investing and financing activities, do not net together cash paid and cash received amounts, even when they are for the same classification of items. For example, the statement
of cash flows should have separate lines for “Cash paid to purchase equipment” and “Cash received from
the sale of equipment.”
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39
A.1. Financial Statements
CMA Part 1
Question 10: Three years ago, James Company purchased stock in Zebra Inc. at a cost of $100,000.
The stock was sold for $150,000 during the current fiscal year. The result of this transaction should be
shown in the investing activities section of James’s statement of cash flows as
a)
Zero
b)
$50,000
c)
$100,000
d)
$150,000
(ICMA 2014)
Cash Flows from Financing Activities
Cash flows from financing activities are calculated in the same manner as those for investing activities.
Again, only the amount of cash in the transaction is used. For example, only the amount of cash paid
to redeem an outstanding bond issue before its maturity date, including any premium paid due to the early
redemption, is reported in the SCF, not the book value of the bond on the date of the redemption nor the
gain or loss on the early extinguishment of the debt. However, as was the case with investing activities,
the information on the book value and the gain or loss may be needed in order to calculate the amount of
cash actually paid to redeem the bond, if that information is not given.
Noncash Investing and Financing Activities
Note: Noncash investing and financing activities are reported in a schedule below the SCF. While it is
not really a fourth category of cash activities, think of it as a fourth category of the SCF. Do not forget
about these noncash transactions if a problem requires the preparation of a complete SCF.
Some investing and financing activities are not included on the face of the statement of cash flows (meaning
within the statement itself) because they are noncash investing or financing transactions.
Examples of noncash investing and financing transactions are:
•
Debt converted to equity.
•
Borrowing money to purchase a fixed asset when the lender pays the loan proceeds directly to the
seller of the asset to make sure the loan proceeds are used as intended.
•
Buying or selling fixed assets for something other than cash (for example, stock).
•
Obtaining a building or other item by gift.
•
Exchanging noncash assets or liabilities for other noncash assets or liabilities.
Despite the fact that no cash is involved in these transactions, they need to be disclosed in the statement
of cash flows if they affect recognized assets or liabilities.
Noncash investing or financing activities must be presented separately in a schedule at the end of the
statement of cash flows. This disclosure is required because these events may be very important for a
potential investor to know about. For example, if the company makes a practice of issuing new shares to
acquire fixed assets, the disclosure of that fact will let the potential investor know that his or her ownership
share will be diluted as the company buys fixed assets.
Note: A stock dividend (a dividend paid in shares of company stock) is not included in the statement of
cash flows because a stock dividend does not represent a cash transaction. A stock dividend is also not
disclosed as a non-cash transaction on the statement of cash flows because it does not affect recognized
assets or liabilities. A stock dividend affects the components of equity only. Stock dividends are explained
in more detail in the Equity Transactions topic in this volume.
40
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Section A
A.1. Financial Statements
Note: An Excel spreadsheet is posted in My Studies containing an example of a statement of cash flows
prepared using the indirect method. The Excel file contains worksheets for three years of balance sheets,
three years of income statements, and two years of SCFs. The amounts in the SCFs have been calculated
by means of formulas that show where in the balance sheets and income statements the numbers come
from
Question 11: Kelli Company acquired land by assuming a mortgage for the full acquisition cost. This
transaction should be disclosed on Kelli’s statement of cash flows as a(n)
a)
Financing activity.
b)
Investing activity.
c)
Operating activity.
d)
Noncash financing and investing activity.
(ICMA 2014)
Question 12: An accountant with Nasbo Enterprises Inc. has gathered the following information in order
to prepare the statement of cash flows for the current year. Net income of $456,900 includes a deduction of $45,600 for depreciation expense. The company issued $300,000 of dividends this year and
purchased one new building for $275,000. The balance sheets from the current period and prior period
included the following balances.
Accounts receivable, net
Accounts payable
Inventory
Prior Year
$ 56,860
12,900
186,700
Current Year
$ 45,300
10,745
194,320
Using the indirect method, what is the amount of cash provided by operating activities?
a)
$202,500
b)
$405,205
c)
$504,285
d)
$521,405
(ICMA 2013-2)
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41
A.1. Financial Statements
CMA Part 1
Question 13: Selected financial information for Kristina Company for the year just ended is shown
below.
Net income
Increase in accounts receivable
Decrease in inventory
Increase in accounts payable
Depreciation expense
Gain on the sale of available-for-sale debt securities
Cash receivable from the issue of common stock
Cash paid for dividends
Cash paid for the acquisition of land
Cash received from the sale of available-for-sale debt securities
$2,000,000
300,000
100,000
200,000
400,000
700,000
800,000
80,000
1,500,000
2,800,000
Assuming the indirect method is used, Kristina’s cash flow from operating activities for the year is
a)
$1,700,000
b)
$2,000,000
c)
$2,400,000
d)
$3,100,000
(ICMA 2014)
The following information is for the next two questions. On November 15, 20X0, Senger Machining Corp. purchased a $300,000 U.S. Treasury bond with a maturity date of January 31, 20X1. On
December 31, 20X0, Senger still owned the Treasury bond. The company also had the following other
balances on December 31, 20X0:
Checking account, ABC National Bank
Money market account, ABC National Bank
U.S. Treasury bill purchased Nov. 1, 20X0, maturing Feb. 28, 20X1
$ 50,000
100,000
500,000
Senger treats all highly liquid investments with maturities of three months or less when purchased as
cash equivalents.
Question 14: What amount should Senger report as cash and cash equivalents on its December 31,
20X0 statement of financial position (balance sheet)?
a)
$150,000
b)
$650,000
c)
$450,000
d)
$950,000
Question 15: On Senger’s statement of cash flows for December 31, 20X0, how should the U.S. Treasury
bond be reported?
a)
It should not be included.
b)
As a cash outflow from investing activities.
c)
As a cash outflow from lending activities.
d)
As a part of the cash, cash equivalents, and restricted cash ending balance.
(HOCK)
42
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Section A
A.1.5 Integrated Reporting
A.1.5 Integrated Reporting
Introduction to Integrated Reporting
“Integrated reporting” is the most recent development in a movement that emphasizes corporate reporting
on non-financial information relating to an organization’s corporate citizenship. An integrated report incorporates non-financial information along with the financial information provided in financial reports and
shows how the financial information is influenced by the non-financial information over the short, medium,
and long term.
What is Non-financial Information and Why Report On It?
The public has come to perceive corporations as prospering at the expense of the broader community,
thereby causing social, environmental, and economic problems, and that is not an incorrect perception.
Corporations have in the past caused many problems for themselves and others because they have viewed
value creation narrowly, as optimizing short-term financial performance for the benefit of their shareholders. This short-term focus on wealth-building for shareholders has caused corporations to overlook the
broader influences that determine their long-term success. The result has been long-term problems such
as depletion of natural resources that will be vital to their businesses in the future, a lack of caring about
the economic viability of their suppliers, and economic distress in their communities due to having shifted
more and more of their production activities to lower-wage locations.
According to Michael E. Porter and Mark R. Kramer in The Big Idea: Creating Shared Value, the problems
caused by corporations’ short-term focus can be addressed by generating “shared value,” that is, creating
economic value for the company and its shareholders in a way that also creates value for society. Porter
and Kramer define “shared value” as policies and operating practices that enhance the competitiveness of
a company while simultaneously advancing the economic and social conditions in the communities in which
it operates. Through shared value creation, a corporation can link its operations to generating long-term
value both for its shareholders and for society as a whole while reducing the corporation’s negative impacts
on society. Thus, shared value is a new way of achieving economic success. A corporation that is creating
shared value defines its success in terms of both internal financial returns and external social and economic
results.27
Along with this change in focus, corporate reporting needs to change, as well. Financial statements alone
cannot communicate the full value of a corporation because they report historical financial performance
only. They cannot provide information about the long-term value-creation potential of a corporation.
The Movement to Report Non-Financial Information
The movement to report on non-financial information actually originated in the 1950s to early 1960s in
response to the needs of information users, later called “stakeholders,” for information beyond what was
presented in financial statements to better explain the value-creation process of the organization as well
as its material non-financial risks.
An organization’s stakeholders include all those who are affected by its actions and include its employees,
managers, owners, customers, suppliers, society, government, and creditors. According to stakeholder
theory, business can be understood as a system of how value is created for stakeholders—in contrast to
the idea that a corporation’s sole responsibility is to maximize value for its shareholders. The stakeholder
worldview connects business and capitalism with ethics.28
27
Michael E. Porter and Mark R. Kramer, The Big Idea: Creating Shared Value, Harvard Business Review, JanuaryFebruary 2011. https://hbr.org/2011/01/the-big-idea-creating-shared-value
28
The concept of stakeholders and stakeholder theory was introduced by R. Edward Freeman in Strategic Management:
A Stakeholder Approach, Pitman Publishing, Boston (1984).
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43
A.1.5 Integrated Reporting
CMA Part 1
Over the years, two separate but compatible concepts have emerged, one becoming “corporate social responsibility” and the other becoming “sustainable development.” Corporate social responsibility focuses on
organizations’ impacts on society, and sustainable development focuses on organizations’ meeting the
needs of the present without compromising the ability of future generations to meet their own needs.
ISO 26000, Guidance on Social Responsibility, is an international standard that was introduced in 2010 and
aids organizations in structuring, evaluating, and improving their social responsibility, including their stakeholder relationships and community impacts. It sets forth society’s expectations about what constitutes
socially responsible behavior.
ISO 26000’s definition of social responsibility incorporates sustainable development under the umbrella of
social responsibility. According to ISO 26000, social responsibility is an organization’s responsibility for the
impacts of its decisions and activities on society and the environment through transparent and ethical
behavior that:
1)
Contributes to sustainable development, including the health and welfare of society,
2)
Takes into account the expectations of stakeholders,
3)
Complies with applicable law and is consistent with international norms of behavior, and
4)
Is integrated throughout the organization and practiced in its relationships.
ISO 26000 provides guidance on how an organization can be socially responsible, but it does not provide
a framework for reporting on social responsibility. The earliest framework for reporting on social responsibility and sustainable development activities was introduced by the Global Reporting Initiative (GRI). GRI
is a non-governmental organization (NGO), founded in the U.S. in Boston, Massachusetts in 1997 to support
economic, environmental, and social sustainability. Since 2002, GRI has been headquartered in Amsterdam,
The Netherlands. The first GRI reporting guidelines, Sustainability Reporting Guidelines on Economic, Environmental, and Social Performance, were launched in 2000, and GRI has updated them several times
since. The GRI framework has become an international standard for reporting on environmental and social
responsibility, including sustainability, and economic performance.
Reporting Requirements
The U.S. has no mandatory non-financial reporting requirements other than some required disclosures
about mine safety and conflict minerals. However, many of the largest U.S. companies prepare non-financial
reports on a voluntary basis.
Many countries outside the U.S. have mandatory non-financial reporting requirements. Some examples
follow but are not exhaustive.
In 2014, the European Commission issued a Directive (Directive 2014/95/EU) on disclosure of non-financial
and diversity information by large, public-interest entities (listed companies, banks, insurance companies,
and other companies designated as such by authoritative bodies) and generally having more than 500
employees. Each EU-member country was required to adopt the Directive into its own legislative requirements, though member countries were allowed some flexibility in adapting the terms. Affected companies
were required to apply the Directive under the terms legislated by their own countries as of 2018 for fiscal
years beginning on or after January 1, 2017.
Covered EU companies are required to report on policies, risks, and program outcomes related to environmental protection, social responsibility, treatment of employees, respect for human rights, and
anticorruption and bribery matters. Companies licensed to trade securities must also issue a diversity report
containing information about age, gender, and professional and educational backgrounds at different management levels. Non-financial statements may be presented to stakeholders either in the company’s annual
report or as a separate report published alongside the annual report or within six months of the balance
sheet date. The Directive requires a statutory auditor or an audit firm to verify that the required nonfinancial disclosures have been published, but it does not require an auditor’s assurance report with respect
to the content.
44
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Section A
A.1.5 Integrated Reporting
South Africa was the first country to include integrated reporting in its official reporting requirements. The
King Code of Governance for South Africa 2009 (King III) stated that “the board should appreciate that
strategy, risk, performance, and sustainability are inseparable” and recommended that companies prepare
an integrated report including non-financial information along with financial information. The principles of
King III were incorporated into the listing requirements of the Johannesburg Stock Exchange (JSE), and
listed companies are required to prepare an integrated report or explain why they are not doing so. However, King III did not contain guidelines on how the report should be structured or what it should include.
The reporting requirement coupled with the dearth of guidelines led to the birth of the Integrated Reporting
Committee (IRC) of South Africa, a national body that brought together accountants, companies, internal
auditors, directors, institutional investors, the JSE, and others with an interest in corporate reporting. The
IRC of South Africa developed a framework for an integrated report in 2011, and that framework was used
as a starting point for the development of the International Integrated Reporting Council’s (IIRC) International <IR> Framework, which was issued in 2013.
The International <IR> Framework
The International Integrated Reporting Council was founded in August 2010 as the International Integrated
Reporting Committee, bringing together a cross-section of representatives from the corporate, investment,
accounting, securities, regulatory, academic, and standard-setting sectors as well as civil society. The IIRC’s
stated purpose was to create a globally-accepted framework for a process that results in communications
by an organization about value creation over time.29 The group’s work product, the International <IR>
Framework, was published in December 2013.
According to its website, today the International Integrated Reporting Council (IIRC) is a global coalition of
regulators, investors, companies, standard setters, the accounting profession, and non-governmental organizations (NGOs). The coalition promotes communication about value creation as the next step in
the evolution of corporate reporting.30 Value creation is defined in the Framework as “the process that
results in increases, decreases, or transformations of the capitals31 caused by the organization’s business
activities and outputs.32
•
The IIRC’s mission is “to establish integrated reporting and thinking within mainstream business
practice as the norm in the public and private sectors.”
•
The IIRC’s vision is “to align capital allocation and corporate behavior to wider goals of financial
stability and sustainable development through the cycle of integrated reporting and thinking.”
•
The IIRC’s objective is “to change the corporate reporting system so that integrated reporting
becomes the global norm.”33
29
Per https://www.iasplus.com/en/resources/sustainability/iirc, accessed February 5, 2019.
30
Per http://integratedreporting.org/the-iirc-2/, accessed February 5, 2019.
31
“Capitals” are the resources organizations use in the production of goods or the provision of services. Capitals are
discussed in detail later in this topic.
32
The International Integrated Reporting Committee (IIRC), The International <IR> Framework, December 2013, Glossary, p. 33, http://integratedreporting.org/resources/, accessed January 24, 2019.
33
Per http://integratedreporting.org/the-iirc-2/, accessed February 5, 2019.
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45
A.1.5 Integrated Reporting
CMA Part 1
The International <IR> Framework introduces the concept of reporting non-financial information as an
integral part of the annual report that may be read by all stakeholders. Originally, an organization’s
stakeholders included those who could be expected to be significantly affected by the organization’s business activities. The IIRC expanded the definition of stakeholders in the Framework to include those whose
actions can be expected to significantly affect the organization and also expanded the list of those groups
identified as stakeholders, as follows:
[Stakeholders are] Those groups or individuals that can reasonably be expected to be significantly affected by an organization’s business activities, outputs or outcomes, or whose
actions can reasonably be expected to significantly affect the ability of the organization to create value over time [emphasis added]. Stakeholders may include providers
of financial capital, employees, customers, suppliers, business partners, local communities,
NGOs, environmental groups, legislators, regulators, and policy-makers.
Integrated Report, Integrated Reporting, Integrated Thinking, and Their Relationships
The Framework builds on the concepts of corporate social responsibility and sustainable development, but
it also introduces new and enhanced concepts.
An integrated report is defined by the IIRC in the Framework as:
A concise communication about how an organization’s strategy, governance, performance
and prospects, in the context of its external environment, lead to the creation of value over
the short, medium, and long term.
Integrated reporting is defined in the Framework as:
A process founded on integrated thinking that results in a periodic integrated report by an
organization about value creation over time and related communications regarding aspects
of value creation.
Integrated thinking is defined in the Framework as:
The active consideration by an organization of the relationships between its various operating and functional units and the capitals [see next topic] that the organization uses or
affects. Integrated thinking leads to integrated decision-making and actions that consider
the creation of value over the short, medium, and long term.
Integrated thinking is an important concept in integrated reporting. When integrated thinking is a part of
all of an entity’s activities, management reporting will naturally incorporate the non-financial information
into its management reporting, analysis, and decision-making. Information systems will be better integrated and better able to support both internal and external reporting and communication. 34
34
46
<IR> Framework, Glossary, p. 33.
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Section A
A.1.5 Integrated Reporting
The ”Capitals”
Organizations depend on various forms of capital for success. “Capitals” are the resources an organization
uses in producing and providing products and services. The capitals are stocks of value that are increased,
decreased, or transformed by the activities and outputs of the organization. The Framework discusses six
capitals:
Financial capital is the pool of funds available to an organization to use in the production of goods or the
provision of services. It is funds obtained through financing activities such as debt, equity, or grants or
generated through the reinvestment of funds obtained from operations or investments. Financial capital is
increased when a corporation earns a profit or obtains additional financing.
Manufactured physical capital is manufactured physical objects available to an organization for use in
the production of goods or the provision of services. Manufactured capital includes property, plant, and
equipment that belong to the organization, but it includes much more, as well. It includes external manufactured assets or infrastructure available to the organization such as roads, bridges, and waste and water
treatment plants. It also includes assets manufactured by the reporting organization for sale or for retention
by the organization for its own use.
Intellectual capital results from employees’ efforts that generate intangible assets. Thus, it is intellectual
property such as patents, copyrights, software, rights, and licenses. It is also “organizational capital” such
as knowledge, systems, procedures, and protocols.
Human capital is the skills, capabilities, and experiences of people. It includes employees’ motivations to
innovate, their alignment with and support for the organization’s governance framework, approach to risk
management, and ethical values; their ability to understand, develop and implement the organization’s
strategy; and their loyalties and motivations for improving processes, goods, and services. It also includes
their ability to lead, manage, and collaborate. The quality of a company’s human capital is improved when
employees become better trained.
Social and relationship capital derives from the relationship between a company and the society from
which it secures its license to operate. It is the institutions as well as the relationships within and between
communities, groups of stakeholders, and the ability to share information to enhance individual and collective well-being. It includes intangibles associated with the brand recognition and reputation that an
organization has developed and the willingness to engage that the organization has with external stakeholders.
Natural capital is renewable and non-renewable natural and environmental resources such as air, water,
land, forests, and minerals that provide goods or services supporting the past, current, or future prosperity
of an organization. Natural capital also includes the health and biodiversity of the ecosystem.
The capitals serve as part of the theoretical underpinning for the concept of value creation within the
Framework.35
35
<IR> Framework, §2C, pp. 11-12.
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47
A.1.5 Integrated Reporting
CMA Part 1
The Purpose and Goals of Integrated Reporting
An integrated report is a single report that presents both financial and non-financial information in a manner
that emphasizes the whole picture and the interdependence of its parts. It communicates how an organization's strategy, governance, performance, and prospects lead to the creation of value in the context of
its external environment in the short, medium, and long term.
The primary purpose of an integrated report is to explain to providers of financial capital how an organization creates value over time. An integrated report also benefits all stakeholders that are interested in the
organization’s ability to create value, including employees, suppliers, business partners, local communities,
legislators, regulators, and policy-makers.36
The IIRC’s goal is a world in which integrated thinking is embedded within mainstream business practice in
the public and private sectors. The IIRC sees integrated reporting as facilitating that vision. Thus, the goals
of integrated reporting are to:
•
Improve the quality of information available to providers of financial capital to enable more efficient
and productive allocation of capital.
•
Promote a more cohesive and efficient approach to corporate reporting that draws on different
reporting strands and communicates the full range of factors that materially affect the ability of an
organization to create value over time.
•
Enhance accountability and stewardship for the broad base of capitals (financial, manufactured,
intellectual, human, social and relationship, and natural) and promote understanding of their interdependencies.
•
Support integrated thinking, decision-making, and actions that focus on the creation of value over
the short, medium, and long term.37
Value Creation for the Organization and Others
Value creation is the process of creating outputs that are more valuable than the inputs used to create
them. An organization’s business activities and outputs create value over time. An organization’s ability to
create value for itself enables financial returns to the providers of its financial capital.
The value created is manifested by increases, decreases, or transformations of the capitals. The
value is created for
•
the organization, enabling financial returns to the providers of financial capital, and
•
others, including all stakeholders and society at large.
Note: The value created by the organization for itself is interrelated with the value it creates for stakeholders and society at large. The ability of an organization to create value for itself is dependent
on the value it creates for others.
An organization creates value through making sales, which creates changes in financial capital. However,
a wide range of other activities, interactions, and relationships also create value. Those other activities,
interactions, and relations include but are not limited to:
•
Effects of the organization’s business activities and outputs on customer satisfaction,
•
Suppliers’ willingness to trade with the organization and the terms under which they do it,
•
Initiatives the organizations’ business partners agree to undertake with the organization, and
•
The imposition of supply chain conditions or legal requirements.
36
<IR> Framework, p. 4.
37
<IR> Framework, p. 2.
48
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Section A
A.1.5 Integrated Reporting
An integrated report should include the other interactions, activities, and relationships to the degree that
they are material to the organization’s ability to create value.
Note: Value is created when the benefit derived from its use of capitals is greater than the capitals used.
Value is preserved when it is maintained through continuous improvement, superior quality, superior
service, and customer satisfaction. Value is diminished when poor strategy or poor execution causes
goals not to be achieved. Value is created, preserved, and diminished by management decisions in all
areas, from strategy setting to daily operations.
An integrated report should include the extent of the effects on capitals that are not owned by the organization, or externalities. Externality is primarily an economics term. An externality is a positive or
negative consequence of an economic activity that is received or paid for by unrelated third parties that are
external to the transaction.
•
The effect of a well-educated labor force on the productivity of a company is an example of a
positive externality. The person who pays for and gets a degree receives benefits because people
with more education generally earn more than do people with less education. However, employers,
society, and the economy as a whole also benefit from highly educated people because the work
force is more versatile and productive.
•
Pollution emitted by a factory that injures the health of nearby residents is an example of a negative externality because the residents pay the cost of the emissions as they suffer the
consequences of the pollution. Another example of a negative externality can occur when a mining
company builds a dam to contain waste from the mine. Such dams can and do fail, causing toxic
sludge or water to invade inhabited areas, killing residents and destroying property. Periodically
another such incident is reported in the news media. The most recent incident as this is being
written occurred in Brazil in January 2019. The latest confirmed death toll is 121, with 226 people
still unaccounted for.
A positive externality may ultimately result in a net increase to the value embodied in the capitals, while a
negative eternality may ultimately result in a net decrease. Therefore, providers of financial capital need
information about externalities to the company that are material in order to assess their effects and allocate
resources accordingly.
Value is created over different time horizons and for different stakeholders by means of different capitals.
Over the long term, value is not likely to be created by maximizing one capital, such as financial capital, to
the exclusion of the others.38
38
<IR> Framework, §2.8-2.9, p. 11.
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49
A.1.5 Integrated Reporting
CMA Part 1
The Value Creation Process
The value creation process is central to integrated reporting. The objective of an integrated report is to
communicate how an organization creates value over time. The value creation process is influenced by the
organization’s external environment, its governance, and its business model. An organization’s business
model draws on various capitals as inputs and, through its business activities, converts the inputs to outputs. The outputs are products, services, by-products, and waste. The organization’s activities and its
outputs lead to outcomes, which are their effects on the capitals.39
An integrated report should include insights about:
•
The external environment affecting the organization.
•
The resources and relationships used and affected by the organization: its financial, manufactured,
intellectual, human, social and relationship, and natural capitals.
•
How the organization interacts with the external environment and the capitals to create value over
the short, medium, and long term.40
The graphic below from the Framework depicts the value creation process and is explained on the following
page:
39
<IR> Framework, §2D, p. 13.
40
<IR> Framework, p. 10.
50
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Section A
A.1.5 Integrated Reporting
The elements of the graphic are as follows.
41
•
The six capitals are the inputs to the value creation process, and they enter the process at the
left side of the graphic.
•
The external environment (for example, economic conditions, technological change, societal
issues, and environmental challenges) creates the context within which the organization operates.
The external environment is the background of the graphic.
•
The organization’s mission and vision (at the top of the graphic) identifies the organization’s
purpose and intentions.
o
Monitoring and analysis of the external environment in light of the organization’s mission and
vision is needed in order to identify risks and opportunities (on the top left of the circle).
o
The organization’s strategy identifies the way it plans to mitigate or manage risks and maximize opportunities. Strategic objectives are implemented through resource allocation plans
(on the top right of the circle).
•
Governance (at the top center of the circle) involves creating an oversight structure that supports
the organization’s ability to create value. Governance includes all of the means by which an organization is directed and controlled, including the rules, regulations, processes, customs, policies,
procedures, institutions, and laws that affect the way the organization is administered. Governance
spells out the rules and procedures to be followed in making decisions. Governance also involves
the relationships among the various participants and stakeholders within the organization, such as
the board of directors, the shareholders, the chief executive officer (CEO), and the managers.
Governance is the joint responsibility of the board of directors and management.
•
The business model (in the center of the graphic) is at the core of the organization. A company’s
business model is the organization’s system of using its business activities to transform inputs (the
capitals) into outputs and outcomes to fulfill the organization’s strategic purposes and create value
over the short, medium, and long term. The business model encompasses the various capitals
(inputs, at the center far left) and the organization’s business activities (center left) that convert
the inputs to outputs (center right), which include products, services, by-products, and waste.
•
The organization’s business activities and outputs lead to outcomes (center far right). The outcomes are the internal and external consequences, both positive and negative, for the capitals that
result from the organization’s business activities and outputs. The value creation process may
preserve, increase, or decrease the organization’s capitals over time.
•
The outcomes are transformed capitals that are depicted in the graphic emerging from the right
side of the process.
•
The outcomes—the transformed capitals—become inputs to the ongoing value creation process.
•
Information about performance (on the bottom left of the circle) is required for decision-making.
Performance is monitored through setting up measurement and monitoring systems.
•
Regular review of each component of the value creation process and its interactions with other
components and a focus on the organization’s outlook (on the bottom right of the circle) lead to
revisions and refinement to make improvements.41
<IR> Framework, §2D, pp. 13-14.
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51
A.1.5 Integrated Reporting
CMA Part 1
The Content of an Integrated Report
An integrated report should include the following eight content elements [not necessarily in this order],
which parallel the items in the graphic depicting the integrated reporting process.
42
52
1)
Organizational overview and external environment: What does the organization do, and
what are the circumstances under which it operates? The report should provide information about
the company’s use of and effects on the capitals and how the organization’s strategy relates to its
ability to create value in the short, medium, and long term, and significant factors affecting the
external environment and the organization’s response to it. It should also include quantitative
information such as number of employees, revenue, countries in which the organization operates,
and changes from prior periods.
2)
Governance: How does the organization’s governance structure support its ability to create value
in the short, medium, and long term? The report should provide information about how regulatory
requirements and the skills and diversity of the organization’s leadership structure influence the
design of the governance structure. It should include information on
a.
The organization’s attitude toward risk,
b.
Methods of addressing integrity and ethical issues,
c.
How the organization’s culture, ethics, and values are reflected in its use of and effects on the
capitals and on its relationships with key stakeholders, and
d.
How compensation and incentives are linked to value creation and to the organization’s use of
and effects on the capitals in the short, medium, and long term.
3)
Business model: What is the organization’s business model? An integrated report should describe
the business model, including key inputs, business activities, outputs, and outcomes.
4)
Risks and opportunities: What are the risks and opportunities that affect the organization’s
ability to create value over the short, medium, and long term, and how is the organization dealing
with them?
5)
Strategy and resource allocation: Where does the organization want to go and how does it
intend to get there? The report should identify the organization’s short-, medium-, and long-term
strategic objectives, how it intends to achieve them, how it plans to allocate resources to implement its strategy, and how it will measure achievements and outcomes for the short, medium, and
long term.
6)
Performance: To what extent has the organization achieved its strategic objectives for the period,
and what are its outcomes in terms of effects on the capitals? The report should contain qualitative
and quantitative information about performance, such as a discussion of quantitative indicators,
the organization’s positive and negative effects on the capitals, the state of key stakeholder relationships, and linkages between past and current performance and between current performance
and the organization’s future outlook.
7)
Outlook: What challenges and uncertainties is the organization likely to encounter in pursuing its
strategy, and what are the implications for its business model and future performance? The report
should highlight anticipated changes, the organization’s expectations about the external environment it expects to face in the short, medium, and long term, how it will affect the organization,
and how the organization is equipped to respond to the challenges and uncertainties likely to arise.
8)
Basis of presentation: How does the organization determine what matters to include in the
integrated report, and how are those matters quantified or evaluated? The report should provide
a summary of the frameworks and methods used to quantify or evaluate material matters and a
brief description of the process used to identify relevant matters, evaluate their importance, and
narrow them down to material matters.42
<IR> Framework, §4, pp. 24-32.
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Section A
A.1.5 Integrated Reporting
Guiding Principles for Preparation and Presentation of an Integrated Report
The following seven principles are the guiding principles for preparing an integrated report:
1)
Strategic focus and future orientation: The report should provide information about the organization’s strategy and the way it relates to the organization’s ability to create value in the short,
medium, and long term, and to its use and effects on the capitals.
2)
Connectivity of information: The report should present a holistic43 picture of the combination,
interrelatedness, and dependencies between and among the factors that affect the organization’s
ability to create value over time.
3)
Stakeholder relationships: An integrated report should provide information about the nature
and quality of the organization’s relationships with its key stakeholders. The report should include
how and to what extent the organization understands, takes into account, and responds to stakeholders’ legitimate needs and interests.
4)
Materiality: The information disclosed in an integrated report should be about material matters,
that is, matters that substantively affect the organization’s ability to create value over the short,
medium, and long term. The materiality determination process involves identifying relevant matters, evaluating their importance, prioritizing the matters, and determining what information to
disclose about material matters.
5)
Conciseness: An integrated report should be concise.44 It should include context that is sufficient
to understand the organization’s strategy, governance, performance, and prospects without including less relevant information.
6)
Reliability and completeness: The report should include all material matters, both positive and
negative, in a balanced way and without material error.
7)
Consistency and comparability: The information in the report should be presented on a basis
that is consistent over time, meaning reporting policies are followed consistently from one period
to the next unless a change is needed to improve the quality of information reported. The information should also be presented in a way that enables comparison with other organizations to the
extent it is material to the organization’s own ability to create value over time.45
43
“Holistic” means the parts of a whole are intimately interconnected and are understandable only as parts of the whole.
44
“Concise” means brief but comprehensive, giving a lot of information clearly and in a few words.
45
<IR> Framework, §3, pp. 16-23.
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53
A.1.5 Integrated Reporting
CMA Part 1
Benefits of Adopting Integrated Reporting
•
Integrated reporting can impose a form of discipline on a company’s reporting by ensuring that the
company concisely reports material information that shows how well it is performing in non-financial
areas that affect the company’s strategies and their execution. The result is greater clarity about the
relationship between financial and non-financial performance and how value creation is affected.
•
Integrated reporting can help managers gain a better understanding of the relationship between
financial performance and non-financial performance. Managers are forced to think about when and
under what conditions trade-offs and interdependencies between financial and non-financial performance arise. Better internal decision-making may result.
•
Internal measurement and control systems for producing reliable and timely non-financial information
are improved. Adopting integrated reporting forces organizations to increase the quality of their information systems, internal controls, and monitoring systems so that the integrated report can meet
standards for independent assurance by external auditors.
•
Greater employee engagement may result.
•
Integrated reporting can lower an organization’s reputational risk.
•
Customers who care about sustainability may be more committed.
•
Better communication about the organization’s performance, position, vision, and mission in both
financial and non-financial terms can result in deeper engagement and improved relationships with
shareholders and stakeholders.
•
Integrated reporting can communicate a company’s vision of the future and how it addresses nonfinancial challenges and opportunities, enhancing confidence of long-term investors in the company’s
leadership and its ability to build sustainable value.
Challenges of Adopting Integrated Reporting
•
Adopting integrated reporting requires support of the board of directors and the CEO.
•
Non-financial information does not have the same established reporting standards as financial information has. The information covers more diverse topics and varies by industry. Quantitative
disclosures are not usually measured in monetary units.
•
Understanding what is a material issue that should be reported is very challenging. Management
needs to determine what information its providers of financial capital will want to know. The judgment
of what matters are relevant and important is firm-specific, and each organization needs to develop
a process for how relevant and important matters are defined, which stakeholders will be addressed,
how input will be obtained from them, and the relative weights to assign to issues and audience
members.
•
In order to establish the reliability and comparability of integrated reports, an assurance opinion is
necessary, and it should be in the form of “positive” assurance, for example, “the company has fairly
presented the necessary information” (in the U.S.) or “the necessary information presents a true and
fair view” (internationally).46
(Continued)
46
“Positive assurance” is in contrast to “negative assurance.” Negative assurance means the auditor states that he or
she is not aware of any material modifications that should be made to the report. Negative assurance is not adequate
for an auditor’s statement regarding an integrated report.
54
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Section A
A.1.5 Integrated Reporting
•
Internal controls over non-financial data are not as effective as controls over financial data. Thus, a
lack of data quality may prevent reporting of some non-financial information, and data quality presents a challenge to the independent auditor when attempting to provide positive assurance on nonfinancial information.
•
Preparation of an integrated report requires collecting and analyzing structured and unstructured
data, which entails investments in new information systems and data, new processes and control
systems, dedicating resources, and obtaining assurance from third parties.
•
Specialists with analytical skills will need to be brought in to make sense of the data and incorporate
it into financial reporting.
•
Integrated reporting may cause disclosure of proprietary information and revelation of competitive
information.47
Sustainability Accounting Standards Board (SASB)
Sustainability is an important part of integrated reporting. In November 2018, the Sustainability Accounting
Standards Board (SASB) launched a set of industry-specific sustainability accounting standards that cover
financially material issues. The SASB standards comprise specific recommendations for 77 industries about
the factors most likely to have financially material impacts on a typical company in each industry.
The codified standards may be a resource individual organizations can use in their determination of what
items are material enough to be included in an integrated report. According to the SASB’s announcement,
the standards can help businesses to better focus on the sustainability issues that matter to their financial
performance and to communicate their performance on those issues to providers of capital.
The Sustainability Accounting Standards Board Foundation is an independent, nonprofit standard-setting
international organization that develops and maintains reporting standards that enable businesses to identify, manage, and communicate financially-material sustainability information to their investors.
Information about the SASB is available at www.sasb.org. Any of the 77 industry-specific standards can be
downloaded there, as well.48
47
Institute of Management Accountants, 2016. Statements on Management Accounting – Integrated Reporting, pp. 811.
48
SASB Codifies First-Ever Industry-Specific Sustainability Accounting Standards, https://globenewswire.com/news-release/2018/11/07/1646736/0/en/SASB-Codifies-First-Ever-Industry-Specific-Sustainability-AccountingStandards.html, release date Nov. 7, 2018, accessed January 28, 2019.
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55
A.2. Recognition, Measurement, Valuation, and Disclosure
CMA Part 1
A.2. Recognition, Measurement, Valuation, and Disclosure
Following are specific topics relating to recognition, measurement, valuation, and disclosure in the financial
statements that candidates need to be familiar with:
1)
2)
Assets
a.
Cash and cash equivalents
b.
Accounts receivable
c.
Inventory
d.
Investments
e.
Property, plant, and equipment (fixed assets)
f.
Intangible assets
Liabilities
a.
Reclassification of short-term debt
b.
Warranty liabilities
c.
Off-balance sheet financing
d.
Accounting for income taxes
e.
Leases
3)
Equity transactions
4)
Income statement
a.
Revenue recognition
b.
Income measurement
1) Asset Valuation
1a) Cash and Cash Equivalents
Guidance in the Accounting Standards Codification® on accounting for cash and cash equivalents is in
ASC 305.
Cash is usually the first item presented on the balance sheet because it is the most liquid asset.
Candidates need to know both what is included in the definition of “cash” on the balance sheet as well as
what is not included in the balance sheet definition of “cash.”
Many companies present the first line of the balance sheet as “Cash and cash equivalents.” Cash equivalents
are not cash but they are often presented together with cash on the balance sheet.
Cash
Following are items that are included in cash and those that are not cash. Candidates should memorize
both of these lists.
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Section A
1a) Cash and Cash Equivalents
Items Included in Cash on the Balance Sheet
The three main items classified as cash and included as cash on the balance sheet are:
1)
Cash (of any currency)
2)
Checking accounts
3)
Savings accounts
Items NOT Classified as Cash on the Balance Sheet
The following items are not classified as cash and will therefore not be included in the cash balance on the
balance sheet. They are still assets to the company and will be on the balance sheet, but they are just not
classified as cash. However, some of them may be cash equivalents, in which case they may be shown in
the same line on the balance sheet as the cash when the line is called “cash and cash equivalents.”
The main items that are not classified as cash on the balance sheet are:
1)
CDs (Certificates of Deposit). CDs are classified as either temporary (current asset) or long-term
(non-current asset) investments depending on when the CDs mature.
2)
Money market funds.
3)
Legally restricted deposits.
Cash Equivalents
Cash equivalents are defined as very short-term, highly liquid investments that are (1) readily convertible to a known amount of cash, and (2) so near their maturity that there is no significant risk of changes
in value because of a change in interest rates.
Usually, only securities with original maturities of three months or less when acquired by the company
qualify to be classified as cash equivalents. It is important to base the determination on the time to maturity
on the date the company acquired the item, not on its original term when issued.
Money market accounts in banks and money market mutual funds are included in the definition of cash
equivalents because they are immediately accessible.
Example: Consider a 20-year bond, acquired 19 years and 10 months ago that is due to mature. It is
not classified as a cash equivalent, even though it is maturing in two months, because when it was
acquired its time to maturity was more than three months. The bond does not become a cash equivalent
three months before its maturity date.
However, if that same bond had been acquired two months before its maturity date, then it would be
classified as a cash equivalent because it had a maturity of three months or less when it was acquired.
Companies choose to invest money they will not need in the short term because it is a way to earn interest
or some other kind of return on the cash. These investments are short-term and are generally classified as
cash equivalents. The types of investments used for cash equivalents generally tend to be less risky than
those for long-term investment purposes and they also provide a lower return.
Usually a company presents cash and cash equivalents together and shows them as one number
on its financial statements. Though cash and cash equivalents are often combined, they are different. Cash
is cash on hand and in checking accounts, but a cash equivalent is an investment even though it is “almost
cash” and may be quickly and easily converted to cash.
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57
1b) Accounts Receivable
CMA Part 1
Question 16: All of the following are examples of cash equivalents for presentation on the statement of
financial position except
a)
Commercial paper
b)
Money market funds
c)
Treasury bills
d)
Treasury bonds
(CMA Adapted)
1b) Accounts Receivable
Guidance in the Accounting Standards Codification® on accounting for receivables is in ASC 310.
The main issues with respect to receivables are:
1)
Valuing the accounts receivable on the balance sheet.
2)
Calculating the allowance for credit losses under the percentage-of-sales method and the percentage-of-receivables methods.
3)
Understanding the factoring of receivables with and without recourse.
Valuing Accounts Receivable
For financial statement presentation, short-term receivables are valued and reported at their net realizable value, or the net amount of cash expected to be received. The amount of consideration a company
expects to receive from an individual customer in exchange for transferring goods or services is the transaction price. The net amount the firm expects to receive in cash may be different from the amount legally
receivable at any given time due to future returns and allowances, other variable consideration, and credit
losses on receivables.
Therefore, determining the net realizable value of accounts receivable involves estimation of (1) expected
credit losses on receivables and (2) any returns or allowances to be granted, or (3) other variable consideration expected. Variable consideration is the term used to refer to prices of goods or services that are
dependent on future events.
Discounts and Initial Recording of the Account Receivable
Receivables should initially be recorded at the net amount of cash the company expects to be entitled to
receive in exchange for the goods or services transferred to the customer. Therefore, any trade discounts
that are given or any other discounts that the company expects its customers to take should be subtracted
before recording the receivable in the books. This reduced amount is also the amount that should be recognized as revenue on the income statement.
Two types of discounts may be given: trade discounts and cash (or prompt payment or sales) discounts.
Note: Cash discounts (also called sales discounts or prompt payment discounts) and trade discounts are
applied only to the cost of the product that is purchased. If the seller pays for the shipping costs and
then charges them to the customer, the discount is not applied to the shipping costs.
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Section A
1b) Accounts Receivable
Trade Discounts
Trade discounts are discounts that are given for large purchases, to repeat customers, or for a special offer.
It does not matter why the discount was given, simply that it was given.
Accounting for Trade Discounts
Accounting for trade discounts is fairly straightforward since the trade discount is a simple reduction of the
selling price. A trade discount may be given to good, long-term customers, purchasers of large amounts,
or as an incentive to win new clients.
When a trade discount is extended, the sales revenue and the receivable are recorded at the discounted
price. If more than one trade discount is given (for example, a discount for being a long-standing customer
and an additional discount for a large order), it does not matter which discount is calculated first because
the ending discounted sales amount will be the same no matter which discount is calculated first. What is
important, though, is that the second discount is not applied to the entire sale amount, but rather to the
reduced amount after the application of the first discount.
Cash Discounts (Sales Discounts or Prompt Payment Discounts)
A cash discount, also called a sales discount or a prompt payment discount, is a discount given when
a customer pays a receivable in full before a set date. The purpose of a cash discount is to encourage early
payment of the amount due by giving a discount if the payment is made before the final due date.
A cash or sales discount offered is noted on the invoice the customer receives. For example, an invoice
might say “Terms: 2/10, n/30.” Terms noted like that mean that if the customer pays within 10 days of the
invoice date, the customer can pay 2% less than the invoiced amount, and the invoice will be considered
paid in full. However, if the customer does not pay within 10 days, the full un-discounted amount is due
within 30 days. The preceding is only an example and any combination of days and percentages is possible.
Businesses frequently take cash/sales discounts, because the amount of the discount usually translates to
a substantial benefit when the difference between the full invoiced amount and the discounted amount is
regarded as an interest charge on the discounted amount—an interest charge for taking only 20 additional
days to pay (per the example above, at least).
Accounting for Cash (or Sales) Discounts
Prompt payment discounts are variable, and the receivables should reflect management’s estimate of the
balance of discounts that will be taken based on its experience with the customer, with similar customers,
or with similar transactions.
There are two possible accounting treatments for cash discounts given. The company can either record
receivables at the full amount (the gross method) or record them at the discounted amount (the net
method). The gross method is used more frequently in practice.
Gross Method
Under the gross method, the company recognizes a receivable and revenue equal to the full (gross) amount
of the sale. When receivables are paid within the discount time period (and thus less than the full amount
is paid), an adjusting entry is made to account for the fact that less than the full amount is paid.
If the customer does not pay within the discount period but rather pays in full by the due date, the accounting is very simple because the company records the receivable at its full amount and that is also the
amount of cash that is collected. The two journal entries will be as follows:
Dr
Accounts receivable ........................................................ 100
Cr
Sales revenue .................................................................. 100
To record the sale.
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59
1b) Accounts Receivable
Dr
CMA Part 1
Cash ............................................................................. 100
Cr
Accounts receivable .......................................................... 100
To record the receipt of cash for the sale.
However, if the customer pays within the time frame required for the discount and takes the discount, the
journal entries to record the sale and the receipt of cash will be more involved and will look like the following:
Dr
Accounts receivable ........................................................ 100
Cr
Sales revenue .................................................................. 100
To record the sale.
Dr
Cash ............................................................................... 98
Dr
Cash discounts (or sales discounts) given .............................. 2
Cr
Accounts receivable .......................................................... 100
To record the receipt of cash and also to recognize that only $98 was received.
Even though the full amount of the receivable was not paid, the entire receivable must be removed from
the books, since the customer owes no more money. The $2 discount amount is debited to an account
called cash discounts (or sales discounts) given, which is a contra-revenue account. The amount of the
discount taken will reduce the revenue account on the income statement, but the adjustment is made to
the discounts given contra-revenue account instead of to the revenue account itself to enable analysis.
Allowance for Discounts – Under the Gross Method
However, rather than debiting income each time a discount is taken, proper expense recognition under the
gross method requires that the company reasonably estimate the expected discounts to be taken and set
up an allowance account for discounts. The allowance account is a valuation account and a contra-asset
account that carries a negative balance and reduces the reported receivables on the balance sheet. The
other side of the entry is estimated expense for discounts taken, and that debit goes to the contra-revenue
account, discounts given.
The company uses the allowance in order to properly value the receivables on the balance sheet at the end
of the period and to avoid overstating them. The allowance that is set up should be equal to the balance of
discounts the company expects its customers to take in the future for sales already made. The net of the
accounts receivable balance and the balance in the allowance account for discounts should be equal to the
amount the company expects its customers to pay.
When a customer takes the discount, the debit for the discount amount is made to the allowance account
instead of to the contra-revenue account.
The process of estimating the discounts to be taken and setting up and using the allowance for discounts
is very similar to the process for the allowance for credit losses on receivables, covered later in this topic.
Net Method
The net method of accounting for cash/sales discounts recognizes the amount of the potential discount at
the time of sale, and each receivable is recorded at its net amount (after the discount), assuming the
customer will take the discount. If the outstanding balance is not paid within the discount period, the lost
discount is recognized in a separate account such as cash discounts (or sales discounts) forfeited,
which is a revenue account on the income statement. Under the net method, the journal entries for the
sale and the customer’s payment are as follows.
Dr
Accounts receivable .......................................................... 98
Cr
Sales revenue .................................................................... 98
To record the revenue and the receivable at the net amount.
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Section A
1b) Accounts Receivable
When the discount period passes for each sale, an additional journal entry is required to increase accounts
receivable and income by the discount amount forfeited, as follows:
Dr
Accounts receivable ........................................................... 2
Cr
Cash discounts (or sales discounts) forfeited ............................2
To record sales discount forfeited on receivable that has passed the discount period.
When the receivable is collected, the following journal entry is recorded:
Dr
Cash ............................................................................. 100
Cr
Accounts receivable .......................................................... 100
To record receipt of the gross amount of the receivable.
The discounts forfeited account is a revenue account and will increase the revenue figure on the income
statement as each sale passes its discount period.
According to ASC 606-10-32-2, the transaction price is the amount of consideration the company expects
to be entitled to in exchange for transferring the promised goods or services to a customer. Therefore,
technically the net method is called for by the revenue recognition standard. However, the net method
may not be practical for most companies because it is quite labor-intensive, requiring analysis and
bookkeeping time to calculate and record sales discounts forfeited on each receivable that has passed its
discount period. If collection periods are fairly short, any differences between the revenues and receivables
that result from the gross method and the net method will probably be immaterial.
Credit Losses on Receivables
Unfortunately, some of a company's receivables will not actually be collected. A credit loss may occur on a
receivable because a customer goes bankrupt, an amount is disputed, or the customer simply fails to pay
for some other reason. Because an asset recorded on the balance sheet should reflect the amount of future
benefit the company expects to receive, it is essential that a company makes sure that its assets are not
overstated. The company accomplishes this by valuing the receivables at year-end by estimating the
balance of outstanding receivables that it will actually collect in the future. This expected amount is what
the company should present on the balance sheet.
The valuation of the receivables takes place through the use of a contra-asset account called “allowance
for credit losses.” The valuation allowance decreases the carrying amount of the receivables as presented
on the balance sheet in recognition of the fact that not all of them will actually be received as cash. Thus,
the allowance account should always have a negative (credit) balance, and, when combined with the gross
accounts receivable account (which carries a debit balance), it serves to decrease the value of net accounts
receivable reported on the balance sheet.
The valuation account usually follows the accounts receivable account in the general ledger. The combination of the (positive) accounts receivable account balance and the (negative) valuation account balance
equal the estimated receivable amount that will be collectible. The estimated collectible amount is called
“net receivables” and usually only the net receivable amount is presented on the balance sheet.
The Two Allowance Methods
The amount of current expected credit losses and thus the amount of potentially collectible receivables can
be estimated by means of two methods. The two methods are called the percentage of sales method
and the percentage of receivables method. Although the journal entries are recorded in the same general ledger accounts for both methods, the amounts of those journal entries are calculated differently.
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61
1b) Accounts Receivable
CMA Part 1
Similarities Between the Two Methods
Under both methods, the following steps are performed:
1)
Determine the expected credit losses on outstanding receivables.
2)
Determine the credit loss expense the company needs to recognize on the income statement in
the current period.
3)
Record a debit to an expense account called credit loss expense and a balancing credit to the
allowance for credit losses account.
The purpose of valuing accounts receivable is to recognize anticipated credit loss expense before the writeoffs occur and to reduce the accounts receivable balance reported to the amount the company realistically
expects to collect.
Both methods use the allowance for credit losses account as the contra-account. Under both methods, the
allowance account will have the same five “elements” in each period. The two methods differ with respect
to which element is calculated (through an estimation) and which number becomes a residual number (the
balancing number for the account).
The T-account for the allowance for credit losses account and the five elements in it are:
Allowance for Credit Losses
(1) Beginning balance
(2) Credit losses written off
(3) Collection of previously written-off credit losses
(4) Amount charged as credit loss expense
(5) Ending balance
A basic description of the process and the different approaches taken by the two methods follows.
Percentage of Sales Method
The percentage of sales method uses the amount of credit sales made during the period to estimate the
percentage of those credit sales that will become credit losses. The company may use historical data or any
other method that makes sense to determine the percentage of sales that will not be credit losses.
Under the percentage of sales method, a company estimates the amount of its credit sales from the period
that will not be collected in the future. The estimated credit loss amount is recognized as the credit loss
expense for the period. In the percentage of sales method, the company uses the income statement to
value and match the credit loss expense with the period in which the sales were made. The ending balance
in the allowance account is the beginning balance adjusted by any credit losses written off during the period
(recorded as debits to the allowance account), by collections of previously written-off credit losses (credits
to the allowance account), and by the credit loss expense recorded for the period (a debit to credit loss
expense and a credit to the allowance account).
Percentage of Receivables Method
Under the percentage of receivables method, the company focuses on adjusting the ending balance in
the allowance account to whatever it needs to be to create a net accounts receivable figure that represents
the balance of receivables the company expects to be collected. It values the ending receivables by estimating the percentage of the year-end receivables that will become credit losses in the future. Thus, the
company uses the balance sheet to value its accounts receivable. The amount of credit loss expense the
company records is whatever amount is needed to change the unadjusted balance in the allowance account
to a balance that will create the correct net accounts receivable figure when the allowance account is
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Section A
1b) Accounts Receivable
efham CMA
deducted from the accounts receivable account. A certain amount of “working backwards” is necessary in
the calculation of the credit loss expense under the percentage of receivables method, as the credit loss
expense figure on the income statement becomes the balancing figure.
Companies frequently use accounts receivable aging reports to estimate the balance of outstanding receivables that will not become credit losses and the balance required in the allowance for credit losses account
as of the date of the aging report.
Note: Both the percentage of receivables and the percentage of sales methods are acceptable
under U.S. GAAP, as long as the company uses the same method every year so the method is consistent
from period to period.
However, a third method—the direct write-off method—is not acceptable for U.S. GAAP. Under the
direct write-off method, an individual receivable is written off and debited to expense only when it actually becomes a credit loss. No allowance account is used under the direct write-off method and therefore
the direct write-off method does not match revenues and expenses.
The Allowance for Credit Losses T-Account
Under both methods, when an allowance is recorded, the allowance for credit losses account (the
valuation account) is credited and credit loss expense is debited for the amount by which the valuation
account is being adjusted. The difference between the two methods is which figure in the T-account (see
below) is calculated directly and which figure is a residual, or balancing, figure.
Three journal entries are made that involve the allowance account. The three journal entries are:
1)
To write off a specific receivable when it becomes a credit loss.
2)
To record the collection of a previously written-off receivable.
3)
To record the credit loss expense for the period.
Because the allowance account is a valuation account, it is used to reduce the balance of receivables shown
on the balance sheet, similar to the way accumulated depreciation reduces fixed assets. Therefore, the
allowance account must always carry a credit balance because it is not likely that a company will collect
more from its customers than the customers owe them. Accounts receivable will be presented on the balance sheet as follows:
Accounts receivable
Less: Allowance for credit losses
$100,000
(3,750)
$96,250
The $96,250 is the net accounts receivable, which is gross accounts receivable ($100,000) net of the
$3,750 allowance for credit losses.
Exam Tip: One of the ways to solve problems that relate to the valuation of receivables is to set up the
T-account for the allowance account. Five items are used in the allowance T-account and generally the
question will give all of the numbers except for two (note that the items in bold below are usually given
in the exam). One of the numbers not given will need to be calculated from information that is given.
Solve for the number that must be calculated and then use that and the other three numbers available
to calculate the fifth and final number. Setting up these questions in a T-account makes solving these
problems much easier.
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63
1b) Accounts Receivable
CMA Part 1
The allowance T-account looks like the following under both methods:
Allowance for Credit Losses
(1) Beginning balance
(2) Credit losses written off
(3) Collection of previously written-off credit
losses
(4) Amount charged as credit loss expense
(5) Ending balance
In general, items numbered 1, 2, and 3 will be given in the problem. Alternatively, sometimes a question
will give the ending balance in the allowance account before it is adjusted for the period’s credit loss expense. In this second instance, the preliminary ending balance given includes the beginning balance
adjusted by amounts actually written off during the period and by amounts collected of previously writtenoff credit losses. The question will most likely ask for the amount for item 4 or 5. Calculate one of those
two items using information given in the problem, and then solve for the final amount by “backing into it.”
Allowance Account Journal Entries
The following are the five items recorded in the allowance account and the journal entries that are used to
record these items.
1)
The Beginning Balance of the Allowance Account
The beginning balance of the allowance account is generally given in the problem. The beginning
balance is the ending balance of the previous period and it should be a credit balance because the
allowance account is an asset valuation account. It reduces the balance of an asset.
However, if the balance just before the credit loss adjustment is made is given instead, the balance
in the allowance account may be a debit balance if accounts written off during the period (debits
to the allowance account) have exceeded the credit balance in the account at the beginning of the
period.
2)
Writing Off a Receivable Deemed to be a Credit Loss
When an account finally goes bad and the company becomes aware of the specific entity that is
not going to pay, that individual receivable is written off the books. The receivable is written off
with the following journal entry:
Dr
Allowance for credit losses (reduces allowance) ..................... X
Cr
Accounts receivable – Company A (reduces A/R) ...................... X
Note: The journal entry above is item (2) in the preceding T-account.
The journal entry above does not record any expense because the expense was already recognized
when the allowance account was set up and the credit loss expense account was debited. In fact,
writing off an account that has been deemed a credit loss does not even change the net accounts
receivable balance. The debit balance in the gross accounts receivable account and the credit
balance in the valuation contra-account decrease by the same amount, so the net of the two
accounts is unchanged.
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Section A
3)
1b) Accounts Receivable
Collecting a Previously Written-off Receivable
Occasionally, a company collects a receivable that it had previously written off. When a previously
written-off receivable is collected, the company makes two journal entries. The first entry is made
to reverse the entry that previously wrote off the receivable, as follows:
Dr
Accounts receivable – Company A ....................................... X
Cr
Allowance for credit losses .................................................... X
The journal entry above puts the receivable back on the books so that its receipt can be recorded
and also increases the credit balance in the allowance account. The credit balance in the allowance
account must be increased because the receivable that was thought to be one that would be a
credit loss has in fact has been collected. Therefore, it must be a different receivable that will be
a credit loss, and so the allowance account should include the amount for the other receivable.
The second journal entry is the collection of the cash. It is:
Dr
Cash ................................................................................ X
Cr
Accounts receivable – Company A.......................................... X
Note that both of the above entries involve accounts receivable, the first one a debit to accounts
receivable and the second one a credit to accounts receivable, and they are for the same amount.
Therefore, if the accounting system permits, these two journal entries can be combined into one
journal entry as follows:
Dr
Cash ................................................................................ X
Cr
Allowance for credit losses .................................................... X
Note: The journal entry above is item (3) in the preceding T-account.
4)
Amount Charged as Credit Loss Expense
At the end of each period, a journal entry will be made to record the current expected credit loss
expense for that period. Under both the percentage of sales method and the percentage of receivables method, credit loss expense is debited and the allowance for credit losses account is credited.
The difference between the two methods is in how the credit loss expense is determined (see
below). The journal entry is:
Dr
Credit loss expense ............................................................ X
Cr
Allowance for credit losses .................................................... X
Note: The above journal entry is item (4) in the preceding T-account.
The allowance account is in essence a holding account. Someone is not going to pay, but since the
company does not yet know who will not pay, it is not able to credit (reduce) any specific customer’s receivable account to write off the credit loss. Therefore, the expected credit loss is “held”
in the allowance account until time passes and the non-payer is identified.
Under the percentage of sales method, the credit loss expense amount is calculated as a percentage of credit sales made during the period. The calculated amount, represented by Item 4 in
the allowance T-account above, is debited to credit loss expense and credited to the allowance
account.
Under the percentage of receivables method, the required ending balance in the allowance for
credit losses account is calculated as a function of outstanding receivables. The ending balance
becomes item (5) in the allowance T-account. The amount of the credit to the allowance account
(Item 4 in the allowance T-account above) is whatever amount is required to adjust the ending
balance in the allowance account to what it needs to be. The debit to the credit loss expense
account is the other side of the entry.
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65
1b) Accounts Receivable
5)
CMA Part 1
The Ending Balance in the Allowance Account
The ending balance in the allowance for credit losses account will reduce the ending net accounts
receivable balance shown on the balance sheet. The allowance account must have a credit balance
because it must reduce accounts receivable, not increase accounts receivable. Sometimes accounts
receivable written off during a period will exceed the credit balance in the allowance account,
causing the allowance account to show a debit balance. When that occurs, the debit balance in the
allowance account must be adjusted to a credit balance at the financial statement date by recording
a credit to the allowance account that (1) adjusts the debit balance to zero and (2) creates the
required credit balance in the allowance account. Thus, when the allowance account has a debit
balance before adjustment, the credit transaction to adjust the allowance account will need to be
the amount of the debit balance plus the ending balance required in the allowance account.
Usually only net accounts receivable (that is, gross accounts receivable minus the balance in the
allowance account) is presented on the balance sheet.
Under the percentage of sales method, the ending balance in the allowance account is a residual
figure. After calculating the credit loss expense amount, the ending balance in the allowance account is simply the accumulated balance of all of the items in the allowance account.
Under the percentage of receivables method, the ending balance required in the allowance
account is calculated first as a function of ending receivables. From the required ending balance,
work backwards to determine what the credit loss expense for the period credited to the allowance
account must be in order for the allowance account to have the required ending balance. The
amount of the credit to the allowance account is the residual figure.
Note: On the exam, for any allowance-related question, it is strongly recommended that candidates
solve the question by setting up the T-account for the allowance account and then putting numbers into
that structure.
Differences Between the Two Methods
The amount of credit loss expense to be recorded each period is calculated differently in each of the two
methods. Candidates should be familiar with how the different figures are calculated under each method.
Percentage of Sales Method
The steps in the percentage of sales method are as follows:
1)
Calculate the credit loss expense for the period as a percentage of total credit sales. The percentage
used is based on the company’s historical information. When the company makes the calculation,
it ignores any previous balance in the allowance account or any previously recognized credit loss
expense. The company is calculating the amount of the current period’s credit sales that it estimates will become credit losses and that should therefore be recognized as expense for this period.
2)
Debit credit loss expense for the calculated credit loss expense amount and credit the allowance
for credit losses account for the same amount.
3)
Calculate the ending balance in the allowance account.
4)
Check the reasonableness of the allowance account balance. If it is not reasonable (for example,
if the resulting balance is a debit balance), reappraise.
Note: The ending balance in the allowance account after calculating the credit loss expense using the
percentage of sales method may be not reasonable because of previous write-offs that have exceeded
the amount of the past allowance. In that case, additional credit loss expense will need to be recognized
in the current period so that the current expected credit losses fairly represent the amount the company
expects to lose from its current credit sales.
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Section A
1b) Accounts Receivable
The percentage of sales method is an income statement approach because its goal is to match credit
losses incurred with the revenues they are related to.
The T-account for the percentage of sales method is as follows.
Allowance for Credit Losses - Percentage of Sales
(1) Beginning balance
(2) Credit losses written off
(3) Collection of previously written-off credit losses
(4) Amount charged as credit loss expense for the period
as calculated from the amount of credit sales
(5) Ending balance (residual figure)
Percentage of Receivables Method
The steps in the percentage of receivables method are:
1)
Calculate the required ending balance in the allowance account by using some percentage of ending
accounts receivable or by applying different percentages, as appropriate, to the various aging
classifications on an accounts receivable aging report.
2)
Determine what the “plug figure” in the allowance account needs to be in order for the ending
balance in the account to be as calculated in Step 1. This “plug figure” is the credit loss expense
for the period.
3)
Debit credit loss expense for the amount calculated as credit loss expense in Step 2 and credit the
allowance for credit losses account for the same amount.
The percentage of receivables method is a balance sheet approach because its goal is to value the ending
accounts receivable at their net recoverable amount. The percentage of receivables method emphasizes
asset valuation.
Note: If the required credit balance at the end of a year in the allowance account is less than the credit
balance already in the allowance account at year-end, the credit loss expense recognized is actually a
reduction of credit loss expense, or a gain. The allowance account will be debited to reduce its credit
balance and credit loss expense will be credited. Such a situation can arise if the previous estimates of
expected credit losses were too high and the company actually collected more of its receivables than
anticipated.
The T-account for the percentage of receivables method follows.
Allowance for Credit Losses - Percentage of receivables
(1) Beginning balance
(2) Credit losses written off
(3) Collection of previously written-off credit losses
(4) Amount charged as credit loss expense for the
period (residual figure)
(5) Ending balance calculated using ending A/R
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67
1b) Accounts Receivable
CMA Part 1
Note: An accounts receivable aging report can be used to determine the required ending balance in
the allowance account. An accounts receivable aging report groups the receivables by their past due
status, showing the balances that are 0-30 days past due, 31-60 days past due, 61-90 days past due,
and so forth. Different percentages of expected credit losses can be applied to each group of receivables
to determine what the ending balance in the allowance account needs to be. The result can be a more
accurate estimate of credit losses.
Example: Anita’s Supply Co. uses the percentage of receivables method to value its accounts receivable
and uses its accounts receivable aging report to estimate the current expected credit losses from the
outstanding receivables. At December 31, 20X9, Anita’s prepared the following aging schedule in order
to calculate the balance it needed to have in its allowance for credit losses account:
Age of Accounts
Under 60 days
61-90 days
91-120 days
Over 120 days
Outstanding
Balances
$925,000
115,000
56,000
44,000
% Expected
Credit Losses
2%
5%
10%
30%
As of December 31, 20X9, before recording the year-end adjustment for the allowance account, Anita’s
had a debit balance of $5,000 in its allowance account.
The accounts receivable manager calculated that the balance in the allowance account needed to be a
credit balance of $43,050 by multiplying each aging category’s receivable balance by its expected credit
losses percentage and summing the results, as follows:
($925,000 × 0.02) + ($115,000 × 0.05) + ($56,000 × 0.10) + ($44,000 × 0.30) = $43,050
Since the balance before adjustment in the allowance account was a debit balance of $5,000, to adjust
the debit balance of $5,000 to a credit balance of $43,050, a credit transaction in the amount of $48,050
($43,050 + $5,000) needs to be recorded in the allowance account as of December 31, 20X9. The other
side of the transaction will be a debit of $48,050 to credit loss expense.
Note: If the balance before adjustment in the allowance account had been a credit balance of $5,000
instead of a debit balance of $5,000, the necessary credit to the allowance account to adjust its balance
to a credit balance of $43,050 would have been $38,050 ($43,050 − $5,000), and the debit to credit
loss expense would have also been $38,050.
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Section A
1b) Accounts Receivable
Question 17: Fidler Company has estimated its credit loss expense by using 1% of net sales. However,
the company is contemplating aging its accounts receivable and using this as a basis for estimating its
expected credit losses, as it is believed that this will provide a better estimate of the credit losses. The
following aging schedule was prepared as of November 30 of the current year, the end of the fiscal
year.
% Expected
Age of Account
Amount
Credit Losses
Under 60 days
61-90 days
91-120 days
Over 120 days
$730,000
40,000
18,000
72,000
1%
6%
9%
25%
Net sales for the year were $4,200,000. The allowance for credit losses account had a debit balance of
$14,000 as of November 30 of the current year.
If Fidler estimates its credit losses by aging the accounts receivable, the adjusting entry to the allowance
for credit losses account made on November 30 of the current year will be for:
a)
$56,000
b)
$43,320
c)
$29,320
d)
$15,320
(CMA Adapted)
Question 18: Johnson Company uses the allowance method to account for expected credit losses from
its accounts receivable. After recording the estimate of credit loss expense for the current year, Johnson
decided to write off in the current year the $10,000 account of a customer who had filed for bankruptcy.
What effect does this write-off have on the company’s current net income and total current assets,
respectively?
Net Income
Total Current Assets
a)
Decrease
Decrease
b)
No effect
Decrease
c)
Decrease
No effect
d)
No effect
No effect
(CMA Adapted)
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69
1b) Accounts Receivable
CMA Part 1
Question 19: The following information is available for a small retailer:
Beginning Balances:
Accounts receivable
Allowance for credit losses
Accounts receivable, net
$10,000
(750)
$ 9,250
Transactions during the period:
Credit sales
Collections on credit sales
$60,000
55,000
During the period, accounts receivable totaling $1,000 were written off as credit losses. This brought
the balance in the allowance account to a debit balance of $250.
Required: Calculate the ending balance in the allowance account and the amount that is charged to
credit loss expense using the following methods:
a. Percentage of Sales. Assume that 3% of credit sales is the current expected credit loss expense.
b. Percentage of Receivables. Assume that 6% of the outstanding receivables are expected to be
credit losses.
(HOCK)
Question 20: Based on the industry average, Davis Corporation estimates that its credit losses should
average 3% of credit sales. The balance in the allowance for credit losses account at the beginning of
Year 3 was $140,000. During Year 3, credit sales totaled $10,000,000, accounts of $100,000 were
deemed to be credit losses, and payment was received on a $20,000 account that had previously been
written off as a credit loss. The entry to record credit loss expense at the end of Year 3 would include
a credit to the allowance for credit losses account of
a)
$300,000
b)
$260,000
c)
$240,000
d)
$160,000
(CMA Adapted)
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Section A
1b) Accounts Receivable
Sales Returns and Allowances
A company needs to recognize that customers will return a certain amount of sold merchandise, or the
company may grant an allowance on the sales price if the customer is dissatisfied.
When a customer returns merchandise or the company grants an allowance, the company must eliminate
or reduce the receivable if the sale has not yet been paid for or refund the customer’s payment if payment
has been received. Two accounts in the chart of accounts are used: sales returns and allowances and
allowance for sales returns and allowances.
•
Sales returns and allowances is a contra-revenue account. It carries a debit balance and reduces sales revenue on the income statement.
•
Allowance for sales returns and allowances is a contra-receivables account. It carries a credit
balance and reduces accounts receivable on the balance sheet.
The sales returns and allowances account and the allowance for sales returns and allowances account are
used to show the estimated amount of refunds and allowances the company expects to grant in the future.
Both sales revenue and accounts receivable are reduced to the amount the company expects to receive.
Note: More information on the use of the sales returns and allowances account and the allowance for
sales returns and allowances account is provided in the topic of Revenue Recognition in this volume.
Factoring: Using Receivables as an Immediate Source of Cash
Factoring is selling receivables to a third party. A commercial finance company, called a “factor,” essentially
makes a loan to the seller of the receivables that is guaranteed (collateralized) by the receivables.
However, selling its accounts receivable differs for the seller from borrowing money and pledging the receivables as collateral in two ways:
•
After it sells its receivables to the factor, the seller of the receivables no longer owns the receivables, so the receivables are removed from the seller’s balance sheet.
•
The seller also does not report a loan outstanding on its balance sheet for the funds received in
the sale of the receivables.
The factor notifies the seller’s customers to begin remitting their payments directly to the factor, and the
factor receives repayment of its “loan” as it collects the receivables.
The two forms of factoring are called “without recourse” and “with recourse.”
Traditionally, factoring is without recourse, which means the factor assumes the risk of any credit losses
on the receivables. If a receivable the factor purchased proves to be uncollectible, the factor has no recourse
against the seller of the receivable—the loss is the factor’s loss. Some companies factor their receivables
without recourse in order to transfer the credit loss risk in this manner. However, the greater the risk of
credit losses, the less cash the selling company will receive from the factor.
Note: If the receivables are sold without recourse, any credit loss expense and balance in the allowance
for credit losses account already recorded by the seller for the receivables needs to be reversed.
Sometimes the sale is with recourse. In a sale of receivables with recourse, if a customer does not pay
the receivable, the seller of the receivable is liable to the factor for the credit loss. Therefore, when a factor
purchases receivables with recourse, the factor’s risk of credit losses is limited. Because of the lower level
of risk to the factor, it will pay more when buying receivables with recourse.
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71
1c) Inventory
CMA Part 1
Note: If receivables are factored with recourse, the seller will carry a liability, called recourse liability or
recourse obligation, on its balance sheet for the estimated amount of any expected credit losses. The
recourse liability is very similar in process to the allowance for credit losses account used by a company
that collects its own receivables and bears the risk of the associated credit losses.
1c) Inventory
Guidance in the Accounting Standards Codification® on accounting for inventory is in ASC 330.
Inventory is a critical asset. It is one of the most important and possibly largest items on the balance sheet
for a company that either produces or sells goods. Inventory is not only reported on the balance sheet as
an asset, but it is also an important item used to calculate the cost of goods sold on the income statement.
For a merchandising company, cost of goods sold is usually one of the largest expense items on the income
statement.
Important issues to be familiar with in regard to inventory include:
1)
The valuation of the inventory when it is purchased and recorded
2)
The determination of which specific items of inventory are included in inventory at year end
3)
The recognition of permanent declines in the value of the inventory
Classifications of Inventory
A retailer or a wholesaler will have merchandise inventory. Retailers and wholesalers do not manufacture
the inventory they sell. They buy their inventory and resell it without doing any production.
A manufacturing company has three different classifications of inventory:
•
Raw materials: The individual parts and pieces that will be assembled to make the finished goods.
•
Work-in-process: Units of inventory for which production has started, but has not yet been completed.
•
Finished goods: Units that have been completed but not yet sold.
Note: In this section of the book, the focus is on the accounting for finished goods. The production
process and the allocation of costs in the production process are covered in Section D, Cost Management,
in Volume 2. Here, attention is on a merchandising company or a reseller, in other words a company
that buys finished products and sells them to the consumer without doing any production.
Valuing the Inventory When It Is Purchased
Inventory should be recorded in the books at an amount that includes all the costs paid for the inventory
and for getting the inventory ready and available for sale. Costs include the cost of the inventory,
shipping costs to receive the inventory, insurance while the inventory is in transit, taxes and tariffs, duties,
and any other costs without which the company could not receive the inventory to sell to the customer.
Costs of receiving the inventory are called landing costs.
The journal entry to record the purchase of inventory is as follows:
Dr
Inventory ....................................................all costs required
Cr
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Cash ............................................................. all costs required
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Section A
1c) Inventory
Note: If more than one type of inventory is purchased for only one purchase price, the cost needs to be
allocated among the different inventories purchased using a pro rata distribution based upon the fair
values of the different items purchased.
If a company receives any discounts related to the purchase of the inventory, the discounted price it
pays is the amount that should be recorded as the value of the inventory.
Which Goods Are Included in Inventory?
Which items should be included in ending inventory at the reporting date? Which items belong to someone
else and therefore should be included in that entity’s ending inventory? These questions refer to items that
are in transit, consigned, out on approval, or obsolete. The treatment of these different categories of
goods is discussed below.
In-Transit Goods
In-transit goods are goods that have been shipped prior to the financial statement date but had not yet
been received by the buyer as of the financial statement date. The owner of the goods is determined by
the terms of shipping.
•
Goods sent FOB Shipping Point belong to the buyer from the moment the seller gives them to
the shipping company. Thus, while the goods are in transit they belong to the buyer because title
was transferred at the shipping point. Therefore, goods that have been shipped FOB Shipping Point
by the end of the period should be included in the buyer’s ending inventory even though the buyer
may not have received them by the end of the period. The goods should not be included in the
seller’s ending inventory.
•
Goods sent FOB Destination belong to the seller until the buyer receives them. While the goods
are in transit, they belong to the seller and title is transferred at the destination point only when
the buyer receives them. Goods shipped FOB Destination near the end of the period that have not
been delivered to the buyer by the end of the period should be excluded from the ending inventory
of the buyer and included in the ending inventory of the seller.
Note: The issue of the owner of goods in transit is also connected to accounts receivable. For the seller,
any individual shipment made near the end of a period should be reported on the period-end balance
sheet as either inventory or as a receivable (or cash if the sale was a cash sale).
For example, a shipment shipped FOB Destination on December 30 that arrives on January 3 will be
inventory on the seller’s books until January 3. On January 3, the seller’s accounts receivable is debited
for the full amount of the sale and revenue is credited for the same amount; and cost of sales is debited
for the cost of the sale while inventory is credited for the same amount. That shipment should never be
shown on the seller’s books as both inventory and a receivable.
For the buyer, the item will be either 1) both inventory and a payable or 2) neither inventory nor a
payable.
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1c) Inventory
CMA Part 1
Consigned Goods
Consigned goods are given by one company (the consignor) to another company (the consignee) for the
consignee to sell to the end consumer. Goods may be consigned because the consignee is physically closer
to the consumer or because consignment enables the consignor to get a wider distribution of goods than
the company could achieve on its own.
Ownership never transfers to the consignee when goods are consigned. Instead, title passes directly from the consignor to the end consumer. Therefore, the consignee never bears the risk of loss unless
a contract passes that risk to it. Consigned goods should be reported as inventory on the records of the
consignor because it bears the risk of loss.
Goods out on consignment belong in the inventory of the consignor company because the ownership never
transfers to the consignee. The goods should be carried on the consignor’s balance sheet at the cost the
consignor paid for the goods plus any shipping costs the consignor paid to get the goods to the consignee
company that will sell the goods. The shipping costs to the consignee are costs of making the goods available for sale to the customer and thus are “inventoriable” costs.
Goods held on consignment do not belong to the company that holds them (that is, the consignee) and
therefore should not be included in the consignee’s inventory.
Note: Accounting for and revenue recognition connected to goods out on consignment are covered in
this volume in the topic Revenue Recognition.
Goods Out on Approval
Goods out on approval are goods that are currently in the possession of a potential customer but have not
yet been purchased by the customer. The customer physically has the product and has some period of time
to decide either to purchase it or return it. Goods-out-on-approval items should be included in the seller’s
inventory at their original cost until either the customer accepts the goods or the time to return the goods
expires. Only when either of these events occurs will the sale be recognized and the cost of the goods
removed from the seller’s inventory and transferred to cost of goods sold. If instead the customer returns
the goods, no transaction is necessary.
Obsolete Inventory
Obsolete inventory items are items that can no longer be sold and thus should not be included in the
inventory balance on the balance sheet. Items may become obsolete for a number of reasons: technological advancement that makes the product useless, market loss, new features in newer products, or
the item is used with another product that is no longer available for sale. Any inventory that becomes
obsolete should be written off as a loss in the period in which it is determined to be obsolete.
Costs Included in Inventory
Product costs are included in inventory and they are also called inventoriable costs. Product costs are
costs that are attached to each unit of inventory. They are all the costs directly incurred to bring the goods
in and for a manufacturer, to convert them to a product that can be sold. They include the cost of the
product itself, freight charges on the incoming shipments, other direct costs to acquire the product, and,
for a manufacturer, production costs incurred in production of a salable product. For a manufacturer, production costs include direct materials, direct labor, and manufacturing overhead.
Although costs of purchasing and storing the inventory could be considered product costs, usually those
are not included in product costs because of the difficulty of allocating them to specific units. Usually those
costs are considered period costs. Period costs, as opposed to product costs, are costs not directly related
to acquiring or producing goods. Period costs include general and administrative expenses and selling costs,
including outgoing freight on shipments to customers.
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Section A
1c) Inventory
Determining Which Item Is Sold: Cost Flow Assumptions
Because the inventory on hand that a company holds is purchased at different times, the prices paid for
individual units of the same item are different. The cost of the specific unit of inventory that is sold impacts
both the balance sheet (through reduction of the inventory account) and the income statement (through
increase of the cost of goods sold).
Therefore, the company must have a method of determining exactly which unit of inventory is sold for each
and every sale. The company must essentially determine if the sold unit was the oldest in inventory (that
is, purchased a long time ago), the newest unit (the most recently purchased), or some “average” unit of
inventory.
The different methods for determining which units have been sold are called cost flow assumptions. The
four main cost flow assumptions are:
1)
First in First Out (FIFO), in which it is assumed that the item sold to the customer is the earliest
unit purchased by the seller that has not yet been sold (that is, the oldest item in inventory).
2)
Last in First Out (LIFO), in which it is assumed that the item sold to the customer is the latest
unit purchased by the seller (that is, the newest item in inventory).
3)
Average Cost, in which the costs paid for all the individual units of a given item in inventory are
summed and divided by the number of units purchased to find the average cost for each unit.
4)
Specific Identification, in which each unit of inventory is individually tracked. The specific identification method is used for low quantity, high value inventory items, such as merchandise in a
jewelry store or serialized electronic merchandise where inventory records are kept by serial number.
IFRS Note: Under IFRS, LIFO is prohibited.
Whichever cost flow assumption is used, the resulting cost of a sold unit becomes the cost used as the cost
of goods sold for that sale.
The three most common methods are FIFO, LIFO, and average cost, which will all be discussed below.
Specific identification will be covered only briefly because it is simple to determine the value of what was
sold and what remains on hand at the end of a reporting period since a cost record is maintained for each
individual piece of inventory. For example, many accounting systems provide the ability to track serialized
inventory such as electronic equipment according to serial number, and the cost of each specific unit is
attached to that item in inventory. When an item of serialized inventory is sold, the cost attached to that
specific item is removed from inventory and transferred to cost of goods sold.
1) First in First Out (FIFO)
Under FIFO, the most recently purchased inventory items are included in ending inventory on the balance
sheet. The assumption is that the oldest item in inventory is always the item sold, whether or not that is
actually what happens. In addition, it is assumed the most recently purchased items are still in inventory
at the end of the period.
An example of the FIFO method is a fruit stand. When someone buys an apple, the seller will try to sell the
oldest apple first because if it spoils before its sale it will become “obsolete,” creating a loss for the fruit
stand.
However, unless inventory is highly perishable as apples are, it does not matter whether or not the actual
first item stocked is the first item sold. Whether it is or not, the assumption is made that the first item
stocked is the first item sold.
In a period of rising costs, using FIFO will result in a higher ending inventory balance and a lower COGS
(and therefore higher operating income) when compared to LIFO, which will be covered next. This occurs
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because the newest, most expensive units of inventory are still on hand at year-end (higher ending inventory) and the oldest, lowest-cost units of inventory were sold during the year (lower cost of goods sold).
Note: Under FIFO, ending inventory is essentially valued at current cost (or replacement cost), and cost
of goods sold is reported at an older, historical cost. Therefore, the balance sheet has “current” figures
because the inventory is valued at the more current costs.
Price
In a period of rising prices, FIFO looks like the following:
Cost of a Unit of
Inventory-FIFO
Ending
Inventory
COGS
Time
Benefits of FIFO
•
In a period of rising prices, cost of goods sold will be lower with FIFO than with other cost flow
assumptions because the oldest, lowest-cost inventory will be assumed sold for each sale. Consequently, reported net income will be higher than it would be with other cost flow assumptions, which
may be of benefit to some companies.
•
When FIFO is used, inventory on hand will reflect more-current market prices than would be the case
under other cost flow assumptions because the inventory on the balance sheet will be reported at the
cost of the most recently purchased items.
•
In the U.S., FIFO is the only inventory cost flow assumption that is not restricted in its usage for
income tax purposes by the IRS.
Limitations of FIFO
•
Although reported net income is higher under FIFO than under other cost flow assumptions, net cash
flow will probably be lower. In a period of rising prices, taxable income will be higher, and higher
taxable income means higher income taxes paid, which decreases net cash flow.
•
Use of FIFO when prices are rising creates short-term, overstated operating income that is not sustainable due to lower-cost units purchased long ago being the ones expensed as cost of goods sold.
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Section A
1c) Inventory
Last in First Out (LIFO)
When LIFO is used, the assumption is made that each time a unit is sold it is the one that was purchased
most recently—the newest item in inventory. Therefore, the oldest inventory items (and the lowest-cost
items, assuming rising prices) will be included in ending inventory on the balance sheet.
As a result, in a period of rising prices LIFO will create a lower ending inventory balance and a higher
COGS (and therefore lower operating income) when compared to FIFO. At year end, the oldest, lowestcost items are still in inventory and the newest, highest cost units have been sold and are on the income
statement as cost of goods sold.
The LIFO inventory method can be compared to an elevator. Assume a crowd of people stepping onto an
elevator and heading to the same floor together. The last person who steps on is often the first person
stepping off because that person is closest to the door.
Note: Under LIFO, cost of goods sold is valued at the current cost (or replacement cost) of the inventory.
Inventory is recorded on the balance sheet at an older, historical cost. Therefore, the income statement
has “current” figures on it because cost of goods sold is valued at the current costs.
Price
LIFO in a period of rising prices is shown here:
Cost of a Unit of
Inventory-LIFO
COGS
Ending
Inventory
Time
Whenever a sale takes place, the newest, highest cost item of inventory is considered sold and is reported
as cost of goods sold expense while the oldest, lowest cost unit is assumed to remain in ending inventory.
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Benefits of LIFO
•
LIFO is sometimes the best match for the way goods physically flow into and out of inventory. When
new inventory is received and displayed for sale, items may be placed in front of the existing inventory unless a concerted effort is made to position newer items behind older ones. If newer items are
consistently placed in front of older ones, the newest units are always the units sold.
•
LIFO better matches current costs against current revenues and therefore provides a better measure
of current earnings. When prices are rising, use of LIFO leads to better quality earnings.
•
The primary advantage of LIFO is that when prices are rising the use of LIFO for tax reporting results
in a higher cost of goods sold and a lower taxable income. Lower taxable income leads to lower
income taxes and higher cash flow.
Limitations of LIFO
•
If a company uses LIFO for its tax reporting to gain the advantage of lower taxes, tax law in the U.S.
requires that the company also use LIFO for its financial reporting. As a result, the company’s reported earnings will be lower than they would be under the other cost flow assumptions, assuming
rising prices. Tax law does not have a similar requirement for other inventory cost flow assumptions.
•
Since the items reported as inventory on the balance sheet will be the earliest items purchased, when
prices rise inventory will be valued too low on the balance sheet.
•
If sales exceed purchases of inventory, layers of old inventory will be liquidated. The old costs will be
matched against current revenues and will cause an increase in reported income for the period in
which the liquidation occurs.
•
A company using LIFO may be able to manipulate its net income by altering its purchasing pattern
at year end.
•
Accounting under LIFO can be complex because of the LIFO cost layers.
•
Using LIFO for inventory valuation is not permitted if a company is using IFRS.
Average Cost
The average cost method attempts to create a balance between FIFO and LIFO by using an average cost
for the calculation of ending inventory and COGS. For each sale, the average cost per unit is calculated by
dividing the total cost paid for all the units on hand by the number of units on hand. When average cost is
used, the ending balance for inventory and the amount of cost of goods sold, and thus net income, will be
somewhere in between what they would have been under FIFO and LIFO.
The IRS does not permit the average cost method to be used on a company’s tax return. If a company
chooses to use the average cost method for financial reporting, it can use only FIFO for income tax reporting. Using the average cost method for financial reporting and LIFO for income tax reporting is not an
option, because, as noted above, if LIFO is used on the income tax return, tax regulations in the U.S. state
that LIFO must be used for financial reporting as well.
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Section A
1c) Inventory
Effect of the Different Methods
The different cost flow assumptions have different impacts on ending inventory and cost of goods sold,
depending on whether prices are rising or falling, as follows:
Ending Inventory
Cost of Goods Sold
Gross Profit
Rising Prices
FIFO Higher
LIFO Higher
FIFO Higher
Falling Prices
LIFO Higher
FIFO Higher
LIFO Higher
In general, LIFO is preferable under the following circumstances:
•
Selling prices and revenues are increasing faster than costs and thus distorting net income
•
LIFO has traditionally been used, such as in department stores and in industries where a fairly
constant core inventory remains on hand, such as refining, chemicals, and glass.
LIFO is probably less preferable or even inappropriate when:
•
prices tend to lag behind costs
•
specific identification is needed, such as with automobiles, farm equipment, serialized electronic
equipment, art, and antique jewelry
•
unit costs tend to decrease as production increases, which would nullify any tax benefit that LIFO
might provide because the most recently produced units would be in inventory at lower costs than
inventory produced earlier because the lower-cost units would be the units sold
•
prices tend to decrease, for example in electronics where prices are high when a new technology
is introduced and prices for the same item typically decrease as time passes.
The Frequency of Determining Inventory Balances
Management must decide not only regarding the inventory method (FIFO, LIFO, or Average Cost) that the
company will use, but it must also decide how frequently it will make the necessary inventory calculations.
Two systems are used for determining the frequency of making inventory entries: the periodic method
and the perpetual method. The difference between the two systems lies in how often a company makes
the calculation of its ending inventory and cost of goods sold.
1) Periodic System
Under the periodic system, entries and calculations are made only at the end of the period (either every
month, year, or quarter). The effects of the periodic method on the three main methods of tracking physical
units of inventory are as follows.
FIFO in the Periodic System
At the end of the period, the company determines the total number of units of inventory it had available
for sale during the period (beginning inventory plus inventory purchased during the period) and the cost of
each of the units in beginning inventory and those purchased during the period. Of all of these units, the
units sold are the units in beginning inventory and the earliest units purchased during the period. Ending
inventory consists of the most recently purchased units or those purchased toward the end of the period.
The value of the ending inventory is determined only at the end of the period.
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LIFO in the Periodic System
LIFO in the periodic system is similar to FIFO in the periodic system except for the determination of which
units are included in ending inventory and which units were sold during the period.
At the end of the period, the company determines the number of units of inventory it had available for sale
during the period (beginning inventory plus inventory purchased during the period) and the cost of each of
the units in beginning inventory and the units purchased during the period. Of all of these units, the units
sold are the units most recently purchased during the period. If the number of units sold during the period
is greater than the number of units purchased during the period, some units are sold from the beginning
inventory at their cost in beginning inventory. Ending inventory consists of the oldest units on hand.
If inventory increased during the period, the ending inventory for the period is made up of the units that
were in beginning inventory plus the units purchased closest to the beginning of the period. If inventory
decreased during the period, the ending inventory for the period consists of the remaining units in beginning
inventory that are still unsold at the end of the period. All units that were purchased during the period are
sold by the end of the period.
Again, the value of the ending inventory is determined only at the end of the period.
Average Cost in the Periodic System: A Weighted Average
In the periodic system, average cost is called the weighted average method. At the end of the period,
the company determines the total number of units it had available for sale (beginning inventory plus inventory purchased during the period) and also the total cost it paid for all of the units available for sale.
By dividing the total cost by the total units available for sale, the company determines an average cost for
each unit of inventory available for sale during the period. The average cost per unit is applied to the units
on hand at the end of the period as well as to the units sold in order to calculate ending inventory and
COGS respectively. The calculation of the weighted average cost in the periodic system is done only at the
end of the period.
2) Perpetual System
Under the perpetual system, the calculation of the cost of the unit of inventory sold is made after each
individual sale. For LIFO and the average cost methods, the perpetual system leads to a larger number of
calculations. While the calculations are not difficult, it is important to keep track of all of the necessary
information for these types of questions. The effects of the perpetual method on the three main methods
of tracking physical units of inventory are outlined below.
FIFO in the Perpetual System
Under FIFO, the periodic and the perpetual methods result in the same numbers because according
to FIFO the oldest unit is sold first.
Example: FIFO in a perpetual system can be illustrated using birth order of children in a family. No
matter how many children are born, the oldest child is always the oldest child. Regardless of whether
more children are still being born or all of the children are born in the family, the oldest always remains
the oldest. The same idea can be applied to inventory. Regardless of when the oldest unit is determined,
it will always be the oldest unit until it is sold.
Note: Remember that under FIFO, the FIFO periodic and the FIFO perpetual methods produce
the same result. Knowing this equivalence may help save time in the calculations of a large inventory
question.
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Section A
1c) Inventory
LIFO in the Perpetual System
With perpetual LIFO, it is slightly more difficult to calculate the ending inventory because the LIFO inventory
is in LIFO layers.
A LIFO layer arises when a company purchases more inventory before it sells all of its previously purchased
inventory. The assumption underlying LIFO—the most recently purchased (newest) inventory item is always
the first unit sold—leads to many different individual prices for the units in ending inventory. Each time the
company buys more inventory before selling all the inventory it previously had on hand, a layer is added.
The graph that follows contains a presentation of LIFO perpetual in which inventory layers are created. To
simplify the presentation, assume that the company counts its inventory twice a year rather than after
every purchase. Also assume that in both the first and second half of the year the company purchased
more units of inventory than it sold. Therefore, at the end of the year the company will have the ending
inventory and COGS shown on the graph.
Once a LIFO layer is created, it will remain in place until the company reaches a period when it sells more
units than it purchased during the period. When the company sells more units than it has purchased, one
or more LIFO layers may be eliminated, a process called a “LIFO Liquidation.”
If an exam problem deals with a company’s purchases and sales over a one-month period, it is best to write
down the different purchases and sales and mark out which units are sold and which units remain after
each sale.
Price
LIFO Perpetual Method
Cost of a Unit of
Inventory
COGS
Ending
Inventory
COGS
Ending
Inventory
Time
Each layer will remain in inventory until it is “liquidated.” The liquidation of a layer occurs when the company
sells all of the most recently purchased inventory plus some “older” inventory before purchasing more.
However, keep in mind that the liquidated layer will be the newest, most recently formed layer. Therefore,
the first units of each inventory item that a company purchased could theoretically still be in the company’s
inventory 50 or more years later.
Average Cost in the Perpetual System: A Moving Average
When the average cost method is performed on a perpetual basis, the method is called the moving average method because the average applied to ending inventory and COGS is constantly changing as a result
of calculating a new average cost after each purchase of inventory.
The process of using average cost in a perpetual system is slightly difficult mathematically because of the
need to keep track at all times of the current inventory in respect to both units and total cost. Each time a
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1c) Inventory
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new purchase is made, a new average cost must be calculated, and this new average cost is then used as
the cost per unit for all sales made afterwards until the next purchase is made, at which point a new average
cost will be calculated.
Note: The perpetual system provides a more accurate reflection of inventory transactions than the
periodic system, but it requires extensive time and effort to collect, input, and process the data.
For the exam, candidates may need to make the various calculations under FIFO, LIFO, and average cost
(weighted average or moving average) methods. These calculations include ending inventory, cost of goods
sold, and gross profit from sales.
Example: Below are the March inventory purchase and sales transactions for Medina Company. Note
that prices are rising.
March
March
March
March
March
March
3
7
11
20
21
29
Beginning Inventory
Purchase
Sale
Sale
Purchase
Sale
Sale
Ending Inventory
Units
1,000
1,500
900
700
1,000
600
200
1,100
Cost Per Unit
$5.00
6.00
7.00
Calculate the ending inventory and COGS using FIFO periodic, FIFO perpetual, LIFO periodic, LIFO perpetual, weighted average periodic, and moving average perpetual methods.
Before answering these questions, it is useful to look at the number of units the company had available
for sale during the period and determine how many were sold (and will be in cost of goods sold) and
how many units are in ending inventory.
The number of units sold is 2,400. The company had 3,500 units available to sell during the period (the
1,000 units in beginning inventory plus the 2,500 units purchased), and ending inventory contains 1,100
units. Therefore, 2,400 units must have been sold (3,500 – 1,100). The units sold in each of the four
individual sales during the month can also be summed: 900 + 700 + 600 + 200 = 2,400.
The total value of goods available for sale during the month is $21,000: (1,000 × $5) + (1,500 × $6) +
(1,000 × $7). The total of ending inventory and cost of goods sold must therefore be $21,000 under all
methods. When one of those amounts (inventory or cost of goods sold) is known, the other can be
determined by looking at the difference between the total goods available for sale (here, $21,000) and
the known amount, as shown in the explanations below.
FIFO Periodic
When FIFO is being used, it is usually easier to calculate ending inventory. Once ending inventory is
calculated, subtract the ending inventory from the total cost of all units available for sale, which in this
example is $21,000, to calculate COGS. Since 1,100 units are in ending inventory and FIFO is being
used, the units in ending inventory are the units most recently purchased. Therefore, ending inventory
consists of 1,000 units that cost $7 each and 100 units that cost $6 each for a total of $7,600. If ending
inventory is $7,600, then the COGS sold is $13,400 ($21,000 − $7,600).
FIFO Perpetual
For FIFO, the periodic and perpetual methods yield the same answers. The answers to the FIFO perpetual
method are the same as the answers to the FIFO periodic method.
(Continued)
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Section A
1c) Inventory
LIFO Periodic
The values of ending inventory and COGS can be calculated in a manner very similar to the FIFO periodic
method, except that the 1,100 units in ending inventory are the oldest units purchased. Thus, ending
inventory includes 1,000 units that cost $5 each and 100 units that cost $6 each, which equals $5,600.
If ending inventory is equal to $5,600, then COGS is equal to $15,400 ($21,000 − $5,600).
LIFO Perpetual
With LIFO perpetual, it is necessary to determine the COGS after each individual sale of inventory. After
determining the total COGS amount, subtract it from $21,000 to calculate the ending inventory amount.
For each of the sales, the units sold and their costs are as follows:
March 7
900 units sold. The units sold are from the March 3 purchase for $6: $6 × 900 =
$5,400 COGS.
March 11
700 units sold. 600 units are from the March 3 purchase for $6 and 100 units are from
beginning inventory at $5: ($6 × 600) + ($5 × 100) = $4,100 COGS.
March 21
600 units sold. The units are from the March 20 purchase for $7: $7 × 600 = $4,200
COGS.
March 29
200 units sold. The units are from the March 20 purchase for $7: $7 × 200 = $1,400
COGS.
The sum of $5,400 + $4,100 + $4,200 + $1,400 = $15,100 for cost of goods sold during March.
Therefore, ending inventory must be equal to $5,900 ($21,000 − $15,100). The units in ending inventory include 900 from beginning inventory ($5 each for a total of $4,500) and 200 from the March 20
purchase ($7 each for a total of $1,400).
Weighted Average (Periodic Average Cost)
For the weighted average method, calculate an average cost for all of the units available for sale during
the period. The total cost was $21,000 and 3,500 units were available for sale. $21,000 divided by 3,500
equals an average cost of $6 per unit. The $6 per unit average cost is multiplied by the 1,100 units in
ending inventory to calculate the ending inventory balance of $6,600 and by the 2,400 units that were
sold to calculate cost of goods sold of $14,400.
Moving Average (Perpetual Average Cost)
For the moving average method, after each purchase it is necessary to calculate a new average cost per
unit. This calculation of average cost per unit is shown in the table below for each of the sales and
purchases made during March.
Date
Mar 1
Mar 3
Mar 7
Mar 11
Mar 20
Mar 21
Mar 29
Cost
Units
per Unit
Beg. Inv.
Buy 1,500
$6
Sell 900
Sell 700
Buy 1,000
$7
Sell 600
Sell 200
Total Units
in Inventory
1,000
2,500
1,600
900
1,900
1,300
1,100
Total Cost
in Inventory
$ 5,000
$14,000
$ 8,960
$ 5,040
$12,040
$ 8,238
$ 6,971
Avg. Cost
per Unit
$5.00
$5.60
$5.60
$5.60
$6.34 *
$6.34
$6.34
COGS Calculation
900 × 5.60 = $5,040
700 × 5.60 = $3,920
600 × 6.34 = $3,802
200 × 6.34 = $1,267
* This average cost per unit and the following three average cost per unit amounts have small rounding
differences (the actual calculation is $6.337 and each has been rounded up to $6.34).
Summing all of the COGS items yields $14,029 ($5,040 + $3,920 + $3,802 + $1,267). The ending
inventory is from the table and is the “Total Cost in Inventory” value from the last row, or $6,971.
(Continued)
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Summary:
FIFO Periodic
FIFO Perpetual
LIFO Periodic
LIFO Perpetual
Weighted Average Periodic
Moving Average Perpetual
Ending
Inventory
$7,600
$7,600
$5,600
$5,900
$6,600
$6,971
COGS
$13,400
$13,400
$15,400
$15,100
$14,400
$14,029
Total
$21,000
$21,000
$21,000
$21,000
$21,000
$21,000
Note: In a period of rising prices, LIFO yields the highest cost of goods sold and thus the lowest net
income of all the methods, while FIFO results in the lowest cost of goods sold and the highest net income.
If prices are falling, the opposite will be true.
The resulting cost of goods sold and operating income from the average cost method (weighted or
moving) will always be in between LIFO and FIFO.
Question 21: The advantage of the last-in, first-out inventory method is based on the assumption that
a)
The most recently incurred costs should be allocated to cost of goods sold.
b)
Costs should be charged to revenue in the order in which they are incurred.
c)
Costs should be charged to cost of goods sold at average cost.
d)
Current costs should be based on representative or normal conditions of efficiency and volume of
operations.
(ICMA 2008)
Question 22: In a period of rising prices, which one of the following inventory methods usually provides
the best matching of expenses against revenues?
a)
Weighted average
b)
First-in, first-out
c)
Last-in, first-out
d)
Specific identification
(ICMA 2008)
Question 23: Which one of the following actions would result in a decrease in income?
a)
Liquidating last-in, first-out layers of inventory when prices have been increasing.
b)
Changing from the first-in, first-out to the last-in, first-out inventory method when prices are
decreasing.
c)
Accelerating purchases at the end of the year when using the last-in, first-out inventory method
in times of rising prices.
d)
Changing the number of last-in, first-out pools.
(ICMA 2008)
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Section A
1c) Inventory
Question 24: In periods of rising costs, which one of the following inventory cost flow assumptions will
result in higher cost of sales?
a)
First-in, first-out
b)
Last-in, first-out
c)
Weighted average
d)
Moving average
(ICMA 2008)
Question 25: The inventory method that will yield the same inventory value and cost of goods sold
whether a perpetual or periodic system is used is
a)
average cost
b)
first-in, first out
c)
last-in, first-out
d)
either first-in, first-out or last-in, first-out
(ICMA 2008)
The Physical Inventory Count
At the end of each year, a company undertakes a physical inventory count in order to determine the number
of units on hand of each item as of the year-end. Once the company knows how many units are actually
on hand, it will use its inventory method (FIFO or LIFO, for example) to determine the cost of those units.
The result of the calculation is recorded in the financial statements because it is the actual inventory balance.
After the inventory count is made, the company will need to make an adjusting journal entry so that the
balance sheet reflects the true inventory balance.
If the actual count of inventory is less than the accounting records indicate, the journal entry to write down
inventory is:
Dr
Inventory loss ................................................................... X
Cr
Inventory ........................................................................... X
If the physical count of inventory is greater than the amount recorded in the accounting records, the value
of the inventory needs to be written up. The journal entry is:
Dr
Inventory ......................................................................... X
Cr
Inventory gain .................................................................... X
Note: A physical count is required by U.S. GAAP for annual reporting purposes. Under GAAP, a
physical count of the inventory must be done each year regardless of which inventory cost flow method
is being used. A physical count is not required for interim financial statements, however.
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Errors in Inventory
Candidates need to be able to assess the way an error in one or more of the inventory amounts (beginning
or ending inventory or purchases) affects the balance of any of the other components of the inventory
calculation, such as ending inventory or cost of goods sold.
In questions about inventory errors, it is best to make two calculations. The first is based on the amounts
actually used (with the mistakes) in the accounting and the second is with the amounts that should have
been used. The difference between these two numbers will be the effect of the error.
The two most common questions about errors are “What was the effect on ending inventory?” and
“What was the effect on cost of goods sold?” The relevant formulas are below.
If the question is about ending inventory, the formula is:
Beginning inventory
+
Purchases
=
Cost of goods available for sale
−
Cost of goods sold
=
Ending inventory
If the question is about cost of goods sold, the formula is:
Beginning inventory
+
Purchases
=
Cost of goods available for sale
−
Ending inventory
=
Cost of goods sold
Note: When COGS (an expense) is overstated, operating income is understated. Conversely, when
COGS is understated, operating income is overstated.
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Section A
1c) Inventory
Example: Medina Company completed its physical inventory count at the end of 20X8 and adjusted the
accounting records accordingly. As a result, on January 1, 20X9, the company’s beginning inventory was
$150,000. During 20X9, Medina purchased $525,000 of inventory and had an ending inventory of
$100,000.
However, management later discovered that at the end of 20X8 the company failed to count $30,000 of
inventory. Medina also discovered that the purchases for 20X9 were overstated by $18,000 as a result
of some purchases having been recorded twice. Finally, the ending inventory count at the end of 20X9
was overstated by $15,000.
The best way to determine the total effect of these errors is to set up two COGS calculations: the first
determines what Medina did and the second determines what it should have done.
Beginning inventory
+ Purchases
− Ending inventory
= Cost of goods sold
What Medina DID
$150,000
525,000
(100,000)
$575,000
What Medina SHOULD HAVE DONE
$180,000
507,000
( 85,000)
$602,000
Through these two calculations, it is easy to see that the cost of goods sold was understated as a result
of these errors. If the company had recorded everything correctly, the cost of goods sold would have
been $602,000 instead of the recorded $575,000.
On the exam, candidates are strongly encouraged to set up these two columns in order to answer a
question about the effect of an inventory error or errors.
A self-correcting error is one that corrects itself in time, even if it is not discovered. The miscounting of
inventory is a self-correcting error. While the error in ending inventory will have an effect on two balance
sheets and two income statements, if inventory is correctly counted at the end of the next year then there
will be no further errors as a result of the original miscounting.
Question 26: Holly Company’s inventory is overstated at December 31 of this year. The result will be
a)
Understated income this year
b)
Understated retained earnings this year
c)
Understated retained earnings next year
d)
Understated income next year
(ICMA 2008)
Question 27: Which one of the following errors will result in the overstatement of net income?
a)
Overstatement of beginning inventory
b)
Overstatement of ending inventory
c)
Overstatement of goodwill amortization
d)
Overstatement of credit loss expense
(ICMA 2008)
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efham CMA
Recognizing Permanent Declines in Inventory Values
Inventories are initially recorded at their cost. However, the value of inventory may decline over time. If
the inventory becomes obsolete, is damaged, or is impacted by market conditions, the benefit the company
can expect to receive from its sale may decline to a level below its cost, leading to inventory being overstated on the balance sheet.
Because inventory is an asset, it is important not to overvalue it on the balance sheet. If the inventory’s
value declines, it should be written down. Therefore, at the end of each period a company must evaluate
its inventory to make sure the carrying amount is actually less than or equal to the amount of benefit the
company will receive from it in the future. The process of valuing inventory is similar to the processes of
valuing accounts receivable through the allowance for credit losses and determining impairment of fixed
assets and intangible assets.
Under U.S. GAAP, the way inventory valuation is done depends upon what inventory method the company
is using.
•
For inventories measured using any method other than LIFO or the Retail Method, the inventory
should be measured at the lower of cost or net realizable value (LCNRV). Net realizable value
is defined as the estimated selling price in the ordinary course of business, minus reasonably
predictable costs of selling, including costs of completion, disposal, and transportation.
•
Measurement for inventory measured using LIFO or the Retail Method (including all cost flow assumptions when the Retail Method is used) is at the lower of cost or market (LCM).
The evaluation is done by comparing the cost of the inventory (under whichever cost flow assumption or
inventory valuation method the company is using) to either its net realizable value or its designated market
value, as appropriate. The value of the inventory reported on the balance sheet should be the lower of its
cost or its net realizable value or the lower of its cost or its designated market value.
If the net realizable value or the designated market value (whichever is appropriate, depending on the
inventory method being used) is lower than the historical cost of the inventory, the difference (loss) must
be written off. U.S. GAAP does not specify what account should be debited for the write-down. Two accounts
are acceptable: COGS or a loss account. Methods of recording inventory losses are covered later in this
topic.
The Lower of Cost or NRV for FIFO, Average Cost, or Specific Identification Methods
Inventories measured using any method other than LIFO or the Retail Method—including FIFO, Average
Cost, or Specific Identification—are measured at the lower of cost or net realizable value (LCNRV).
Net realizable value is defined as the estimated selling price in the ordinary course of business, minus
reasonably predictable costs of completion, disposal, and transportation.
An example follows.
Example: Plumbing Wholesale uses FIFO to value its inventory. The company sells several inventory
items. Four items and the calculation of their lower of cost or net realizable values are:
Hist.
Cost
Sell
Price
Cost to
Sell
NRV
Lower of
Cost or NRV
S
7.00
10.00
1.00
9.00
7.00
T
8.00
10.00
1.00
9.00
8.00
U
14.00
19.00
1.00
18.00
14.00
V
16.00
20.00
1.00
19.00
16.00
For each item, the value in the far-right column, the lower of its historical cost under FIFO or its net
realizable value, is the valuation that should be reported.
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Note: Lower of cost or net realizable value can be applied to the entire inventory as one group, to groups
or pools of inventory items, or to each item individually. Applying it to each item individually will
provide the lowest amount for ending inventory. When each item is calculated separately, any
decrease in value will be recorded. However, when groups, or pools, of inventory are used a decline in
the value of one item may be offset by an increase in the value of another item.
The Lower of Cost or Market for Inventories Measured Using LIFO or the Retail Method
For inventories valued using either LIFO or the Retail Method (including all cost flow assumptions when the
Retail Method is used), the inventory should be measured at the lower of cost or market (LCM).
Notes:
(1) LIFO inventories can be valued at the lower of cost or market for financial reporting, but tax regulations prohibit the use of LCM with LIFO for tax reporting. According to 26 CFR 1.472-2(b),
Requirements Incident to Adoption and Use of LIFO Inventory Method, “The inventory shall be taken
at cost regardless of market value.”
(2) When the Retail Method is being used, LCM is calculated according to those Retail Methods. It is not
calculated according to the information that follows that uses a designated market value.
(3) For a reseller that buys merchandise and resells it, “market” refers to the market in which the reseller
purchases the inventory, not the market in which it sells the inventory. For a manufacturer, “market” refers to the cost to reproduce the inventory.
Thus, for both resellers and manufacturers, “market” essentially means the cost to replace or reproduce the inventory.
LIFO and LCM
When the LIFO cost flow assumption is used, the “market” value used in the LCM calculation is a “designated
market value.”
The cost of the inventory is its historical cost, determined using LIFO.
The market value used is called the designated market value and it is the middle value of the following
three numbers, as follows:
1)
Ceiling, also called the Net Realizable Value or NRV. The net realizable value is the item’s
estimated normal selling price minus reasonable costs to complete and dispose of the item.
Net realizable value is the maximum value for the designated market value of the inventory.
Net Realizable Value = Selling Price minus the Cost to Complete and Dispose
2)
Current replacement cost, or the cost to purchase the inventory currently. The current replacement cost will usually be given in any LCM problem.
3)
Floor, or the minimum value that will be used as the designated market value for the inventory.
The floor is the net realizable value minus a normal profit margin.
Floor = Net Realizable Value (Ceiling) minus a Normal Profit Margin
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If the replacement cost is higher than the net realizable value, the net realizable value will still serve as the
ceiling (the maximum value) for the designated market value.
Exam Tips: Compare the cost of the inventory to the middle value of the three values (not the
average of the three amounts) to determine the lower of cost or market. Current replacement cost and
other necessary amounts will be given in the problem and they must be used correctly in the formulas.
Since the middle value is used, the designated market value of the inventory will never be either above
the ceiling or below the floor.
Example: Plumbing Wholesale sells several inventory items and values its inventory using LIFO. Four
of the items and the calculation of their lower-of-cost-or-market values are as follows (the columns
containing the two amounts to be compared for each item to determine its lower of cost or market are
marked with arrows):
Hist.
Cost
Sell
Price
7.00
10.00
1.00
30%
3.00
T
8.00
10.00
1.00
27%
2.70
7.25
9.00
6.30
7.25
7.25
U
14.00
19.00
1.00
26%
5.00
19.50
18.00
13.00
18.00
14.00
V
16.00
20.00
1.00
20%
4.00
14.00
19.00
15.00
15.00
15.00
S
Cost to
Sell
Normal Norm. Profit
Profit %
Amount
Repl.
Cost
NRV
7.50
9.00
NRV−Norm. Designated
Profit
Market
6.00
7.50
LCM
7.00
For each item, the designated market value is the middle value of the replacement cost, the NRV, and
the NRV minus Normal Profit. That designated market value is compared with the item’s historical cost.
The lower of the two amounts is the LCM.
Note: The LCM Method can be applied to the entire inventory as one group, to groups or pools of
inventory items, or to each item individually. Applying it to each item individually will provide the
lowest amount for ending inventory. When each item is calculated separately, any decrease in value
will be recorded. However, when groups, or pools, of inventory are used a decline in the value of one
item may be offset by an increase in the value of another item.
If the designated market value is lower than the cost of the inventory, the difference (the loss) must be
written off.
LIFO and LCM for Taxes
U.S. GAAP does not prescribe rules for applying the LIFO cost flow assumption in valuing inventory. Instead,
IRS regulations provide the rules. As noted above, LCM may not be used with a LIFO cost flow assumption under IRS regulations. If a company uses LIFO for tax purposes, the IRS requires it to also
use LIFO for its financial reporting. However, the company is not required to use the same LIFO applications
for its tax reporting and its financial reporting. A company may use different LIFO applications for tax
reporting and financial reporting. The use of lower of cost or market with LIFO costing is an example of this
flexibility.
Although IRS regulations do not permit the use of LCM with LIFO on the income tax return, LCM is applied
with LIFO for financial reporting purposes. However, when prices are rising, the instances in which inventory
is written down will be fewer under LIFO than they will be under the other inventory cost flow assumptions
because the historical cost of the inventory on the books will be lower. It will be more likely that the
historical cost will be lower than the designated market value when LIFO is being used than it is when cost
flow assumptions for which inventory is valued at the lower of cost or net realizable value are being used.
If inventory is written down to its designated market value under LIFO, the application of LCM with LIFO
for financial reporting but not for tax purposes will cause a temporary difference between book income and
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taxable income, leading to deferred taxes. Deferred taxes are covered in the topic Accounting for Income
Taxes in this section.
Exam Tip: Any questions about inventory write-downs will generally be very straightforward and the
only thing necessary will be to take the information in the question and put it into the calculations to
determine either the net realizable value or the designated market value of the inventory. In reality,
most inventory will be carried at cost. However, on any exam questions, usually more than half of the
inventory items must be written down to either their net realizable value or their market value, whichever
applies to the inventory cost flow assumption being used.
Note: The Retail Method and the use of LCM with it is covered in any intermediate accounting book.
Recording Inventory Write-downs
If the market value (for inventories measured under LIFO or the Retail Method) or the net realizable value
(for all other methods of measuring inventory) is lower than the cost of the inventory, the difference (or
loss) must be written off to a loss account that will be reported on the income statement as a reduction of
income in that period. The journal entry will be:
Dr
Inventory loss or cost of goods sold ..................................... X
Cr
Inventory ........................................................................... X
U.S. GAAP does not specify what account should be debited for the write-down. The loss may be recorded
on the income statement in either of two ways. Both ways are acceptable.
1)
The loss method debits a loss account such as loss on inventory write-down. The loss is identified
separately on the income statement. The loss is an operating loss, so the loss account is in the
administrative expense area of the income statement.49
2)
The cost-of-goods-sold method debits cost of goods sold for the inventory write-down. If the
loss is simply debited to cost of goods sold, though, it is not identified separately on the income
statement. It is buried in cost of goods sold. Furthermore, the income statement lacks representational faithfulness because cost of goods sold does not represent what it purports to represent.
The cost-of-goods-sold method is permitted if the difference is not material. However, most managements
would find it preferable to debit a loss account. Furthermore, ASC 330-10-50-2 states that a substantial
and unusual loss should be disclosed. A substantial and unusual inventory loss could be disclosed on a
separate line in the administrative expense area on the income statement but it may also need to be
explained in a note to the financial statements.
Instead of decreasing the inventory account directly for inventory write-downs, most companies credit a
valuation account on the balance sheet, an allowance account such as allowance to reduce inventory to
market or net realizable value. The historical cost of the inventory remains in the inventory account while
the net realizable value reported for the inventory is the net of the inventory and the allowance account
balances. Use of an allowance account keeps subsidiary inventory ledgers in correspondence with the control account.
However, if the inventory that has been written down has been sold and thus its historical cost has been
transferred from the inventory account to cost of goods sold, the allowance account should be closed out
49
Inventory write-downs that are done in order to report inventory at the lower of cost or net realizable value (or the
lower of cost or market for LIFO or Retail Method inventories) are operating losses because they are specifically required
by accounting standards. Inventory should be evaluated for potential write-downs whenever financial statements are
issued, and any losses recorded as a result of that evaluation are operating expenses. If an inventory loss occurs due to
an unusual or infrequent event such as a fire, hurricane, or other unusual occurrence, that would usually be reported as
a non-operating loss.
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to cost of goods sold. The company then establishes a “new” allowance account for any inventory valuation
required going forward.
In practice, many companies leave the allowance account on the books and at each year-end they adjust
the balance in the allowance account to agree with the amount of valuation reduction needed for the inventory on the books at year-end. The other side of the adjusting entry is to cost of goods sold.
An example follows.
Example: Inventory that cost $200,000 is valued at $150,000, a $50,000 loss. The loss is recorded as
follows:
Dr
Inventory loss............................................................ 50,000
Cr
Allowance to reduce inventory ....................................... 50,000
The inventory is sold for $150,000. The sale is recorded as a receivable and the historical cost of the
inventory in the inventory account is transferred to cost of goods sold:
Dr
Accounts receivable .................................................. 150,000
Dr
Cost of goods sold .................................................... 200,000
Cr
Sales revenue ............................................................ 150,000
Cr
Inventory .................................................................. 200,000
Before the allowance account is closed out, the gross loss on the sale is $50,000: $150,000 sales revenue
less $200,000 cost of goods sold.
The allowance account is closed out by crediting cost of goods sold:
Dr
Allowance to reduce inventory ..................................... 50,000
Cr
Cost of goods sold ........................................................ 50,000
The company now has neither a gross profit nor a gross loss on the sale because the sale is at breakeven:
$150,000 sales revenue less $150,000 cost of goods sold.
The inventory write-down of $50,000 remains in the inventory loss account and is reported in the income
statement as an inventory loss.
Inventory Write-downs on Interim Financial Statements
ASC 270-10-45-6 states that inventory losses from write-downs are not to be deferred beyond the interim
period in which the decline occurs. If the value of the same inventory (unsold) recovers in later interim
periods of the same fiscal year, the recovered amount is to be recognized as a gain in the later interim
period, up to the amount of previously recognized interim losses. However, the standard further states that
if a decline in the value of the inventory is expected to be restored by the end of the fiscal year, such a
temporary decline does not need to be recognized at the interim date since no loss is expected to be
incurred during the fiscal year.
Thus, recognition of interim inventory losses is a matter of management’s judgment.
Note: Under U.S. GAAP, recording inventory recoveries in value to the extent of previously recognized
losses is limited to reporting within a single fiscal year. Inventory write-downs reported on an annual financial statement may not be restored in a later annual period.
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IFRS Notes:
1) Under IFRS, all inventory is valued at the lower of cost or net realizable value. In U.S. GAAP,
inventories measured using any method other than LIFO or the Retail Method are also be measured
at the lower of cost or net realizable value. However, in U.S. GAAP, inventory valued using LIFO or
the Retail Method is valued at the lower of cost or market instead of the lower of cost or net realizable
value.
2) Under IFRS, previous write-downs of inventory may be recovered up to the original cost of the
inventory. Gains cannot be recognized on appreciated inventory, but previous losses can be reversed. Reversal of previous inventory write-downs in annual financial statements is not permitted
in a later annual period under U.S. GAAP (although inventory write-downs in interim financial statements may be reversed up to the original cost of the inventory within the same fiscal year).
1d) Investments
Guidance in the Accounting Standards Codification® on accounting for investments in debt and equity
securities is in ASC 320, 323, and 325.
Firms hold various types of investments for various purposes. Investments may be equity securities or debt
securities. The securities may be marketable (such as publicly traded on secondary markets) or not marketable (such as privately held). Securities may be held as an investment for unused funds until they are
needed or they may be held in order to control the other company.
Debt securities are bonds or notes issued by corporations or governmental authorities that generally are
traded on secondary markets, although some are privately placed. They represent loans made to the issuer
by investors in the securities.
Equity securities represent ownership interests in other companies. Equity securities may be those for
which the investor does not have significant influence over the investee, those for which the investor does
have significant influence over the investee, or those for which the investor has control over the investee
and consolidates the operations of the investee with its own financial statements.
Both debt and equity investments may or may not be traded on secondary markets. If securities are traded
in active markets, their fair values can easily be determined under normal circumstances. 50
•
Marketable debt securities are accounted for at fair value unless management has both the positive intent and the ability to hold them until maturity.
•
Marketable debt securities that management has both the positive intent and the ability to hold
until maturity are accounted for at their amortized cost.
•
As long as a business does not own enough of the voting stock of another company to have the
ability to exercise significant influence or control over the operations of the investee company,
equity securities traded on secondary markets (including over-the-counter markets) are accounted for at fair value.51
50
The FASB has established a fair value hierarchy to provide priority for fair value valuation techniques. The fair value
hierarchy has three levels, with Level 1 as the most accurate and least subjective. Level 1 is quoted prices in active
markets. Level 2 is inputs other than quoted prices that are observable. Level 3 is unobservable inputs such as a company’s own data or assumptions. If a valuation method in Level 1 is not available, a method from Level 2 should be used.
Level 3 should be used only if the options in Levels 1 and 2 are not available.
51
When a business owns enough of the common stock of another company so that it has significant influence over the
other company’s operations, the holding is accounted for under the equity method. Significant influence is usually assumed when the investor owns between 20% and 50% of the investee’s voting stock. When a business owns enough of
the common stock of another company so that it has control over the other company’s operations but the investor and
the investee are operated as separate legal entities, the holding is accounted for by consolidation. Control is usually
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•
Equity securities where the investor does not exercise significant influence or control over the
investee but which are not traded on secondary markets are privately held. Such securities are
accounted for at cost less impairment.
•
Equity securities where the investor does exercise significant influence or control over the investee are accounted for under the equity method or by consolidation. Significant influence is
usually assumed when the investor owns between 20% and 50% of the investee’s voting stock,
and the equity method of accounting for the investment is required. Control is usually assumed
when the investor owns over 50% of the investee’s voting shares, and consolidation is required.
Six different methods are used to account for investments.
•
Four methods are used to account for debt securities and for equity securities other than those for
which the investor has significant influence or consolidates the financial statements.
•
Two additional methods are used to account for equity securities when the investor has significant
influence over or controls the other entity.
The table below lists the six types of investment accounting and when each is used.
Method
Guideline
1. Amortized Cost
Used for investments in held-to-maturity debt securities ONLY.
2. Fair Value Through OCI
Used for investments in available-for-sale debt securities
ONLY.
3. Fair Value Through Income
Statement
Used for investments in trading securities, both debt and equity.
4. Cost (Less Impairment, if
any)
Used for equity securities when the investor does not have significant influence, usually indicated by up to 20% ownership of the
voting stock, when the investment does not have a readily determinable fair value (usually privately held and not traded on an active
secondary market).
5. Equity
Used for equity securities when the investor has significant influence, usually indicated by between 20% and 50% ownership of
the voting stock.
6. Consolidation
Used when the investor controls the other entity, usually when the
investor owns greater than 50% of the voting stock of the investee.
Used for equity securities when the investor does not have significant influence, usually indicated by up to 20% ownership of the
voting stock, when the investment has a readily determinable fair
value (usually publicly-owned and traded on an active secondary
market).
assumed when the investor owns over 50% of the investee’s voting shares. The equity method and consolidation are
covered later in this volume.
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1d) Investments
Investments in Debt Securities – Methods 1, 2, and 3
Note: Guidance in the Accounting Standards Codification® on accounting for debt securities is in ASC
320.
Debt securities are classified into three different categories for accounting and presentation in the financial
statements.
Category
Description
Accounting
Method Used
Held-to-Maturity
Debt securities that are purchased with the intent and the
ability to hold them to maturity.
#1
Amortized Cost
Available-for-Sale
Debt securities not classified as
either trading or held-to-maturity.
#2
Fair Value
Through OCI
Trading
Debt securities bought and held
principally for the purpose of
selling them in the near term
and therefore held for only a
short period of time, with the
objective of generating profits
from short-term price changes.
Trading securities will generally
be reported only by entities
whose primary business is trading, such as broker-dealers
making proprietary trades.
#3
Fair Value Through
Income Statement
A company should classify a debt security as held-to-maturity only if it has both the positive intent and
the ability to hold the security to maturity. If the investing company anticipates that a sale of the security
may be necessary before its maturity, the security should be classified as available-for-sale.
Held-to-Maturity Debt Securities – Method 1
Debt securities classified as held-to-maturity are accounted for at amortized cost, not fair value. Premiums and discounts are amortized as adjustments to interest income. If management has the intent and the
ability to hold the securities to their maturity date, the fair value (market value) of the securities during
the holding period is not relevant, so the securities are not adjusted to fair value during the holding period.
Interest and realized gains and losses are reported in net income.
Available-for-Sale Debt Securities – Method 2
Available-for-sale debt securities are accounted for at fair value. Unrealized holding gains and losses
are reported in the equity section of the balance sheet as part of accumulated other comprehensive income.
Interest and realized gains and losses are reported in net income. Premiums and discounts on availablefor-sale debt securities are amortized, the same as premiums and discounts on held-to maturity debt securities. However, unlike held-to-maturity debt securities, available-for-sale debt securities’ values on the
balance sheet are also adjusted to their fair values at the end of each reporting period. Fair value adjustments are debited and credited to a fair value adjustment (valuation) account for available-for-sale debt
securities. The balance in the valuation account is the difference between the fair value of the debt securities
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and their amortized cost. The amount of the unrealized gain or loss each period is whatever amount is
required to adjust the valuation account to the balance needed to maintain it as the difference between the
fair value and the amortized cost. Unrealized holding gains and losses are reported in equity in accumulated
other comprehensive income.
Trading Debt Securities – Method 3
Trading debt securities are debt securities that are bought and held principally for the purpose of selling
them in the near term and therefore held for only a short period of time. Trading generally reflects active
and frequent buying and selling, and trading securities are generally used with the objective of generating
profits on short-term differences in price.
Trading debt securities are accounted for at fair value, with interest, realized gains and losses, and unrealized holding gains and losses reported in net income. Fair value adjustments during the holding period are
debited and credited to a fair value adjustment account (a valuation account) for trading debt securities.
Trading debt securities will generally be reported only by entities whose primary business is trading, such
as broker-dealers making proprietary trades.
Reassessment of Classification Required
Per ASC 320-10-35-5, at each reporting date the investor company must reassess the classifications of its
investments in debt securities for their continued appropriateness. For example, if the company no longer
has the ability to hold debt securities to maturity, it would not be appropriate to continue to classify them
as held-to-maturity.
The Fair Value Option for Investments in Debt Securities
Note: Guidance in the Accounting Standards Codification® on the application of the fair value option is
in ASC 825.
If a debt security is one that would normally not be reported at fair value through the income statement,
an investor may choose to report that specific debt security using the fair value option, with all unrealized
gains and losses related to changes in its fair value reported on the income statement. The debt security is
carried in a separate account and its fair value is increased or decreased as appropriate (a valuation account
is not used)
•
Available-for-sale debt securities are customarily reported at fair value but unrealized gains and
losses on them are reported in accumulated other comprehensive income. If the fair value option
is chosen for a specific AFS debt security, that debt security will still be reported at fair value on
the balance sheet, but unrealized gains and losses on that security will be reported in income
instead of in equity.
•
Held-to-maturity debt securities are customarily reported at amortized cost and unrealized gains
and losses on them are not reported. If the fair value option is chosen for a specific HTM debt
security, that debt security will be reported at fair value on the balance sheet and unrealized gains
and losses on that security will be reported in income.
Note: Whenever an available-for-sale or held-to-maturity debt security is accounted for at fair value,
any discount or premium on the debt security must still be amortized. The amortized cost at
each reporting date is used to determine the amount of unrealized holding gain or loss each period and
if the security is sold, the amortized cost at the date of sale is used to determine the amount of the
realized gain or loss.
The fair value option is applied to a specific instrument on an instrument-by-instrument basis. The choice
to report at fair value a specific instrument that would otherwise not be reported at fair value is
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1d) Investments
available only when the investor first purchases the financial asset. If an investor chooses the fair
value option, it must apply that option consistently as long as it continues to own that security.
Example: A company invests in a debt security that it classifies as held-to-maturity. Instead of reporting
the security at its amortized cost, the investor company chooses to report that security using the fair
value option with all gains and losses related to changes in its fair value during the holding period
reported on the income statement. When an investor chooses the fair value option for a specific security,
it must continue reporting that security at its fair value until it sells the security.
A valuation account is not used for that security because the fair value option applies to only that HTM
security. Instead, the security is carried in a separate account and the value of the security is increased
or decreased directly in the account, as appropriate. The other side of the entry is a gain or loss on the
income statement.
Nevertheless, the investor also continues to record amortization of any purchase discount or
premium on that debt security. The amortized cost at each reporting date is used to determine the
amount of unrealized holding gain or loss each period. When the security matures, the discount or
premium will be fully amortized and if the investor receives the face value of the debt security at its
maturity, it will have no realized gain or loss. If the debt security is transferred from the held-to-maturity
category prior to its maturity and is sold, the amortized cost at the date of sale is used to determine the
amount of the realized gain or loss.
(See Accounting for the Transfer of Debt Securities Between Classifications, above, for more information.)
Investments in Equity Securities – Methods 3, 4, 5, and 6
Investments in equity securities may be investments where the investor does not have significant influence,
investments where the investor does have significant influence, or investments where the investor company
controls the other entity and is required to consolidate the investee subsidiary’s financial statements.
Investments Where the Investor Does Not Have Significant Influence
Note: Guidance in the Accounting Standards Codification® on accounting for equity securities where the
investor does not have significant influence is in ASC 321.
Equity securities other than those accounted for by the equity method or by consolidation are those where
the investor does not have significant influence. Such an equity security may or may not have a readily
determinable fair value.
Usually a lack of significant influence is indicated by ownership of up to 20% of the voting stock, although
it is possible to lack significant influence with ownership of 20% or more of the voting stock.
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Category
Description
Equity Security that
does have a Readily
Determinable Fair
Value
Sales prices or bid-and-asked quotations are currently
available on a securities exchange or in the over-thecounter market and are publicly reported. A security
may also be included in this classification if it is a mutual
fund or similar investment vehicle that determines and
publishes the fair value per share and that fair value is
the basis for current transactions.
Equity Security that
does not have a
Readily Determinable Fair Value
The security is privately held and is not traded on any
securities exchange or in the over-the-counter market
and thus sales prices or bid-and-asked quotations are
not available.
Accounting
Method Used
#3
Fair Value Through
Income Statement
#4
Cost Less
Impairment
Equity Securities with Readily Determinable Fair Values – Method 3
The fair value through the income statement method is used for equity securities when the investor does
not have significant influence over the investee and the investment has a readily determinable fair
value, usually because it is traded in secondary markets. Little or no influence is usually indicated by less
than 20% investment in the investee.
When an equity investment that will be accounted for under the fair value through the income statement
method is purchased, it is recorded at the cost of acquisition. Then, each time financial statements are
prepared, the investments will be valued at their fair value at the balance sheet date.
Equity securities may be classified on the balance sheet as trading equity securities. As with trading debt
securities, trading equity securities will generally be reported only by entities whose primary business is
trading, such as broker-dealers making proprietary trades. Trading equity securities are accounted for in
the same manner as any other equity securities, at fair value through the income statement. The reporting
difference exists only in their presentation in the statement of cash flows. Broker-dealers are to report their
trading securities activities in the operating section of the statement of cash flows, not in the investing
section.52
Gains and Losses on Equity Securities with Readily Determinable Fair Values
Unrealized Gain or Loss
As the fair value of the equity security changes during its holding period, the unrealized gain or loss is
reported on the income statement as an unrealized holding gain or loss.
In the case of an increase in the fair value, the journal entry will be:
Dr
Fair value adjustment (valuation account) ........................................ X
Cr
Unrealized holding gain (on income statement) ................................ X
For a decrease in fair value, the entry will be as follows:
Dr
Unrealized holding loss (on income statement) .............................. X
Cr
52
98
Fair value adjustment (valuation account) .......................................... X
Per ASC 940-320-45-7.
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1d) Investments
Realized Gain or Loss
When an equity security is sold, the realized gain or loss on the sale is recorded as follows (assuming the
security increased in value while being held):
Dr
Cash (including costs of the transaction) ................. sales price
Cr
Gain ...........................................................................balance
Cr
Investment account ............................. original acquisition price
Note that the realized gain or loss is calculated as follows:
Amount received for the sale
−
Acquisition cost (original cost of the security
=
Realized gain or loss
The full amount of the gain or loss during the holding period is reported as “realized gain or loss” on the
income statement. It is not necessary to reverse previously-recognized unrealized gains or losses on the
security that has been sold. When an investment has been sold, it will simply not be included in calculating
the fair value of all the remaining equity investments in the portfolio at the end of the period. The adjustment to the fair value valuation account that is made at the end of the period for the remaining portfolio
as a whole will have the effect of removing the unrealized gain or loss that had been recognized in previous
periods on the sold investment. The calculation of the adjustment amount is outside the scope of the exam.
Equity Securities Without Readily Determinable Fair Values – Method 4
When an equity security is privately held and is not traded on secondary exchanges and if there is not an
available expedient method to estimate fair value as outlined in ASC 820, Fair Value Measurement,53 the
equity investment should be carried at cost and assessed each period for impairment. Additionally, if there
is an observable price change for the shares, the carrying value should be adjusted upwards or downwards
for this observable change.
In order to assess impairment, the company must perform a qualitative assessment. If the situation and
information about the investment indicate that it is impaired, the company must recognize a loss for the
difference between the investment’s assessed fair value and its carrying value.
Note: Because preferred shares have no voting rights, investments in preferred stock are always accounted for using the fair value method if the shares have a readily determinable fair value or, if they
do not have a readily determinable fair value, at cost less impairment. Even if an investor owns 100%
of the preferred shares outstanding of a company, the investor has no opportunity to exert influence
over the investee because the investor cannot vote.
Accounting for Dividends When the Investor Does Not Have Significant Influence
Dividends received on equity securities where the investor does not have significant influence or control
and does not consolidate the investment as a subsidiary are accounted for the same way whether the equity
securities do or do not have readily determinable fair values.
53
The practical expedient is available only to an investment in an investment company and it permits the reporting
entity to use the net asset value per share if the net asset value per share is calculated in a manner consistent with the
measurement principles of Topic 946, Financial Services – Investment Companies.
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Dividends Received
Cash Dividends
Dividend income for equity securities both with and without a determinable fair value is recognized for any
cash dividends declared on common or preferred stock. The following entry is made on the date of record
when the company has a legal right to the dividend.
Dr
Dividend receivable ............................................................ X
Cr
Dividend income .................................................................. X
When the dividend is received, the journal entry is:
Dr
Cash ................................................................................. X
Cr
Dividend receivable .............................................................. X
Stock Dividends
Stock dividends do not give rise to any journal entry. Because only additional shares are received in a stock
dividend, only a memorandum entry is used to record the receipt of the additional shares. This means that
no revenue is recognized from the receipt of a stock dividend.
Note: Stock splits that result in the receipt of additional shares do not result in a journal entry, either.
Liquidating Dividends
A liquidating dividend is a dividend that the company pays from a source other than retained earnings, and
it occurs when the amount of the accumulated dividends received by an investor exceeds the investor’s
share of the amount of retained earnings that the investee company has recognized since the investor
acquired its shares. A liquidating dividend is considered a return of the investor’s capital, rather than a
return on the investor’s capital and as such, the investor’s investment account is reduced by the amount
of the dividend that is a liquidating dividend.
Dr
Cash ................................................................................. X
Cr
Investment .......................................................................... X
Note: Because the investor compares the total of accumulated dividends received with the investor’s
share of retained earnings the investee has recognized since the investor acquired its investment, it is
possible that a given dividend will be a liquidating dividend for one investor but not a liquidating dividend
for another investor.
Long-Term Investments Where the Investor Has Significant Influence or Control
The Equity Method – Method 5
Note: Guidance in the Accounting Standards Codification® on accounting for long-term investments
under the equity method is in ASC 323.
The equity method can be called a “one-line consolidation,” because the net result on the investor’s income
of accounting for an investment using the equity method is the same as the result of using full consolidation.
However, instead of reporting its share of each separate component of income (sales, cost of sales, operating expenses, and so forth) in its income statement, the investor includes only its share of the investee’s
net income in a single line on its income statement.
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1d) Investments
When to Use the Equity Method
The equity method is used when the investor has significant influence over operating and financial policies of the investee, usually as a long-term investor. Owning between 20% and 50% of the outstanding
voting stock usually indicates significant influence.
Note: It is important to remember that the rules governing the equity method and consolidation
are based on influence and control, not the percentage of ownership. The percentages of ownership
are only guidelines. If a company owns 80% of another company but does not have significant influence
over the other company, the investment is accounted for using the fair value method or, if the investment
does not have a readily determinable fair value, at cost less impairment.
ASC 323-10-15-6 provides indicators of “significant influence,” in addition to the percentage of ownership,
as follows:
•
The investor is represented on the board of directors of the investee.
•
The investor participates in the policy-making processes of the investee.
•
There are material intra-entity transactions.
•
There is an interchange of managerial personnel between the investor and the investee.
•
There is technological dependency between the entities, for example using the same systems.
Acquisition of the Equity Method Investment
The investment is initially recorded at cost.
Dr
Investment ...................................................................... X
Cr
Cash ................................................................................. X
Post-Acquisition Events
After acquisition, the investment account will be adjusted for the amount of the earnings or losses that
“belong to” the investor and for a few other events.
Investee’s Earnings
Because the investor owns some percentage of the investee company, some percentage of the earnings of
the investee actually “belong” to the investor, even if they are not distributed. Also, because the investor
has significant influence over the investee company, the investor is in a position to determine when a
dividend is declared or not declared. If the fair value or cost method were used to account for this investment, the investor could “smooth” its income by declaring or not declaring dividends (see the next topic,
Cash Dividends). Therefore, in order to prevent this smoothing of income, each year the investor will recognize its share of the investee’s earnings by debiting the investment account on its balance sheet to
increase it and crediting an income statement account, either investment income or equity in investee’s
income, even if dividends are not declared.
Note: If the investee has preferred stock outstanding, the calculation of the investor’s share of the
earnings is made after the deduction of preferred dividends earned or declared.
Positive investee earnings (profits) increase the balance in the investment account.
Dr
Investment ....................................................................... X
Cr
Investment income (or equity in investee’s income) ................. X
If the investee has a loss, the investor must also report its share of the loss, thereby decreasing the
investment account on its balance sheet.
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Cash Dividends
When dividends on the common shares are declared, the dividends are recorded by the investor as a
reduction of its investment account (because a portion of the investor’s share of the investee’s earnings
have now been distributed) and an increase to the investor’s cash or dividends receivable. The declaration
and receipt of dividends does not affect the investor’s income statement because the investor has already
recognized that income as part of the investor’s share in the investee’s earnings. For the investor, the
dividend receipt represents a transfer from one asset account to another asset account.
Dr
Cash (or dividends receivable) ............................................. X
Cr
Investment account .............................................................. X
Stock Dividends and Stock Splits
When an investor receives shares via a stock dividend or a stock split, the investor makes no journal
entry. There is no change in the percentage of the investor’s ownership in the investee, and there is no
distribution of earnings of the company. Only a memorandum entry is made that increases the number of
shares held and reduces the book value of each individual share of stock held in the investee.
Intercompany Profits and Losses
The investor’s pro rata share of profits or losses on transactions between the investor and the investee
should be eliminated for any items not yet sold to an outside party at the financial statement date. These
profits or losses, which are still inside the companies, are eliminated through the investment and investment
income accounts. It is unlikely that an exam question will ask about intercompany profits and losses under
the equity method.
Intercompany Receivables and Payables
Intercompany receivables and payables are not eliminated under the equity method of accounting, but
receivables and payables from companies that are accounted for using the equity method should be disclosed separately.
Other Considerations
Goodwill
If the investor pays more for the shares than the proportionate net worth of the company purchased, the
difference between these two amounts is equity method goodwill. The amount of goodwill is calculated
as the difference between the price paid (the fair value of everything given up) and the fair value of the
net assets acquired (based on the percentage of ownership).
However, under the equity method, goodwill is not recognized as a separate line item asset. It is simply
included in the investment account with all other assets.
Note: A notational reference to the amount of goodwill will probably be recorded, but it is not separately
listed in the journal entry.
Financial Statement Presentation
The investment account is shown in one line on the balance sheet, and the earnings or losses from the
investment are shown on the income statement as part of net income, but not as operating income. They
are presented as part of the non-operating gains and losses line on the income statement below net operating income, and the components of that line on the income statement are disclosed in the notes to the
financial statements.
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1d) Investments
Disposal of an Equity Investment
When an investment that was accounted for under the equity method is disposed of, a gain or loss is
recognized for the difference between the carrying amount and the selling price.
Changes in Level of Ownership or Degree of Influence
Changing from the Fair Value or Cost Less Impairment Method to the Equity Method
When a fair value or cost method investment qualifies as an equity method investment because of an
additional investment made, the investor adds the cost of the additional investment to the basis of the
previously-held interest and adopts the equity method of accounting as of the date the investment qualifies
for equity method accounting. No retroactive adjustment is made.54
The Fair Value Option for Equity Method Investments
For a specific security that would otherwise be reported using the equity method, an investor may choose
the fair value option instead, with all gains and losses related to changes in its fair value reported on the
income statement. The option is applied to a specific instrument on an instrument-by-instrument basis,
and is available only when the investor first purchases the financial asset. If an investor chooses the fair
value option, the investor must apply the fair value method consistently as long as they own the security.
If the fair value option is used for an equity investment where the investor has significant influence, the
investor does not report the proportionate share of the investee’s income or loss, and dividends received
by the investor are credited to dividend income and do not reduce the investments account. The equity
investment is carried in a separate account and its fair value is increased or decreased as appropriate. The
other side of the entry is a gain or loss on the income statement.
Consolidated Financial Statements – Method 6
Guidance in the Accounting Standards Codification® on accounting for consolidations is in ASC 810.
Consolidated financial statements are usually required for a fair presentation when one of the companies
in a group of companies directly or indirectly has a controlling interest in a subsidiary or subsidiaries and
the parent and subsidiary or subsidiaries are operated as separate legal entities. Consolidated financial
statements present the financial statements of the consolidated companies (the parent and subsidiary or
subsidiaries) as if the companies were a single economic entity.
Two models are used for assessing “controlling interest” and determining whether a company must consolidate its financial statements:
1)
The voting interest model. When an acquirer has a controlling financial interest in the acquiree,
the financial statements of the acquirer and the acquiree should be consolidated. The usual condition for a controlling financial interest is ownership by one reporting entity (directly or indirectly)
of more than 50% of the outstanding voting shares of the acquiree.
Although control is normally demonstrated by ownership of more than 50% of the voting stock of
a company, it is possible for an owner to have control with a smaller ownership percentage or to
have no control with a higher ownership percentage. For example, if non-controlling shareholders55
have substantive participating rights, the majority shareholder does not have a controlling financial
interest and therefore the financial statements should not be consolidated.
54
Per ASC 323-10-35-33.
55
When a parent company owns a controlling interest in a subsidiary but does not own 100% of its voting stock, the
owner(s) of the remainder of the voting stock are called non-controlling interests or non-controlling shareholders.
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Note: A majority-owned subsidiary should not be consolidated if control does not rest with
the majority owner. For example, if the subsidiary is in legal reorganization or bankruptcy—
or if it operates under foreign restrictions, controls, or other governmentally imposed uncertainties so strict that they cast significant doubt on the parent's ability to control the subsidiary—
the parent may not have control.
2)
The variable interest entity (VIE) model. A “variable interest entity” is a legal entity that is
financially controlled by one or more entities that do not hold a majority voting interest. The entity
holding the majority of the financial control is called the VIE’s primary beneficiary. The definition
of a “parent” in a consolidation includes a VIE’s primary beneficiary, and the definition of “subsidiary” includes a VIE that is consolidated by its primary beneficiary.
According to ASC 810-10, the financial statements of VIE’s that have a primary beneficiary must
be consolidated with the financial statements of the primary beneficiary, regardless of the amount
of ownership held in the VIE by the primary beneficiary.
The Consolidation Process
The income or loss of the consolidated company is calculated by including the income or the loss of the
purchased company only for the period after the purchase. The revenues and expenses of the acquired
company are included in the combined financial statements, again, only for the period after the acquisition.
At the end of each period, a consolidation worksheet is prepared. The balance sheets and income statements of the two companies are prepared in a columnar format and an additional column is created for
adjusting or eliminating entries. The main exercise in the consolidation is eliminating intercompany
transactions. An event that gives rise to an asset for one company and a liability for the other company
must be eliminated from the consolidated balance sheet in order to prevent double counting of the event.
Similarly, income statement events (buying and selling) carried out between two consolidated companies
need to be eliminated from the consolidated income statement.
The main adjustments are:
1)
Eliminating intercompany receivables and payables
2)
Eliminating the effect of intercompany sales of inventory
3)
Eliminating the effect of intercompany sales of fixed assets
4)
Eliminating the parent’s investment account
1) Eliminating Intercompany Receivables and Payables
Because it is not possible for a company to owe money to itself, when the consolidated financial statements
are prepared any payables or receivables between the consolidated companies need to be eliminated.
If intercompany payables and receivables were not eliminated, the balance sheet would be “grossed” up
because payables and receivables would be overstated. The amounts of intercompany payables and receivables to eliminate should be equal to each other since if one of the consolidated parties has a related party
receivable then another of the consolidated parties must have a related party payable.
2) Eliminating the Effect of Intercompany Sales of Inventory
When an inventory sale takes place between consolidated companies, several adjustments need to take
place.
•
104
The inventory sold by one consolidated company to another consolidated company must be reported in the consolidated financial statements at the value recorded by the original purchaser
of the inventory. If the inventory sold to the related party included some profit for the seller, the
buyer of the inventory will have recorded it at an amount higher than the seller’s purchase price.
Because it is necessary to show all of these companies as if they were one company, the inventory
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Section A
1d) Investments
must be reported at the value at which it was purchased by the “group.” If the inventory is still on
the books of the company that purchased it, the inventory account must be written down to the
cost that was paid when the consolidated group of companies first acquired the inventory.
•
Furthermore, any profit recognized by one member of the consolidated group on inter-company
sales of inventory not yet sold to an unrelated third party by the group must be eliminated because
the company cannot make a profit simply by selling inventory to itself.
•
If the buyer of the inventory has sold it to an unrelated third party, the consolidated reported profit
will be the sale price received by the company that ultimately sold the inventory to the unrelated
third party minus the inventory’s cost to the original purchasing company.
3) Eliminating the Effect of Intercompany Sales of Fixed Assets
The following adjustments must also be made if an intercompany sale of fixed assets has taken place:
•
The carrying value of the asset needs to be adjusted to the amount it would have been if the fixed
asset had never been sold within the group. The historical cost on the consolidated balance sheet
needs to be the amount the selling company paid for the asset.
•
The intercompany gain on the sale is unrealized until the asset is sold to an outside party, so the
gain recorded by the seller must be eliminated. This adjustment must be made every year.
•
Since the unrealized gain is eliminated from the valuation of the asset, the gain element must be
eliminated from the related depreciation expense in the consolidated income statement. The depreciation expense on the consolidated income statement should be what it would have been if the
asset had not been sold to the related party.
•
The accumulated depreciation needs to be the amount it would have been if the asset had not
been sold. This adjustment must be made every year.
•
The retained earnings of the selling company need to be reduced in order to eliminate the gain
that was recognized by the selling company on the sale of the fixed asset.
4) Eliminating the Parent’s Investment Account
Because the parent company owns shares of the subsidiary, it has an investment in subsidiary account on
its balance sheet that represents its investment in the subsidiary. Because the subsidiary’s balance sheet
is added to the parent’s balance sheet in the consolidation, the parent would be double-counting that investment unless an adjustment is made. The adjustment eliminates the investment account on the parent’s
books against the equity accounts on the subsidiary’s books. (Candidates do not need to worry about the
details of the elimination, other than to know that it happens.)
Other Eliminations
Any other intercompany transactions also need to be eliminated. Intercompany transactions could be related to bonds, loans, notes payable or anything similar.
Non-controlling Interests
Non-controlling interests are the claims to the net assets of the subsidiary that are held by investors other
than the parent company. Non-controlling interests arise when the parent does not own 100% of the subsidiary. If the parent does own 100% of the subsidiary, then no non-controlling interests can exist.
In the consolidation, the balance sheet of the subsidiary is added to the balance sheet of the parent. For
example, if the parent owns only 90% of the subsidiary, technically it should include only 90% of the assets
and liabilities of the subsidiary because 90% is all it owns. However, the parent will prepare the consolidation worksheet as though it owned 100% of the subsidiary. The parent then sets up a balance sheet account
called non-controlling interests that represents the claims on the subsidiary’s net assets by the noncontrolling shareholders.
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•
In the consolidated balance sheet, the offsetting credit amount for the portion that does not belong
to the parent company is shown as a separate caption in the stockholders’ equity section.
•
Accumulated other comprehensive income of the subsidiary is also apportioned between the parent
and the non-controlling interest and the amounts are shown separately in the equity section.
•
In the income statement, the amount of net income belonging to the parent and to the noncontrolling interests are consolidated, but they must be separately identified. Net income of the
parent and 100% of the subsidiary, including the income attributable to the non-controlling interest, is shown first. That is followed by a line identified as net income (or net loss) attributable to
the non-controlling interest, and the net income (net loss) attributable to the non-controlling interest is subtracted from (added to) the consolidated net income. The remainder is net income
attributable to the parent.
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Section A
1e) Property, Plant, and Equipment
1e) Property, Plant, and Equipment
Except as noted, guidance in the Accounting Standards Codification® on accounting for property, plant,
and equipment is in ASC 360.
Property, plant, and equipment—also called fixed or capital assets—includes land, buildings, and equipment
acquired for operations and not for resale. Fixed assets are long-term assets that possess physical substance and they are usually depreciated.
For many companies, “Property, Plant, and Equipment” constitutes the largest asset on the balance sheet,
especially for production companies with large production facilities. Therefore, it is an important that the
company correctly value and account for fixed assets.
Initial Recording of the Fixed Asset
Fixed assets should be initially recorded in the accounting records at historical cost, which is the amount
paid for the asset and all other costs necessary to get the asset ready for use.
It is important to be familiar with the costs included in the different classes of fixed assets. Below are some
of the major classifications of assets and the items specific to each classification.
•
Buildings. The purchase price, costs of renovating or preparing the building, cost of permits, any
taxes assumed by the purchaser, insurance paid during the construction of the building, and materials, labor, and overhead of construction.
•
Machinery and equipment. The cost of the machine, freight-in, handling, taxes, testing the machinery, installation, and any other costs of getting the machinery ready for its intended use. Partial
destruction of property can be included if, for example, a wall needs to be torn down in order to
install machinery onto a factory floor. If a wall needs to be torn down to install the machinery, the
demolition cost and the cost of rebuilding the wall are included in the cost of the machinery.
•
The cost of improvements made to equipment after its acquisition should be added to the asset’s
historical cost if the improvements will provide future benefits.
•
Land. The land purchase price, including any mortgages the purchaser assumed, transaction costs,
site preparation costs, the costs of purchasing and razing (destroying) an existing structure, the
amount of any delinquent real estate taxes assumed by the purchaser, permanent improvements,
and other costs necessary to prepare the land for its intended use. The costs of destroying an
existing building are included in the land cost because the land is not ready for its intended use
until the building is removed.
Any proceeds from the sale of an asset resulting from preparing the land for use should be treated
as a reduction in the cost of the land, not income. For example, if trees are cleared and the
timber sold, the proceeds from the sale of the wood are accounted as a reduction in the cost of the
land.
Note: When a company constructs fixed assets for its own use, it will often need to obtain some financing
in order to pay for the costs of the construction. In some cases, the company can capitalize some of the
interest it incurs on that external financing. Capitalization of interest is covered in any intermediate
accounting textbook.
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1e) Property, Plant, and Equipment
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Depreciation
Depreciation is the systematic and rational allocation of the costs of a fixed asset over its expected useful
life. In other words, depreciation matches the cost of acquiring the asset with the revenues the asset will
generate over its useful life by spreading the recognition of the acquisition cost over the time period during
which the asset will be useful (provide revenue) to the company. Depreciation is a method of cost allocation.
It is a purely mathematical process of dividing in some manner the cost of the asset among the periods in
which it will be used.
IFRS Note: Under U.S. GAAP, no attempt is made to report fixed assets at their fair value during their
life because the value of the asset may fluctuate and changes in fair value are difficult to measure
objectively. In contrast, IFRS permits revaluation of fixed assets to fair value if the revaluation is performed on a regular basis and the policy is applied consistently to all assets in the asset class.
Net Book Value of Fixed Assets
Each year, depreciation is usually recorded by debiting an expense account, depreciation expense, and
crediting accumulated depreciation. Accumulated depreciation is a valuation account that decreases the
carrying value of fixed assets, recorded at their historical cost, to their book value. The book value is the
cost of the fixed assets minus the accumulated depreciation. The historical cost recorded in the fixed asset
account at the time of acquisition will remain unchanged until disposal unless subsequent expenditures for
that asset are capitalized.
The accumulated depreciation account is presented on the balance sheet as a reduction or valuation of the
fixed assets account. In the example that follows, $76,250 is the carrying value or book value of the company’s fixed assets.
Fixed assets
Less: Accumulated depreciation
$100,000
(23,750)
$76,250
Note: The fixed asset account itself is not reduced as an asset is depreciated.
Calculation of Depreciation
Four methods are used to calculate the amount of depreciation to record each period. Some general information is needed before depreciation can be calculated under any of the methods. The needed information
and the definitions of the terms are:
•
Estimated useful life. Also known as “service life,” “estimated useful life” refers to the length of
time an asset is expected to be useful and it is the period of time over which depreciation is
recognized. At the end of its useful life, the asset should have a book value equal to the estimated
salvage value.
•
Estimated salvage value. Also known as “residual value,” “estimated salvage value” refers to
the value an asset is expected to have at the end of its useful life. The book value may not be
depreciated below the salvage value. However, some companies have an accounting policy that
salvage value is always $0.
•
Depreciable amount or depreciable base. The depreciable base is the amount to be depreciated over the asset’s useful life. It is equal to the capitalized amount (that is, the cost of the asset)
minus its salvage value.
Note: Land is never depreciated because the useful life of land is unlimited.
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Section A
1e) Property, Plant, and Equipment
Depreciation Methods
The annual depreciation charge can be calculated in four main ways. No matter which depreciation method
is used, the journal entry on the previous page is the same. The following four methods are simply different
ways of calculating the value of “X” in the journal entry.
1) Straight-line Depreciation
Straight-line depreciation (STL) results in an equal amount of depreciation taken each period:
Periodic Depreciation
=
Depreciable Base
Estimated Useful Life
The depreciable base is the asset’s initial cost (including all costs required to purchase the asset and
make the asset ready for use, such as sales or value-added taxes, shipping-in costs, and installation costs)
minus the anticipated salvage value.
Note: Straight-line depreciation is the easiest depreciation method to calculate. As such, it is the depreciation method that will usually appear in questions that include depreciation but are not specifically
questions about depreciation.
All other depreciation methods result in greater depreciation in the early years of an asset’s life and lesser
depreciation in the latter years. All the other depreciation methods are called accelerated depreciation
methods.
2) Double Declining Balance
The annual depreciation rate in the double declining balance (DDB) method is two times the percentage
that would be recognized under the straight-line method, but that percentage is applied to the net book
value of the asset at the beginning of each year instead of to its depreciable base, as in straight-line
depreciation.
Example: If the useful life of the asset is 10 years, take a depreciation charge each year equal to 20%
of the asset’s book value at the beginning of the year. Twenty percent is used because 20% is twice
the 10% that would have been used each year under the straight-line method.
However, the 20% is applied to the net book value of the asset at the beginning of each year, whereas
with straight-line depreciation, the 10% would have been applied to the depreciable base each year.
The annual depreciation to be recorded is calculated as follows:
Double declining rate × book value of the asset at the beginning of the year
In the double-declining balance method, the depreciation charge is calculated using the book value at the
beginning of the period, not the original depreciable base.
Salvage value is not taken into account when calculating the periodic depreciation charge. However, the
anticipated salvage value is used. Near the end of the asset’s useful life, it is important not to depreciate
the asset below its salvage value. Therefore, the final year’s depreciation amount needs to be adjusted so that the asset’s net book value after the final year’s depreciation has been recorded
will be equal to its salvage value.
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Note: Many companies use DDB for the first few years of an asset’s life and then switch to straight-line
for the remaining years.
Example: A company buys an asset costing $100,000 that has an estimated salvage value of $10,000.
The estimated useful life is 4 years.
The depreciable base is $90,000 (calculated as the cost less the salvage value). Given a 4-year useful
life, the annual depreciation recorded under the straight-line method would be 25% of the depreciable
base. Under the DDB method, the annual depreciation is two times 25%, or 50% of the asset’s beginning book value. The depreciation charge for Year 1 must be calculated before calculating the
depreciation charge for Year 2 in order to know the book value at the beginning of Year 2, and so on.
Year 1: $100,000 book value × 50% = $50,000 depreciation recorded
Year 2: $50,000 BV ($100,000 − $50,000 depreciation recorded in Year 1) × 50% = $25,000 depreciation recorded
Year 3: $25,000 BV ($100,000 − $50,000 depreciation recorded in Year 1 − $25,000 depreciation
recorded in Year 2) × 50% = $12,500 depreciation recorded
Year 4: $12,500 BV ($100,000 − $50,000 depreciation recorded in Year 1 − $25,000 depreciation
recorded in Year 2 − $12,500 depreciation recorded in Year 3) × 50% = $6,250. However, recording
the entire $6,250 as depreciation in Year 4 would reduce the asset’s book value below its $10,000
salvage value. Thus, the Year 4 depreciation recorded is only $2,500 ($12,500 BV − $2,500 depreciation = $10,000 BV after the Year 4 depreciation is recorded).
The total depreciation recorded during Years 1 through 4 is $90,000, the amount of the depreciable base
($50,000 + $25,000 + $12,500 + $2,500), and at the end of 4 years the net book value of the asset
will be its salvage value of $10,000.
Note: With all the other methods of depreciation, the depreciation recorded can be calculated for any
year of the asset’s life independent of the other, earlier years. However, when the double declining
balance method is used, to calculate the depreciation recorded for Year 2, for example, it is necessary
to first calculate the depreciation recorded for Year 1 in order to know the book value to use in calculating
the Year 2 depreciation. And before calculating Year 3’s depreciation, depreciation needs to be calculated
for Years 1 and 2, and so forth.
In contrast, under the straight-line, sum-of-the-years’-digits and units-of-production methods (the last
two are discussed next), depreciation for any year subsequent to the first year can be calculated without
first calculating any of the preceding years’ depreciation amounts.
3) Sum-of-the-Years’-Digits
In the sum-of-the-years’-digits (SYD) method, the amount of depreciation to be recorded for any given
period is calculated using fractions based on the estimated useful life of the asset.
Under the SYD method, the depreciable base (cost less estimated salvage value) is multiplied by a fraction
that is determined using the useful life of the asset. The denominator of the fraction is a sum of all of the
asset’s estimated years of useful life. For example, if the asset has a useful life of 5 years, the denominator
is the sum of the useful years: 5 + 4 + 3 + 2 + 1 = 15. The numerator is the number of years remaining
in its life, including the year for which depreciation is being calculated. Thus, for a 5-year asset, the depreciation recorded in the first year is 5/15 of the depreciable base. In the second year, the depreciation
recorded will be 4/15 of the depreciable base, in the third year 3/15, and so on.
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If the number of years is too great to sum easily, the sum-of-the-years’-digits, or the denominator of the
fraction, can be calculated using the following formula, where n represents the total number of years of
useful life for the asset:
Sum-of-the-Years’-Digits
n(n + 1)
=
2
For example, the SYD to use for the denominator for an asset with a five-year useful life is:
Sum-of-the-Years’-Digits
=
5(5 + 1)
2
=
5×6
2
=
15
The above sum-of-the-years’-digits can also be achieved through the following summation: 1 + 2 + 3 + 4
+ 5 = 15.
Example: A company buys an asset costing $100,000 that has an estimated salvage value of $10,000.
The estimated useful life is 4 years.
The depreciable base is $90,000 (calculated as the cost less the salvage value). This depreciable base
of $90,000 will be depreciated over the asset’s 4-year useful life. With a useful life of 4 years, the sum
of the year’s digits is 10 (1 + 2 + 3 + 4 = 10). Therefore, in Year 1, the company will record depreciation
equal to 4/10 of the depreciable base, or $36,000. The calculation for each of the 4 years is below:
Year 1: $90,000
Year 2: $90,000
Year 3: $90,000
Year 4: $90,000
Total
×
×
×
×
4/10
3/10
2/10
1/10
=
=
=
=
$ 36,000
27,000
18,000
9,000
$ 90,000
The total depreciation recorded over the life of the asset is equal to the depreciable base, and the final
book value equals the salvage value.
IFRS Note: Under IFRS, if individual components of a large fixed asset have different usage patterns
and useful lives, then the individual components must be depreciated separately. For example, if the
engine on a machine has a 5-year life while the rest of the machine has a 15-year life, the engine must
be depreciated over 5 years and the remaining cost of the machine must be depreciated over 15 years.
Under U.S. GAAP, component depreciation is allowed but not required.
4) Units-of-Production Method
The preceding depreciation methods are based on time. The units-of-production method is based on
actual physical usage of the asset during a given period.
Under the units-of-production method, an estimate is made of the number of units the asset will be able to
produce over its useful life. The depreciation rate per unit produced is calculated as the cost less the estimated salvage value divided by the estimated number of units to be produced over the asset’s estimated
useful life.
Depreciation Rate =
Cost Less Salvage Value
Estimated number of units to be produced
by the asset over its estimated useful life
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The depreciation recorded for any period is the depreciation rate multiplied by the number of units actually
produced during the period.
Example: A new piece of equipment is purchased for $2,000,000. The equipment is expected to produce
1,000,000 units over its estimated useful life and to have a $200,000 salvage value. The depreciation
rate is ($2,000,000 − $200,000) ÷ 1,000,000, or $1.80 per unit produced.
During its first year of operation, the equipment produces 120,000 units. The amount of depreciation
recorded for the first year of operation is $1.80 × 120,000, or $216,000.
Depreciation for Tax Purposes
In the U.S., the Internal Revenue Service prescribes the method of depreciation to be used on a company’s
tax return, and the method is specific for tax purposes.
MACRS, or Modified Accelerated Cost Recovery System, is the most common type of depreciation required
by the U.S. tax laws, although it is not the only acceptable method a company can use on its tax return.
The depreciable base for tax purposes, is always 100% of the cost of the asset and the other costs required
to make it ready for use. Therefore, any anticipated salvage value at the end of the asset’s life is never
subtracted from the original cost when calculating depreciation for tax purposes or when calculating the tax
basis (book value for tax purposes) when the asset is sold.
Furthermore, U.S. tax laws require that a portion of a year’s depreciation be taken in the year the asset is
acquired and a portion of a year’s depreciation be taken in the year the asset is disposed of. The most
common portion used is one-half year’s depreciation in both the first and the last year, regardless of the
actual date the asset was purchased. Taking one-half year’s depreciation in the first and last year is called
the half-year convention.
For example, if an asset is being depreciated over a three-year period for tax purposes, that three-year
period begins in the middle of the fiscal year in which the asset is acquired (July 1 if the company is using
a calendar year as its fiscal year) and it ends in the middle of the year in which the asset is completely
depreciated and/or disposed of. Thus, a three-year asset purchased in 20X1 when the company’s fiscal
year is the same as the calendar year will be depreciated over four calendar years as follows:
20X1
½ of one year’s depreciation
20X2
1 year’s depreciation
20X3
1 year’s depreciation
20X4
½ of one year’s depreciation
Note that the above depreciation schedule works out to three full years of depreciation, even though the
depreciation is taken over a period of four tax years.
The U.S. Internal Revenue Service (IRS) provides MACRS tables that give the percentage of the original
cost to be depreciated each year. There are several tables, each incorporating a given convention, and the
half-year convention is the most commonly used. The percentages for the first and last year in the halfyear convention table have already been adjusted to reflect one-half year’s depreciation in those years.
Therefore, when calculating annual depreciation amounts using the MACRS tables, the percentages should
be used as given.
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1e) Property, Plant, and Equipment
efham CMA
For example, for an asset that is being depreciated over three years using MACRS and the half-year convention, here are the percentages given in the tables:
Year 1
33.33%
Year 2
44.45%
Year 3
14.81%
Year 4
7.41%
Total
100.0%
The first year’s depreciation in the schedule above is 33.33% of the asset’s total cost. If one full year’s
depreciation were recorded in the first year, the full year amount would be 66.67% of the asset’s total cost.
One-half of that is 33.33%. The final year’s depreciation is adjusted similarly.
Exam Tip: Knowledge of these percentages are not necessary for the exam. If MACRS is to be
used on the exam, the percentages will be given in the question.
Example: The amount of depreciation to be taken for each year for an asset with an original cost of
$90,000 that is being depreciated as three-year property using MACRS and the half-year convention will
be as follows:
Year 1
33.33%
$29,997
Year 2
44.45%
40,005
Year 3
14.81%
13,329
Year 4
7.41%
6,669
100.00%
$90,000
Totals
Straight-Line Depreciation When Used for Tax Purposes
Straight-line depreciation can be used for tax purposes. However, straight-line depreciation for tax purposes
is different from straight-line depreciation used for financial reporting under U.S. GAAP. If straight-line
depreciation is used for tax purposes, do not subtract the salvage value to determine the depreciable base
for the depreciation to be reported on the tax return, even though for financial reporting under U.S. GAAP
the salvage value would be subtracted. The depreciable base for tax purposes is always 100% of
the asset’s cost.
The U.S. Internal Revenue Service generally requires assets depreciated on the straight-line basis on the
tax return to be depreciated monthly. If an exam question specifies that a company uses straight-line
depreciation for tax purposes, it will usually state that the asset was purchased on either January 1 or on
June 30/July 1.
1)
If the asset was purchased on January 1, take a full year of depreciation in the year acquired. A
three-year asset will be depreciated over only three tax years, not four tax years.
2)
If the asset was purchased on June 30 or July 1, take one-half year of the annual straight-line
depreciation amount in the year acquired and leave one-half year of depreciation for the final year.
A three-year asset will be depreciated over four tax years.
If the asset was purchased on any date other than January 1, June 30, or July 1, calculate the monthly
straight-line depreciation for the first year and the final year of the asset’s life as needed. The asset will be
depreciated over one tax year more than its life. For example, a three-year asset that was purchased on
October 1 will be depreciated for three months in the first tax year it is owned and for nine months in the
fourth tax year.
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1e) Property, Plant, and Equipment
CMA Part 1
Which Method of Depreciation is Best?
The depreciation method a company should use is the one that best matches the recognized depreciation
charge with the revenue management expects to receive from the asset. The method of depreciation should
not be selected on the basis of which method will result in a desired net income amount. Considerations
for which depreciation method should be used include:
•
If the revenues management expects to receive from the use of the asset will be constant over its
useful life, straight-line depreciation should be used so that the costs are also constant over the
asset’s useful life.
•
In contrast, if revenues from the use of the asset will be higher at the beginning of the asset’s life,
then an accelerated method of depreciation should be used. If an accelerated method of depreciation is used, depreciation recorded will be higher and net income and net assets will be lower in
the early years of the asset’s life (and vice versa in the later years of the asset’s life) than they
would be if straight-line depreciation were used.
•
If revenues from the asset will be lower at the beginning of the asset’s life, the amount of depreciation recorded in the early years should be lower than the amount recorded in later years. Lower
depreciation in the beginning of the asset’s life can usually be achieved through the units of production method. Depreciation recorded will be lower and net income and net assets will be higher
in the early years of the asset’s life (and vice versa in the later years of the asset’s life) than they
would be if straight-line depreciation were used.
If the company can reliably estimate the timing of revenues to be received from the use of the asset,
selecting the depreciation method that best matches the cost with the revenues will provide the most useful
information to financial statement users for assessing future cash flows from the asset.
Note: More information on depreciation and accounting for fixed assets is available in any intermediate
accounting textbook.
Impairment of Long-Lived Assets to be Held and Used
Under U.S. GAAP, fixed assets are not written up to recognize any increase in the fair value of the asset
over time. However, according to ASC 360-10-35-17, a company must write its fixed assets down if the
carrying value of the assets is not recoverable.
To determine if the carrying value of an asset or asset group is recoverable, the company compares the
carrying amount of the asset or asset group with the sum of the estimated undiscounted future cash flows
expected to result from the use and ultimate disposition of the asset or asset group. This comparison is
called a recoverability test, and it is used as a screening tool only, not as a method of establishing an
asset’s fair value.
The carrying value of the asset or asset group may be greater than its fair value, but if the carrying value
is recoverable based on the future undiscounted cash flows from its use and disposition, no impairment
loss is recognized. Thus, if the undiscounted future expected cash flows from the asset or asset group are
greater than its book value, the asset is not impaired and no adjustment needs to be made.
If the carrying value is greater than the sum of the estimated future undiscounted cash flows that will be
created by the asset or asset group, the asset or asset group is impaired. The impaired asset or asset
group must be written down to its fair value and an impairment loss must be recognized.
Fair value is determined according to the market price if an active market for the asset exists. If the asset
has no active market, the asset’s fair value is the present value of the expected future net cash flows from
the asset.
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Note: The process of writing down impaired fixed assets to their fair value is similar to the processes
that are accomplished for accounts receivable through the allowance for credit losses and for inventory
with the lower of cost or net realizable value or lower of cost or market. The objective in all of these
processes is to make certain that assets are not overvalued.
The amount by which an impaired asset is written down is reported as a current period loss.
The journal entry to record an impairment loss is:
Dr
Impairment loss ................................................................ X
Cr
Accumulated depreciation ..................................................... X
No entry is made to the fixed asset account. After the impaired asset has been written down, the adjusted
book value of the asset (that is, the original cost in the fixed asset account less the adjusted balance
attributed to the asset in the accumulated depreciation account) becomes its new cost basis. Future depreciation is recognized based on the new cost basis and the asset’s remaining useful life.
An impairment loss for a fixed asset that is to be held and used is included in income from continuing
operations before income taxes.
Note: If the future estimated undiscounted cash flows from the asset are less than the asset’s carrying
value, write the asset down to its fair value.
If the future estimated undiscounted cash flows from the asset are greater than asset’s carrying value,
the asset is not impaired and no adjustment is needed.
IFRS Notes:
1) The impairment process in IFRS is a one-step process. The carrying value of the asset is compared
to the recoverable amount. The recoverable amount is the higher of 1) the fair value of the asset,
if sold, minus any costs of sale, or 2) its value in use, which is the present value of the future net
cash flows expected to be received from the asset or cash-generating unit, discounted at the current
market risk-free rate of interest. (U.S. GAAP uses undiscounted future cash flows.)
2) Under IFRS, a company may increase the carrying the value of its fixed assets (called “writing
them up”) if the fair value of that class of assets is materially different from its carrying value. The
increase in the value is recognized in accumulated other comprehensive income and carried in
the equity section of the balance sheet as a revaluation surplus.
3) If the revaluation is the recovery of a previously recognized loss when the asset was impaired, the
revaluation gain is reported on the income statement.
4) A decrease due to impairment is recognized on the income statement, unless the loss to impairment
is a write-down as a result of a previous increase in the asset because of an increase in its fair value.
Question 28: In Joan Co.’s review of long-lived assets to be held and used, an asset with a cost of
$10,000 and accumulated depreciation of $5,500 was determined to have a fair value of $3,500. Determine the amount of impairment loss to be recognized if the expected undiscounted future cash flows
from the asset are (a) $5,000 or (b) $3,000.
(Source Unknown)
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1f) Intangible Assets
CMA Part 1
1f) Intangible Assets
Except as noted, guidance in the Accounting Standards Codification® on accounting for intangible assets
is in ASC 350, Intangibles-Goodwill and Other. Guidance on accounting for the intangible asset goodwill
acquired in a business combination is in ASC 350 and also in ASC 805, Business Combinations.
Intangible assets are assets that are not physical or that cannot be touched. The accounting for intangibles
is very similar to that for property, plant & equipment with many of the same issues:
1)
Initial recording of the intangible asset
2)
Amortization of the cost of the intangible asset (for intangibles, amortization is equivalent to depreciation of tangible assets)
3)
Adjusting the value of the asset to recognize any permanent decreases in its value (impairment)
Initial Recording of Intangible Assets
Like fixed assets, intangible assets are recorded at the cost paid to acquire them including expenditures
required to make the assets ready for their intended use.
Note: Internally-generated assets such as patents or goodwill are not recorded on the balance
sheet because they do not meet the definition of asset.
Research and development costs are generally expensed as incurred and thus they are not capitalized
and amortized. For example, a patent that results from research and development activities would not
lead to an asset on the books of the company that developed it.
An asset is something that has arisen from a past transaction. Internally-generated assets such as patents and internally-generated goodwill did not arise from a single past transaction.
In addition, because internally-generated goodwill was not acquired in a monetary transaction and thus
has no historical cost, internally-generated goodwill cannot be valued. Even if a company contracts for
and pays for a public relations program or an institutional advertising program, the cost of the program
is not the value of any “goodwill” that results. Thus, production costs for advertising and public relations
are expensed as incurred, while media costs for advertising and public relations programs are expensed
the first time the advertising takes place. The accounting treatment for internally-generated goodwill is
similar to that for research and development costs.
If a company that has internally generated goodwill is sold to another company, the sale transaction
provides the basis for the goodwill to be recorded on the books of the buyer and the valuation of that
goodwill.
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1f) Intangible Assets
Amortization and Accounting Treatment of Intangibles
After the intangible asset has been recorded, it must be properly valued as time passes.
•
If the asset has a determinable, limited life, it is amortized over that useful life.
•
If the asset does not have a determinable useful life, the asset is not amortized, but it must
be tested regularly for impairment.
The following are common types of purchased intangibles that have determinable useful lives:
•
Purchased patents. A patent is the right of exclusive use granted by a government. Patents in
the U.S. are valid for 20 years and if purchased, they are amortized over the shorter of two possible
time frames: either the patent’s legal life or the economic useful life of the patent. It is very
possible that the economic useful life will be shorter than the legal life because of changing technologies. A purchased patent should be recorded on the books as an asset at the purchase price,
which is also the amount that should be amortized over its useful life.
•
For internally developed patents, the capitalized and amortized amount is generally limited to
registration fees and legal fees for filing the patent. This accounting treatment is consistent with
the accounting treatment of research and development costs, which are generally expensed as
incurred and thus cannot be capitalized and amortized.
•
If a company successfully defends a patent in court, the cost of the legal defense is added to
the intangible asset account and is amortized over the patent’s remaining useful life. However, if
the company is unsuccessful in its defense, the remaining book value of the patent as well as
the legal costs of the defense must be expensed immediately because the court ruling has essentially stated that the company has no patent or patent rights. Without a patent and patent rights,
the company has no asset.
•
Franchises are contractual agreements that allow franchisees to operate a specific business using
the franchisor’s name. The franchisee should capitalize the costs of acquiring the franchise and
amortize them over the franchise’s useful life. A franchise with an indefinite life should be carried
at cost and should not be amortized but should be tested at least annually for impairment.
•
Leasehold improvements are additions a lessee makes to a building or property that the lessee
cannot remove when the lease period is over. For example, if a lessee installs an air conditioning
system in a leased building, the air conditioning system is considered a “leasehold improvement”
and cannot be uninstalled and taken away once the lease expires.
The cost of leasehold improvements should be amortized over the shorter of either the remaining lease term or the useful life of the improvements.
•
A trademark (®) or trade name is a distinctive sign, word, or symbol. Trademarks can be registered for 20 years and renewed for longer time periods. The costs that should be capitalized
include legal and registration fees, design costs, and any cost of successfully defending the name.
A trademark should be amortized over its useful life, but the amortization period should not exceed
40 years.
•
A copyright (©) is granted for intellectual property consisting of original works and is effective
for the life of the author plus 70 years. A purchased copyright is recorded at its purchase price. An
internally generated copyright can be recorded only at its registration costs.
Because it is difficult to assess the useful life of a copyright, companies usually write off amounts
capitalized for copyrights over a fairly short period of time.
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1f) Intangible Assets
CMA Part 1
Impairment of Limited-Life Intangible Assets
If at any time it is determined that an intangible asset with a finite life that is being amortized (for
example, a patent) is impaired or is no longer an asset (for example, the company loses a patent lawsuit),
the asset should be written down to the amount of its expected future benefit. Any loss must be written off
in the period that the asset is determined to be impaired.
The company should evaluate an intangible asset whenever there is any indication that its carrying amount
may not be recoverable. The evaluation and the calculation of any write-down is a two-step process.
1)
The company performs the recoverability test by comparing the undiscounted sum of the future
cash flows from the asset’s expected use and its eventual disposal with the book value of the asset.
If the book value is greater than this undiscounted sum, the asset is impaired.
2)
If the asset is determined to be impaired, it should be written down to its fair value. The fair value
is the present value of the future net cash flows, discounted at the company’s market rate of
interest. (Note that the undiscounted sum of the future cash flows used in Step 1 is not used in
Step 2.) The loss is the amount by which the book value is greater than the fair value.
Any loss must be written off in the period the asset is determined to be impaired. The loss is part of income
from continuing operations and is reported on a separate line from any goodwill impairment.
Impairment of Indefinite-Lived Intangible Assets Other Than Goodwill
Intangible assets with indefinite lives are not amortized but they may become impaired. Intangible assets
should be tested for impairment annually and between annual tests if circumstances change. The impairment test and subsequent write-down if necessary for intangible assets with indefinite lives is a 2- or 3step process.
1)
The first step is optional. Qualitative factors are used to determine if it is more likely than not
(meaning a probability greater than 50%) that the asset is impaired. Examples of factors that
could impact indefinite-lived intangible assets include increases in raw materials or labor that could
have a negative effect on the fair value of the asset, financial performance such as negative or
declining cash flows, economic factors, competition, regulatory issues, issues related to technology, and any other relevant events or circumstances that could affect the fair value of the asset.
If the company determines that the probability is less than 50% that the asset is impaired, it does
not need to proceed any further. This qualitative assessment should be performed at least annually
for each indefinite-lived intangible asset that is not amortized.
If the company determines that the probability is greater than 50% that the asset is impaired (or
if the company chooses not to perform the first step), the company performs the next step.
2)
The next step (or Step 1, if the company does not perform the optional first step) is a quantitative
assessment called a fair value test. The fair value of the intangible asset is calculated and compared with the asset’s book value (carrying amount). The calculated fair value of the intangible
asset is determined by considering the same types of events and circumstances listed in Step 1
that affect the fair value: cost factors, financial performance, environmental factors, management
changes, legal, regulatory, political, business or other factors, and macroeconomic conditions. Not
only negative events and circumstances should be considered, but positive events and circumstances should be considered, as well.
If the fair value is more than the book value, then the asset is not impaired and no further action
is necessary.
3)
118
If the calculated fair value is less than the book value, the next step is to write the asset down to
its fair value and recognize a loss.
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Section A
1f) Intangible Assets
Any impairment loss is part of income from continuing operations and is reported on a separate line from
any goodwill impairment.
The optional qualitative assessment can be performed just on certain intangible assets or on all of them.
Alternatively, the company can skip the qualitative test and perform the quantitative, fair value, test.
A previously-recognized impairment loss may not be reversed.
Goodwill and the Impairment of Goodwill
Guidance in the Accounting Standards Codification® on accounting for the impairment of goodwill is in
ASC 350-20-35-1 through 35-61.
Goodwill is defined as the amount by which the payment a purchaser has made for a company exceeds the
fair value of the net identifiable assets (identifiable assets less identifiable liabilities) purchased. Purchased
goodwill must be reported as a separate line item on the balance sheet. Generally, other intangibles
are combined and reported as one figure on the balance sheet.
Goodwill can be acquired or developed internally, but the only goodwill recognized in the accounting records
is purchased goodwill. The amount of goodwill purchased is equal to the difference between the purchase price paid for a business and the fair value of the net assets received.
A company should record purchased goodwill on the books as an asset at the cost paid for it. Goodwill is
considered to have an indefinite life, and therefore it should not be amortized. However, every year the
company must assess its goodwill to determine if it has been impaired during the year.
Note: If the price paid for a business is less than the value of the net identifiable assets, the purchase
is called a bargain purchase. The acquirer must first reassess its review of the identifiable tangible and
intangible assets acquired and liabilities assumed to determine whether all of the items have been correctly identified and valued and make any necessary corrections. Any additional assets or liabilities
identified in that reassessment should be recognized.
After the reassessment has been done, if the purchase price is still less than the fair value of the net
assets received, the acquirer recognizes a gain on the purchase equal to the amount by which the
purchase price is less than the value of the net assets received. The gain is recognized in income from
continuing operations as of the acquisition date.
Because some companies might attempt to make an intentional error in measuring the net assets acquired in order to book such an immediate gain, the nature of the gain must be disclosed in the financial
statements so users of the financial statements can evaluate it.
The costs of developing goodwill or maintaining purchased goodwill are expensed as they are incurred. Examples of these costs are training and hiring employees from the purchased company.
Goodwill is not amortized but it must be tested for impairment every year or whenever changes in circumstances indicate that the carrying amount of the asset may not be recoverable. Since goodwill arises from the
purchase of a business, impairment testing of the goodwill must be done in the context of the value of the
business to which the goodwill is related. The steps for testing for impairment of goodwill are:
1)
As with other intangible assets that are not being amortized, the company has the option to first
perform a qualitative assessment to determine if it is more likely than not that the fair value of the
reporting unit is less than its carrying amount. If the company concludes that it is not, then the
company does not need to go further. However, if the company concludes that it is more likely
than not that the fair value of the reporting unit is less than its net carrying amount, the company
proceeds to the quantitative, two-step impairment test.
a.
The company compares the fair value of the reporting unit whose purchase gave rise to the
goodwill, including the goodwill, with the reporting unit’s carrying amount (assets minus
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2) Valuation of Liabilities
CMA Part 1
liabilities), also including the goodwill. If the fair value of the reporting unit is greater than
its carrying amount, the goodwill is not impaired and the company can stop there and not
perform the second step. If the fair value of the reporting unit, including the goodwill that
arose from its purchase, is less than the carrying amount of the unit’s net assets including the
goodwill, the company performs the final step to measure the amount of the impairment loss,
if any.
b.
The company assigns the fair value of the reporting unit to all the assets and liabilities of the
unit as if the unit were newly acquired in a business combination. The excess of the fair value
of the reporting unit over the net amount assigned to its assets and liabilities (assets minus
liabilities) equals the implied fair value of the goodwill.
c.
The implied fair value of the goodwill is compared with the carrying amount of the goodwill. If
the carrying amount of the reporting unit goodwill is greater than its implied fair value, the
carrying amount of the goodwill is written down to its implied fair value and an impairment
loss is recognized currently.
The loss recognized cannot be greater than the carrying amount of the goodwill.
A goodwill impairment loss is presented on a separate line in the continuing operations section of the income
statement unless the goodwill impairment is associated with a discontinued operation, in which case it is
presented in the discontinued operations section of the income statement.
As with other indefinite-lived intangible assets, the company has the option to bypass the qualitative
assessment for goodwill and proceed with the quantitative, fair value test.
IFRS Notes:
1) Under IFRS, internal development costs of intangible assets are capitalized when the technological
and economic feasibility of the project can be demonstrated. Under U.S. GAAP, internal development
costs are usually expensed as incurred. They may be capitalized only if a specific U.S. GAAP standard
allows capitalization for that asset.
2) Under IFRS, a previously recognized impairment loss on an intangible asset may be reversed if the
estimates of the recoverable amount have changed.
3) If the intangible asset has a specific, active market, the intangible asset may be written up in value
to that fair value. (Note: Goodwill may not be written up.)
2) Valuation of Liabilities
2a) Reclassification of Short-term Debt
When a company expects to refinance some or all of its short-term liabilities by means of new long-term
debt or by issuing equity, the amount of the liability to be refinanced should not be classified as a current
liability. Rather, the amount of the short-term liability that will be refinanced is reclassified as a
non-current liability on the balance sheet.
Note: Reclassification of short-term debt to long-term debt if the liability will be refinanced after the
balance sheet date is an example of the correct treatment of subsequent events, or events that take
place after the financial statement date but before the financial statements are issued. Subsequent events are covered in ASC 855. Issuers of financial statements are required to evaluate
subsequent events through the date the financial statements are issued. If an event is significant enough
that the financial statements would be misleading without its disclosure, the company should recognize
the event in the financial statements.
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2b) Warranty Liabilities
In order for a company to reclassify its short-term obligations as long-term obligations, it must both:
•
Have the intent to refinance them, and
•
Be able to demonstrate the ability to refinance them.
The ability to refinance the short-term debt can be demonstrated by either:
•
Completing the refinancing transaction and converting the short-term obligations to long-term
obligations after the end of the year but before the financial statements are issued or are available
to be issued, or
•
Entering into a financing agreement with another party after the end of the year but before the
financial statements are issued or are available to be issued that will enable the refinancing to
occur. If this requirement is met, the company also must be able to show the ability to actually
perform the agreement.56
Note: If some of the short-term obligations that were intended for refinancing are actually settled
(paid) in the following year before the issuance of the financial statements by using short-term assets,
the settled amount of obligations must be shown as short-term obligations on the year-end balance
sheet.
Note: If the company refinances only part of its short-term obligations, it must continue to show the
short-term obligations that were not refinanced as current liabilities.
2b) Warranty Liabilities
A warranty is a promise a company makes to a buyer to repair or replace a product if it proves to be
defective during a specific time period. Warranties can be of two types:
1)
An assurance-type warranty is a manufacturer’s warranty given along with the sale of the product that provides assurance only that the product meets agreed-upon specifications in the contract
at the time it is sold, without any additional payment being required from the customer. An assurance-type warranty is included with the product price, and the consideration received from the
transaction includes the warranty.
Assurance-type warranties that cover only the compliance of the product with agreed-upon specifications do not constitute a separate performance obligation57 under ASC 606, Revenue
Recognition, and are accounted for as liabilities under ASC 460, Guarantees.
3)
A service-type warranty is an extended warranty that is usually sold separately from the product. Service-type warranties provide a service in addition to product assurance. A service-type
warranty may offer protection against wear and tear or certain types of damage. A service-type
warranty may be offered by the manufacturer but also may be offered by either the reseller or by
a third party.
When a warranty, or a part of a warranty, provides a service in addition to the assurance that the
product complies with agreed-upon specifications, the promised service is a performance obligation
and the company should allocate the transaction price to the product and to the service. Servicetype warranties constitute a separate performance obligation under ASC 606, Revenue Recognition, and a portion of the consideration received from the transaction is allocated to the warranty
and recognized as revenue over the warranty period. ASC 606 is discussed in detail later.
56
See ASC 470-10-45-14.
57
A performance obligation is a promise made in a contract with a customer to transfer to the customer either (a) a
good or service (or a bundle of goods and services) that is distinct or (b) a series of distinct goods or services that are
substantially the same and that have the same pattern of transfer to the customer.
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2b) Warranty Liabilities
CMA Part 1
Classification of Warranties
A warranty that is not sold separately may nevertheless represent a separate performance obligation under ASC 606 if it provides any service beyond assuring that the product complies with agreedupon specifications. A single warranty can have elements of both an assurance-type and a service-type
warranty. If a warranty includes elements of both and the company cannot reasonably account for them
separately, the company should account for both of the warranties together as a single performance obligation.58
All warranties need to be carefully assessed to determine whether they should be accounted for as liabilities
under ASC 460 or whether they need to be accounted for as separate performance obligations under ASC
606, or both. To assess whether a warranty provides a customer with a service in addition to the assurance
that the product complies with agreed-upon specifications, the company should consider the following factors:
1)
Is the warranty required by law? A warranty required by law should be accounted for as an assurance warranty.59 It is not a performance obligation under ASC 606.
2)
What is the length of the warranty coverage period? The longer the coverage period, the more
likely it is that the promised warranty is a performance obligation because it is more likely that it
provides a service in addition to the assurance that the product complies with the agreed-upon
specifications. For example, a “lifetime warranty” provided at no extra charge with purchase of a
product that promises to repair or replace the product at any time for any reason is likely a separate
performance obligation that needs to be accounted for under ASC 606, even though it is not purchased separately.
3)
What is the nature of the tasks that the company promises to perform? Specified tasks performed
in order to provide the assurance that a product complies with agreed-upon specifications, such
as providing a return shipping service for defective products, probably do not give rise to performance obligations under ASC 606.60 However, referring again to a “lifetime warranty,” a promise
to repair or replace the product for any reason at any time during the life of the product goes
beyond simply assuring that the product complies with agreed-upon specifications and tends to
indicate a separate performance obligation.
Example: A manufacturer of pet accessories promises that its products are guaranteed for life “even if
chewed.” For instance, if a dog chews on its leash and destroys it at any time, no matter how long it has
been in use, the manufacturer will replace it with a new one with no questions asked. The lifetime
guarantee is a service in addition to the assurance that the product complies with specifications, so it is
a service-type warranty even though it is not sold separately. It should be accounted for as a separate
performance obligation, and a portion of the consideration from each sale should be allocated to the
warranty.
1) Accounting for Assurance-Type Warranties
Guidance in the Accounting Standards Codification® on accounting for assurance-type warranties is in
ASC 460.
Warranties that represent assurances that the product meets agreed-upon specifications are assurancetype warranties and are accounted for as liabilities under ASC 460.
58
ASC 606-10-55-34.
59
ASU 2014-09, Section C (Background Information and Basis for Conclusions), Implementation Guidance, Paragraph
BC377.
60
ASC 606-10-55-33.
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2b) Warranty Liabilities
Per ASC 460-10-25-5, because of the uncertainty surrounding claims under warranties, warranty obligations are considered contingencies and losses are to be accrued if the conditions in ASC 450-20-25-2 are
met, specifically:
•
If it is probable that an obligation has been incurred due to a transaction that occurred on or
before the date of the financial statements, and
•
If the amount of the obligation can be reasonably estimated.
Assurance-type warranties may be current liabilities or they may be partly current liabilities and partly noncurrent liabilities.
•
If the term of the warranty extends only into the next accounting period, a current liability is
recorded.
•
If the term of the warranty extends beyond the next period, the estimated liability must be separated into a current portion and a non-current portion.
Because the company does not know exactly how many units will break, or exactly how much it will cost to
fix or replace those units, warranty expense under assurance-type warranties is an estimate.
At the end of each period, the company must make a calculation of the amount of expected warranty claims
that will be received in all future periods. This calculation can be based on a percentage of sales, a cost per
unit sold, or can be calculated in some other manner. No matter which method is used for calculating the
amount of the estimated warranty expense, the journal entry to record the liability and the expense for
warranties is:
Dr
Assurance-type warranty expense ....................... as calculated
Cr
Assurance-type warranty liability ........................... as calculated
This entry will match the expense of the future warranty claims with revenues that were recognized
from the sale of those items.
When a warranty claim is received, the company will reduce the liability and not recognize an expense
because the expense was already recognized in the period when the sale was made. The entry to record
actual cost incurred is:
Dr
Assurance-type warranty liability ......................... cost incurred
Cr
Cash, inventory, accrued payroll, as appropriate ..... cost incurred
At the end of each period the company must evaluate the balance in the assurance-type warranty liability
account to make certain that it is appropriate. If the credit balance in the account is estimated to be too
low or if the balance has become a debit balance because of warranty claims during the period that have
exceeded the estimated liability, additional expense and liability are recognized using the first entry above.
If it is determined that the liability is greater than necessary, a portion of the first entry is reversed in order
to bring the assurance-type warranty liability account down to its proper estimated value.
Note: As each assurance-type warranty period expires, the company will need to remove any remaining
estimated warranty liability balance attributable to that warranty period by reversing any remaining
amount of the first entry above.
Candidates should be able to calculate both the warranty expense for a period and the remaining warranty liability.
•
The assurance-type warranty expense is a simple percentage of sales (or other calculation) and
does not take into account the amount of cost actually incurred for warranty claims.
•
The assurance-type warranty liability is the total assurance-type warranty expenses recognized
in the past (as debits to assurance-type warranty expense and credits to assurance-type warranty
liability) minus all costs incurred on warranty claims.
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2b) Warranty Liabilities
CMA Part 1
Question 29: East Corp. manufactures stereo systems that carry a two-year assurance-type warranty
against defects. Based on past experience, assurance warranty costs are estimated at 4% of sales for
the warranty period. During 20X9, stereo system sales totaled $3,000,000, and assurance warranty
costs of $67,500 were incurred. In its income statement for the year ended December 31, 20X9, East
should report assurance warranty expense of:
a)
$52,500
b)
$60,000
c)
$67,500
d)
$120,000
(Source Unknown)
Disclosing Assurance-Type Warranties on the Balance Sheet
Assurance-type warranties are classified as current or non-current on the balance sheet based on the remaining time period that the warranty is valid.
1)
If the warranty term extends only into the next accounting period, a current liability is recorded.
2)
If the warranty term extends beyond the next period, the estimated liability must be separated
into a current portion and a long-term portion.
The warranty liability on the balance sheet is calculated as:
Total warranty expenses recognized (accrued) in the past on warranties that are still open
−
All costs that have been incurred on warranty claims on those warranties
=
Warranty liability on the balance sheet
2) Accounting for Service-Type Warranties
Guidance in the Accounting Standards Codification® on accounting for service-type warranties is in ASC
606, Revenue Recognition.
When a warranty such as an optional extended warranty is sold separately from the product, the warranty
is a distinct service because the company promises to provide the service to the customer in addition to
the product. The option to purchase the warranty separately provides evidence that the warranty is a
service in addition to the product. A service-type warranty is a separate performance obligation under ASC
606.
However, a warranty does not need to be sold separately in order to be a separate performance obligation.
The company should assess all warranties to determine whether they are assurance-type or service-type
warranties. A warranty could even have elements of both assurance and service.
The seller of a service-type warranty should account for the promised warranty as a performance obligation
in accordance with ASC 606-10-25-14 through 25-22. A portion of the transaction price of each sale should
be allocated to that performance obligation.
The recognition of revenue for the consideration allocated to a service-type warranty is deferred and is
usually recognized on a straight-line basis over the life of the warranty contract. However, if historical
evidence indicates that costs under the contracts are incurred on some basis other than a straight-line
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Section A
2b) Warranty Liabilities
basis, then the revenue should be recognized over the contract period in proportion to the expected costs. If the extended warranty picks up after the manufacturer’s warranty expires, recognition of
the extended warranty revenue does not begin until after the manufacturer’s warranty has expired.
Since service-type warranty revenue is recognized throughout the term of the contract, expenses incurred in fulfilling the contracts should be expensed as period costs when incurred.
Thus, consideration received for a service-type warranty is a contract liability on the balance sheet according to ASC 606, representing the seller’s performance obligation over the term of the contract. The
name of the liability account may be contract liability or it may be more descriptive, such as service-type
warranty liability.
Dr
Cash or accounts receivable .......................Consideration allocated to warranty
Cr
Service-type warranty liability ....................... Consideration allocated to warranty
The consideration received for the service-type warranty is transferred to revenue as the contract is performed.
Estimated future costs of service-type warranties are not accrued as liabilities. Actual costs are expensed
as they are incurred.
Example: A manufacturer that sells direct to consumers offers a one-year assurance-type warranty
against defects for its products and an extended 4-year service-type warranty for an additional cost.
When the extended warranty is purchased along with the product, the $5,200 consideration received for
both is allocated $5,000 to the product and $200 to the service-type warranty. The consideration allocated to the product includes the assurance-type warranty that covers the product for the first year, and
the extended, service-type warranty covers the product from Year 2 through Year 5. The manufacturer’s
entry on the date of the sale for each unit sold is:
Dr
Cash .......................................................................... 5,200
Cr
Sales revenue ............................................................... 5,000
Cr
Service-type warranty liability ............................................ 200
On the sale date, the manufacturer also estimates that its liability for the assurance-type warranty will
be $100 for each sale during Year 1, the period covered by the assurance-type warranty, and records
its liability for the assurance-type warranty as follows:
Dr
Assurance-type warranty expense .................................... 100
Cr
Assurance-type warranty liability ........................................ 100
The manufacturer processes a claim against the assurance-type warranty during Year 1 that involves
one hour of labor at $20 and parts costing $60:
Dr
Assurance-type warranty liability ........................................ 80
Cr
Parts inventory ................................................................... 60
Cr
Accrued payroll .................................................................. 20
The manufacturer evaluates the balance in the assurance-type warranty liability account at each reporting date and adjusts it according to its estimated remaining liability. The other side of the adjusting entry
is either a debit or a credit to assurance-type warranty expense.
Since the product is under the assurance-type warranty for the first year, the service-type warranty
covers years 2 through 5 (4 years).
(Continued)
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2c) Accounting for Income Taxes
CMA Part 1
At the end of Year 2 following the sale (after expiration of the assurance-type warranty) and for each of
the three following years, the manufacturer recognizes one-fourth of the revenue for the service-type
warranty on a straight-line basis. Entries at the ends of Years 2, 3, 4, and 5 to recognize the revenue
from the service-type warranty for each sale are:
Dr
Service-type warranty liability............................................ 50
Cr
Service-type warranty revenue ............................................ 50
Costs for repairing or replacing items covered by the service-type warranty during years 2, 3, 4 and 5
are expensed as incurred, as follows:
Dr
Service-type warranty expense ...................... Amount incurred
Cr
Salaries and wages payable ............................. Amount incurred
Cr
Parts inventory .............................................. Amount incurred
2c) Accounting for Income Taxes
Guidance in the Accounting Standards Codification® on accounting for income taxes is in ASC 740.
Every company makes two separate calculations of income during a period. The first calculation is book
income, or financial income, which is calculated using the rules of GAAP and is based on accrual accounting. Book income is the pre-tax financial income reported in the financial statements. From the perspective
of the company, book income is the “correct” income because it is calculated according to GAAP.
The second calculation of income is made for the company’s taxable income. “Taxable income” is a tax
accounting term and it refers to the amount of income on which the company’s income tax due is computed.
Taxable income must be calculated according to the relevant tax laws of the country in which the company
operates. In the U.S., taxable income is calculated by following the Internal Revenue Code. Taxable income
is calculated by subtracting tax-deductible expenses from taxable revenue. Taxable income is calculated to
determine the amount of money the company must pay the government as income taxes for the period.
According to the U.S. Internal Revenue Code, a business must use the same accounting method to assess
taxable income as it uses to keep its books.61 For example, if a business uses accrual accounting and carries
accounts receivable on its financial statements, it must also use accrual accounting and carry accounts
receivable on its tax return. However, even when a company is using accrual accounting and generally
accepted accounting principles for its financial reporting and files its taxes using accrual accounting, there
will be differences between its financial reporting income and its taxable income because certain specific
receipts and expenses are recognized at different times for financial reporting and tax purposes.
The fact that book income and taxable income are different gives rise to deferred taxes, which are nothing
more than a form of tax payable or prepaid tax. It is the difference between the amount of tax due on the
company’s book income (which will be the debit to income tax expense) and the amount of tax payable on
the company’s taxable income (which will be the credit to taxes payable or to cash in the journal entry).
Note: Deferred taxes will never arise because a company keeps its books on the accrual method but
files its taxes on the cash method because that is not permitted.
61
According to the Internal Revenue Code §446(a). Thus, deferred tax items will never arise from a company keeping
its books on the accrual method but filing its taxes on the cash method, for example.
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Section A
2c) Accounting for Income Taxes
Four potential events will cause a difference between financial income and taxable income, as follows:
1)
An item is recognized on the income tax return as revenue that increases taxable income before it
is recognized on the income statement as revenue that increases net income for financial reporting
purposes.
2)
An item is recognized on the income tax return as a deductible expense that reduces taxable
income before it is recognized on the income statement as an expense that reduces net income
for financial reporting purposes.
3)
An item is recognized for financial reporting purposes as revenue that increases net income on the
income statement before it is recognized as revenue that increases taxable income on the income
tax return.
4)
An item is recognized for financial reporting purposes as an expense that reduces net income on
the income statement before it is deductible as an expense that reduces taxable income on the
income tax return.
Some examples of the differences are:
•
Revenue recognized on the income tax return before it is recognized on the income
statement for financial reporting purposes: Consideration received in advance, before the
performance obligation has been satisfied (when the customer obtains control of the good or service), such as prepaid rental income and payments received in advance on service contracts are
recognized as revenue on the income tax return when received, but for financial reporting purposes
they are recorded as a contract liability when received and recognized as revenue only when the
performance obligation has been satisfied.
•
Expense recognized on the income tax return before it is recognized on the income statement for financial reporting purposes: In the U.S., the Internal Revenue Service prescribes
an accelerated depreciation method for most assets for tax reporting, called Modified Accelerated
Cost Recovery System (MACRS), which is similar to the double declining balance method. If a
company uses MACRS depreciation for tax purposes and straight-line depreciation for financial
reporting purposes, depreciation expensed in the early years of the asset’s life will be greater for
tax purposes than for book purposes.
•
Revenue recognized for financial reporting purposes before it is recognized as revenue
on the income tax return: The investor recognizes earnings from investments that are accounted
for under the equity method when earned by the investee for financial reporting purposes but for
tax purposes only when received as dividends.
•
Expense recognized for financial reporting purposes before it is recognized as a deductible expense on the income tax return: For tax purposes, expense accrued for financial
reporting purposes for estimated liability for assurance-type warranties62 and pending litigation is
not allowed as a tax deduction until the amounts are paid.
62
An assurance-type warranty is a manufacturer’s warranty given along with the sale of the product that provides
assurance only that the product meets agreed-upon specifications in the contract at the time it is sold, without any
additional payment being required from the customer. An assurance-type warranty is included with the product price,
and the consideration received from the transaction includes the warranty.
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2c) Accounting for Income Taxes
CMA Part 1
Book Income, Taxable Income, and Deferred Taxes
Book income and taxable income are two different perspectives on the same thing: the amount of income
that should be taxed. The difference between book income and taxable income arises from temporary
timing differences in when certain activities, incomes, and expenses are defined as taxable incomes and
tax-deductible expenses versus when they are recognized as revenues and expenses in book income.
It is important to remember that accountants keep the company’s books in accordance with GAAP. Therefore, the amount of taxes a company wants to pay is “correct” according to GAAP income, although it
frequently is different from what the government says a company has to pay.
The tax due based on book income is the amount a company wants to pay in taxes because it is calculated on the “correct” amount of income—meaning the income the company defines as taxable. Through
the tax code, the government calculates the taxable income amount that the tax the company has to
pay is based on. The difference between book income and taxable income caused by timing differences
gives rise to deferred taxes.
The difference between the taxes a company wants to pay and the taxes the government expects it to pay
is recorded on the balance sheet as either an asset or a liability. That difference is the deferred tax
amount. Deferred taxes can be either assets or liabilities.
As a very simplified example, if the tax the company “wants to pay” is $90 but the amount it “has to pay”
is $100, taxes would be recorded as follows:
Dr
Income tax expense (want to pay) ..................................... 90
Dr
Prepaid taxes (or deferred tax asset) ............................... 10
Cr
Cash (have to pay) ........................................................... 100
In the preceding example, the company makes a prepayment of taxes because it must pay the larger
amount that the taxing authorities require. Hence, this prepayment of taxes is recognized as an asset on
the balance sheet according to the books.
On the other hand, if the amount the company “has to pay” is $90 but the amount it “wants to pay” is
$100, the company has not paid all of the tax due according to book income and the company has a tax
payable, which is recorded on the balance sheet as a liability:
Dr
Income tax expense (want to pay) ................................... 100
Cr
Cash (have to pay) ............................................................. 90
Cr
Taxes payable (or deferred tax liability) ............................. 10
Note: The term “prepaid taxes” used for a deferred tax asset in the journal entry above is descriptive
only. It is used to show that a deferred tax asset is similar to a prepaid tax. There is no account or line
item on a balance sheet called “prepaid taxes.”
The terms “taxes payable” and “deferred tax liability” do not mean the same thing and cannot be used
interchangeably. The term “taxes payable” in the journal entry above is descriptive only, used to show
that a deferred tax liability is similar to a tax payable.
When used with deferred taxes, the correct terms are “deferred tax asset” and “deferred tax liability.”
The concept will be developed further in the discussion that follows.
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Section A
2c) Accounting for Income Taxes
The following table provides a few examples of the amounts calculated under GAAP, the tax code, and the
deferred tax effect.
WANT-TO-PAY TAXES
Under GAAP
NEED-TO-PAY TAXES
Under Tax Code
DEFERRED
Tax Status
$10,000
$ 5,000
$5,000 Liability
$ 5,000
$10,000
$5,000 Asset
$12,000
$12,000
No Effect
The Asset-Liability Method
The FASB has determined that the asset-liability method is the proper way to account for the difference
between income taxes due based on book income and income taxes due based on taxable income. Under
the asset-liability method, deferred tax assets and deferred tax liabilities are used to recognize the future
tax consequences of events recognized in the financial statements that represent temporary differences
between the financial statements and the tax return.
Note: ASC 740-10-25-2b states, “a deferred tax liability or asset shall be recognized for the estimated
future tax effects attributable to temporary differences and carryforwards.” Thus, the standard sets up
an asset-liability method of recognizing the temporary timing differences relating to taxes. The justification for the asset-liability method is that timing differences actually lead to assets and liabilities for
the company as a result of essentially prepaying taxes to the government or in deferring its taxes payable
to a future period. These assets and liabilities need to be recognized in the financial statements.
Note: Deferred income tax accounting is inter-period income tax allocation: allocating income tax
expense to the correct period. The effect of inter-period income tax allocation is to recognize a tax asset
or liability for the tax consequences of the temporary differences that exist at the financial statement
date.
Example: For tax purposes, certain receipts are recognized as taxable revenue when they are received.
However, for book purposes they are recognized as revenue when the performance obligation is satisfied.
Prepaid rent, which under ASC 606, the revenue recognition standard, is a contract liability when received, is an example of that type of receipt. The amount of cash received for rent paid in advance will
be reported in full on the tax return as taxable revenue in the year it is received, but in the accounting
records it will be included in book income only as the performance obligation represented by the prepayment (the use of the asset) is satisfied and the lessee receives the use of (that is, has obtained
control of) the rented asset.
For example, prepaid rent in the amount of $5,000 is received at the end of December 20X1 for the
month of January 20X2. The cash received will be taxable income for 20X1. However, in the lessor’s
accounting records, the rent will be recognized as revenue for 20X2 because 20X2 is the year in which
the lessor’s performance obligation is satisfied.
The lessor’s tax rate is 35% and the lessor’s tax due on the rental receipt for 20X1 is $20,000, which
includes $1,750, or 35% of the prepaid rent received during December for the month of January. The
$1,750 tax paid on the prepaid rent received will actually be a prepayment of taxes and will be an asset
to the lessor. The lessor debits deferred tax assets for $1,750. The lessor debits income tax expense for
20X1 for $18,250 ($20,000 − $1,750) because that is the amount of tax due for 20X1 on the lessor’s
book income. The lessor credits income tax payable for $20,000, the total of the two debits. When the
tax is paid, the lessor debits income tax payable and credits cash for $20,000.
(Continued)
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2c) Accounting for Income Taxes
CMA Part 1
The lessee moves out at the end of January and no other tenant is found for the remainder of the year.
During January 20X2, the lessee receives the benefit of the consideration it paid in advance during
December 20X1. The $5,000 is recognized as revenue on the lessor’s income statement according to
GAAP. However, no income tax will be due on the $5,000 rental income during 20X2 because the tax
was already paid on it for the 20X1 taxable year.
For 20X2, the lessor owes $25,000 in income tax according to its GAAP net income. That $25,000 includes the $1,750 in the deferred tax asset. However, the lessor owes only $23,250 in income tax
($25,000 − $1,750) because that is what the lessor’s tax return says it should pay. The lessor debits
income tax expense for $25,000 because that is the amount of tax it owes according to its book income.
The lessor also credits the deferred tax asset for $1,750, reducing the deferred tax asset to zero. The
deferred tax asset has reversed. The lessor credits income tax payable for $23,250, the net of the debit
to income tax expense and the credit to the deferred tax asset. When the tax is paid, the lessor debits
income tax payable and credits cash for $23,250.
The lessor’s income statement for 20X2 will show income tax expense of $25,000 even though only
$23,250 was actually paid in cash.
Temporary Timing Differences
Deferred taxes arise because of temporary timing differences, which occur when an item is not recognized for both book and taxable income in the same period. In order for an item to be a temporary timing
difference, the item must be recognized at some point in both book income and taxable income, though
not in the same period. The four items listed previously all create temporary timing differences.
Note: If an income or expense item is recognized only for book purposes or only for tax purposes but
not both, it is a permanent difference. Permanent differences do not give rise to deferred tax assets
or liabilities.
Timing differences are temporary because they will “reverse” over time. When an item is included in taxable
income in one period but not in book income that period, and in some future period the item will be included
in book income but not taxable income, the item is a temporary timing difference that will reverse.
The reversal of temporary differences over time means that over the life of a business there will be no
difference between its total book income and its total taxable income, except for items that cause permanent differences between book income and taxable income.
The situations that lead to temporary timing differences and the type of timing differences that arise from
each are shown in the table below.
Table of Temporary Differences and Their Results
Revenues and Gains
Expenses and Losses
Reported in Taxable Income First
Deferred Tax Asset
Deferred Tax Liability
Reported in Book Net Income First
Deferred Tax Liability
Deferred Tax Asset
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2c) Accounting for Income Taxes
Deferred Tax Assets, Prepaid Taxes, or Future Deductible Amounts
An item that causes taxable income in the current period to be greater than book income in the current
period creates a deferred tax asset. Because taxable income is higher than book income, the company
has had to pay more in taxes than its book income indicates it owes. Therefore, for book purposes the
“overpayment” is a prepaid tax, or a deferred tax asset.
A deferred tax asset is created by either of the following two types of items:
•
An item that is taxable revenue in the current period but is not yet included in book revenue
for the current period. For example, contract liabilities such as consideration received for work to
be performed in the future are included in taxable revenue when received but in revenue for financial reporting only when the performance obligation has been satisfied and control has
transferred to the buyer.
•
An expense that is recognized on the income statement for the current period but is not yet
deductible for tax purposes in the current period. For example, for book purposes assurance-type
warranty expense63 is debited to the income statement as an accrued expense and credited to
assurance-type warranty liabilities when revenue from the associated product sales is recognized.
However, the warranty expense is not a deductible expense for tax purposes until claims are made
by buyers under the warranty and warranty costs are actually paid.
Note: When a deferred tax asset is created by an expense that is deducted from book income but not
deducted from taxable income for the period, it is a future deductible amount because the item that
gave rise to it will cause taxable income to be lower than book income at some point in the future.
Deferred Tax Liabilities, Taxes Payable, or Future Taxable Amounts
An item that causes taxable income in the current period to be lower than book income in the current period
creates a deferred tax liability. Because taxable income is lower than book income, the company does
not pay as much in taxes as its book income indicates it should pay in the current period. However, because
these temporary timing differences will reverse, the tax that was not paid for the current year will need to
be paid in the future. Therefore, for book purposes the difference is recorded as a deferred tax liability.
A deferred tax liability is created by either one of the following two types of items:
•
An item included in revenue for book purposes but not included in revenue for tax purposes
in the current period. For example, if a nonmonetary asset64 is lost or damaged as in a theft or a
casualty (an involuntary conversion), U.S. GAAP requires that a gain or a loss be recognized for
the difference between any proceeds received from insurance and the book value of the lost asset.
If the insurance proceeds exceed the asset’s book value, the company reports a gain on the involuntary conversion on its income statement. However, for tax purposes, any gain on the involuntary
conversion may be deferred if the company uses the insurance proceeds to acquire replacement
property that is worth at least as much as the property that was lost. The gain would be included
in income for book purposes but not included in income for tax purposes.
•
An expense that is deductible for tax purposes but is not an expense for book purposes in the
current period also creates a deferred tax liability. For example, using an accelerated depreciation
method for tax purposes while using straight-line depreciation for book purposes gives rise to
deferred tax liabilities in the early years of the asset’s life that reverse in the later years of the
asset’s life.
63
An assurance-type warranty is a manufacturer’s warranty given along with the sale of the product that provides
assurance only that the product meets agreed-upon specifications in the contract at the time it is sold, without any
additional payment being required from the customer for the warranty.
64
A nonmonetary asset is an asset whose monetary value may fluctuate over time and that is not readily convertible
into cash or cash equivalents. Examples of nonmonetary assets are tangible assets such as property, plant, and equipment and inventory and intangible assets such as patents, copyrights, and goodwill.
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2c) Accounting for Income Taxes
CMA Part 1
Presentation of Deferred Tax Assets and Liabilities on the Balance Sheet
Deferred tax assets and liabilities are classified on the balance sheet as either a net non-current asset
or a net non-current liability.
The net amount and whether it is to be presented as an asset or a liability is determined by subtracting the
deferred tax liability amounts from the deferred tax asset amounts. If the net result is positive (a debit),
the net amount is reported on the balance sheet as a non-current asset. If the net result is negative (a
credit), the net amount is reported on the balance sheet as a non-current liability.
Question 30: A liability that represents the accumulated difference between the income tax expense
reported on the firm’s books and the income tax actually paid is
a)
Capital gains tax.
b)
Deferred taxes.
c)
Taxes payable.
d)
Value-added taxes.
(ICMA 2008)
Permanent Timing Differences
Permanent timing differences are items that cause differences between taxable income and book income
but do not reverse over time. Permanent differences do not give rise to deferred tax assets or liabilities because a permanent timing difference will be recognized for either book or tax purposes, but not for
both.
In an exam question, candidates may need to be able to identify which items in a list are temporary differences and give rise to deferred tax assets or liabilities and which are permanent differences that do not
give rise to deferred tax assets or liabilities. The most commonly tested examples of permanent differences
are municipal bond interest and the dividends-received deduction. Those items will be discussed individually
below, and then other examples of permanent differences will be listed.
Municipal Bond Interest
The most common example of a permanent difference is municipal bond interest received (or any other
tax-exempt interest received from a state or local government entity). A municipal bond, or muni-bond, is
a bond issued by a local government. In the U.S., the federal government does not tax interest earned on
municipal bonds. The fact that muni-bond interest is tax-free means that the income it generates will be
included in book income in the year it is earned, but it will never be included in taxable income for federal
taxes because it is excluded from the definition of federal taxable income. Therefore, it is a permanent
difference that does not reverse.
The Dividends-Received Deduction
The dividends-received deduction is applicable when a U.S. corporation owns shares in another qualifying
U.S. corporation.65 When the company owns less than 20% of the qualifying company, 70% of the dividends
received are not taxable to the investor company. If the company owns between 20% and 80% of the
qualifying company, 80% of the dividends received are not taxable to the investor. If the company owns
more than 80% of the qualifying company, 100% of the dividends received are not taxable. Since in many
65
The criteria for being a qualified corporation are outside the scope of this exam. For the exam candidates need to
know how the dividends received deduction works, not what qualifies for the dividends received deduction.
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2d) Accounting for Leases
cases some of the dividend will still be taxable, only the amount that is deductible on the tax return is a
permanent difference. The portion of the dividend that is not deductible on the tax return will be a temporary difference only if it is received in a different tax year from the tax year in which it is reported as
dividend income on the investor corporation’s income statement.
Other Permanent Differences
Other examples of items that lead to permanent differences are:
•
Expenses incurred in the process of earning tax-exempt income are not deductible for tax
purposes but will be deducted for book purposes.
•
Life insurance premiums paid by the corporation are never deductible expenses for tax purposes if the corporation is the beneficiary. However, for book purposes the premiums are an
expense.
•
Life insurance proceeds received by the corporation are never taxable, but they will be recognized as income on the income statement.
•
Expenses incurred as a result of violating the law are not tax deductible.
•
Any other expenses that are not deductible for tax purposes according to the tax law, such as
excess entertainment expense.
2d) Accounting for Leases
Guidance in the Accounting Standards Codification® on accounting for leases is in ASC 842.
A new standard for leases was issued by the FASB in 2016 with an effective date of December 15, 2018.
The FASB created Topic 842, Leases, for the amended standard. The information that follows is the revised
standard.
The Objective
The objective of the leasing standard in ASC 842 is to increase transparency and comparability among
organizations by having lessees recognize lease assets and lease liabilities on the balance sheet for
essentially all leases.
All leases create an asset (the right to use the asset) and a liability (the liability to make lease payments)
for the lessee, so the basic principle of Topic 842 is that a lessee should recognize the assets and
liabilities that arise from leases.
•
A lessee should recognize a right-of-use asset representing its right to use the leased asset for the
term of the lease and
•
A lessee should also recognize the liability to make lease payments over the lease term.
The lessee amortizes the right-of-use asset.
Each lease payment made by the lessee will include a payment of interest and a payment representing a
reduction of the lease liability.
Note: The lease liability is defined as the lessee’s obligation to make the lease payments arising from
a lease, measured on a discounted basis.66 Measurement on a “discounted basis” means the lease liability is generally analogous to the outstanding principal balance on a loan.
66
ASC 842-10-20 (Glossary).
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2d) Accounting for Leases
CMA Part 1
Definition of a Lease
A lease is an agreement between a lessor and a lessee. The lessor is the owner of the asset. The lessor
leases the asset to the lessee, the one who is going to control the use of the asset and make payments to
the lessor for the right to use the asset. According to ASC 842-10-20, a lease is:
“A contract, or part of a contract, that conveys the right to control the use of identified
property, plant, or equipment (an identified asset) for a period of time in exchange for
consideration.”
Control over the use of an identified asset means that the lessee has both:
1)
The right to obtain substantially all of the economic benefits from the use of the asset, and
2)
The right to direct the use of the asset.
The Two Categories of Leases
For lessees, there are two different types of leases for financial accounting purposes, and both require the
lessee to recognize a right-of-use asset and a lease liability. The two types are: 1) finance leases and 2)
operating leases.
For the lessee, a finance lease is one that meets one or more of the following criteria:
1)
The lease transfers ownership of the underlying asset to the lessee by the end of the lease term.
2)
The lease grants the lessee an option to purchase the underlying asset, and the lessee is reasonably certain to exercise the option to purchase.
3)
The lease term is for a major part of the remaining economic life of the asset, unless the commencement date of the lease falls at or near the end of the underlying asset’s economic life.
4)
The present value of the sum of the lease payments and any residual value guaranteed67 by the
lessee not already reflected in the lease payments is equal to or greater than substantially all of
the fair value of the underlying asset.
5)
The underlying asset is of such a specialized nature that it is expected to have no alternative use
to the lessor at the end of the lease term.68
Note: The FASB has stated, in ASC 842-10-55-2, that one reasonable approach to assessing items “3”
and “4” in the finance lease classification guidelines is use of the following firm guidelines, which were
used in ASC 840, the former leasing standard, for classifying a capital lease.
•
A “major part” of the remaining economic life of the asset means seventy-five percent or more.
•
A “commencement date that falls at or near the end of the asset’s economic life” means a commencement date that falls within the last 25 percent of the total economic life of the asset.
•
“Substantially all of the fair value of the underlying asset” means ninety percent or more of the asset’s
fair value.
If the lessee decides to use any of the firm guidelines above, the lessee should apply them consistently
to the classification of all of its leases.
When none of the criteria for a finance lease are met, the lessee classifies the lease as an operating lease.
67
Per ASC 842-10-20 (Glossary), a guaranteed residual value is a guarantee made by a lessee to the lessor that the
value of the underlying asset returned to the lessor at the end of the lease will be at least a specified amount. When
there is a guaranteed residual value, the lessor transfers to the lessee the risk of loss if the value of the underlying asset
is less than the specified amount. Per ASC 842-10-55-35, if the lessor has the right to require the lessee to purchase
the underlying asset by the end of the lease term, the stated purchase price is included in the lease payments and that
amount is a guaranteed residual value.
68
Per ASC 842-10-25-2.
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2d) Accounting for Leases
Lease Recognition by the Lessee
Finance Lease Recognition by the Lessee
For a finance lease, the lessee is required to:
1)
Recognize a right-of-use asset and a lease liability at the commencement date of the lease 69 in
the lessee’s statement of financial position (balance sheet) at the present value of the lease payments not yet paid, discounted at the discount rate for the lease. The discount rate for the lease
is the rate implicit in the lease if that rate is readily determinable by the lessee. If the rate
implicit in the lease is not readily determinable, the lessee uses its incremental borrowing rate as
the discount rate for the lease obligation.70
The rate implicit in the lease is determined by the lessor.
Note: The lessee’s incremental borrowing rate is the rate of interest the lessee would have
to pay to borrow on a collateralized basis over a similar term an amount equal to the lease
payments in a similar economic environment.71
The cost of the right-of-use asset consists of:
2)
•
The amount of the initial lease liability.
•
Any payments made to the lessor before the commencement date of the lease.
•
Any initial direct costs72 incurred by the lessee.73
Recognize interest expense incurred after the commencement date on the lease liability and
separately recognize amortization of the right-of-use asset in the lessee’s income statement
and statement of comprehensive income (income statement).74
Note: The amount of interest expensed on the income statement is calculated based on the
principal amount of the lease liability still outstanding each period. Each period when a payment
is made, part is a payment of interest and part is the reduction of the lease liability.
3)
Recognize any variable lease payments75 not included in the lease liability in the period when the
obligation for those payments is incurred.76
4)
In the statement of cash flows, recognize repayments of the principal portion of the lease liability
as cash flows from financing activities and payments of interest on the lease liability and any
variable lease payments as cash flows from operating activities.
69
Per ASC 842-20-25-1.
70
Per ASC 842-20-30-1 through 30-3.
71
Per ASC 842-10-20 (Glossary).
72
“Initial direct costs” are incremental costs of a lease that would not have been incurred without the lease.
73
Per ASC 842-20-30-5.
74
Per ASC 842-20-25-5a.
75
Per ASC 842-20-20 (Glossary), variable lease payments are payments made by a lessee to a lessor for the right to
use an underlying asset that vary because of changes in facts or circumstances occurring after the commencement date
of the lease, other than the passage of time. Variable lease payments may be based on an index or rate, such as an
escalator based on the Consumer Price Index, or they may be based on performance or usage of the asset. However,
only variable lease payments that are based on an index or rate are included in the calculation of the lease payments
that determine the measurement of the lease liability and affect the lease classification, per ASC 842-10-30-5 and 306. The variable lease payments should be included at the level of the index or rate at the commencement date of the
lease. Any differences in the future payments due caused by changes in the index or rate are expensed in the period
incurred.
76
Per ASC 842-20-25-5b.
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2d) Accounting for Leases
CMA Part 1
Operating Lease Recognition by the Lessee
For an operating lease, the lessee is required to:
1)
Recognize a right-of-use asset and a lease liability at the commencement date of the lease in the
lessee’s statement of financial position (balance sheet). The right-of-use asset and the lease liability are measured the same way as they are measured for a finance lease.
2)
Recognize a single lease cost after the commencement date, calculated so that the total cost of
the lease (including amortization of the right-of-use asset and interest expense on the lease liability) is allocated on a generally straight-line basis over the term of the lease.77
3)
Recognize any variable lease payments not included in the lease liability in the period when the
obligation for those payments is incurred.78
4)
Recognize all lease payments as cash flows from operating activities in the statement of cash
flows.
Short-term Leases
For leases having a term of 12 months or less, the lessee may make an accounting policy election, by
class of underlying asset, not to recognize lease assets and lease liabilities. If a lessee makes such an
election, it should recognize the lease payments as expenses on a generally straight-line basis over the
lease term.79
However, the lease term used to determine qualification as a short-term lease may be longer than the
initial lease term. The lease term is defined in the Codification as:
The noncancelable period for which a lessee has the right to use an underlying asset, together
with all of the following:
•
Periods covered by an option to extend the lease if the lessee is reasonably certain to exercise that
option
•
Periods covered by an option to terminate the lease if the lessee is reasonably certain not to exercise that option
•
Periods covered by an option to extend (or not to terminate) the lease in which exercise of the
option is controlled by the lessor.80
Therefore, according to the definition of the lease term, if the lease includes an option to extend the term
of the lease that is reasonably certain of exercise by the lessee or an option to terminate it prior to its
termination date that is reasonably certain not to be exercised by the lessee, those options are included in
the lease term used to determine whether or not the lease qualifies as a short-term lease.
Example: A one-year lease that includes a renewal option that the lessee is reasonably certain to exercise cannot qualify as a short-term lease, and the lessee must record a right-of-use asset and a lease
liability.
77
Per ASC 842-20-25-6a.
78
Per ASC 842-20-25-6b.
79
Per ASC 842-20-25-2.
80
Per ASC 842-10-20 (Glossary).
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3) Equity Transactions
IFRS Notes:
Lease Classification by Lessees: Under U.S. GAAP, lessees classify leases as either finance leases or
operating leases. For both finance leases and operating leases, the lessee is required to recognize a
right-of-use asset and a lease liability. For a finance lease, the lessee recognizes amortization of the
right-of-use asset and separately recognizes interest expense and repayments of the principal portion
of the lease liability. For operating leases, the lessee recognizes a single lease cost after the commencement date, calculated so that the total cost of the lease (including amortization of the right-of-use asset
and interest expense on the lease liability) is allocated on a generally straight-line basis over the term
of the lease. The lessee may make an accounting policy election by class of underlying asset not to
recognize right-of-use assets or lease liabilities for short-term leases of 12 months or less and instead
to recognize the lease payments as expenses on a generally straight-line basis over the lease term.
Under IFRS, no formal classification between finance leases and operating leases exists for lessees. All
leases, other than leases accounted for under the exemptions that follow, are accounted for by recognizing a right-of-use asset and a lease liability. The lessee recognizes amortization of the right-of-use
asset and separately recognizes interest expense and repayments of the principal portion of the lease
liability.
Exemptions: Under IFRS, a lessee may elect not to apply the requirements to recognize a right-of-use
asset and lease liability for short-term leases and leases for which the underlying asset is of low value
and may instead recognize the lease payments as expenses either on a straight-line basis or on another
systematic basis if it is more representative of the pattern of the lessee’s benefit.
•
The election of the exemption for short-term leases is made by class of underlying asset.
•
The election of the exemption for leases for which the underlying asset is of low value can be made
on a lease-by-lease basis.
Measurement of the right-of-use asset by lessees: Under U.S. GAAP, the right-of-use asset at the
commencement of the lease is measured as the historical cost of the right-of-use asset to the lessee.
The historical cost does not change during the term of the lease, although it is amortized.
Under IFRS, alternative measurement bases are allowed for the right-of-use asset, including the revaluation model as permitted by IAS 16, Property, Plant, and Equipment.
3) Equity Transactions
Guidance in the Accounting Standards Codification® on accounting for owners’ equity is in ASC 505.
Owners’ equity, or shareholders’ equity, is the “balancing” element of the balance sheet. Assets represent
what the company owns, liabilities represent what the company owes to outside parties, and owners’ equity
represents what the company owes to the owners of the company. Regardless of the business’s form or
the total number of owners, those owners will most likely have a claim on some of the assets of the company, represented by the owners’ equity on the balance sheet. More formally, owners’ equity is defined as
the residual interest in the assets of an entity after deducting its liabilities. In theory, if the owners were to
liquidate the business, the owner’s equity represents the amount due to them after all of the assets are
liquidated and external debts are paid. However, assets are recorded at their historical value but would be
liquidated at the market value, and these two amounts are almost never the same.
The specific accounts a company has in the owners’ equity section of its balance sheet will depend upon
the form of the company. A sole proprietorship will have one capital account for the owner, whereas a
partnership will have a capital account for each partner.
Note: On the exam, “owners’ equity” and “shareholders’ equity” may be used interchangeably. Additionally, in this textbook “equity” may appear without the word “owners’” or “shareholders’” in front of
it.
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3) Equity Transactions
CMA Part 1
efham CMA
Corporate Shareholders’ Equity
The corporate balance sheet includes two main classifications of owners’ equity: contributed capital and
retained earnings.
1)
2)
Contributed capital consists of the assets put into the company by the owners in return for their
share of ownership of the company. The fair value of what is received in exchange for the shares,
whether cash or another asset, is recorded in two different equity accounts:
•
The capital stock account records the stated, or par, value of shares that have been sold. The
company will have different capital stock accounts for each different type of share that it has
issued.
•
The additional-paid-in-capital (APIC) account consists of the value received for the shares
that was over and above the stated, or par, value. A company may have a number of different
APIC accounts for either specific types of shares or specific transactions.
Retained earnings represent the undistributed profits of the company that were reinvested in
the company. These may also be called undistributed earnings.
Note: Owners’ equity also includes the balance of accumulated other comprehensive income, treasury
stock, and any non-controlling interests.
Accumulated other comprehensive income represents the accumulated balance of several specific types
of transactions that are not included in the income statement but are included in equity and adjust the
balance of equity, even though they do not flow to equity by means of the income statement as do
retained earnings.
Treasury stock represents issued shares that have been repurchased by the issuing corporation. The
accumulated balance in the Treasury Stock account is either the amount paid for issued shares that have
been repurchased or the par value of issued shares that have been repurchased. The treasury stock
account is a contra-equity account that reduces equity on the balance sheet.
Non-controlling interests arise when a company owns more than 50% of the outstanding common stock
of another company and therefore consolidates the financial statements of the subsidiary company with
its own but does not own 100% of the acquired company. The fair values of the partially-owned subsidiary’s assets are recorded in the asset section of the consolidated balance sheet at 100% of their fair
values. The ownership interests held by owners other than the parent are called non-controlling interests. Non-controlling interests are recorded in the equity section of the balance sheet, separately
from the parent’s equity, and they represent the claims that the non-controlling interests have on the
equity of the subsidiary.
Corporations may sell two general types of stock: common stock or preferred stock.81 The form and
type of stock depends upon the way in which the company registered the stock and the characteristics the
company has given to it.
Common Stock
Types of Common Stock
Common stock is classified according to whether or not it has a “par” value. Par value is the stated value
of each share of stock, although the par value does not impact the selling price of the stock. The par value
is assigned to the shares when they are registered and does not need to be any specific amount. In fact,
par value is usually a small amount.
81
It is possible for a company to have some type or class of stock that does not fall exactly into one of these two
categories.
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Section A
3) Equity Transactions
The par value of all shares issued represents the legal or stated capital of a company. Legal capital is the
portion of contributed capital that is required by statute to be retained in a business, and it cannot be
distributed as dividends. Because of the restriction against distribution of its legal capital, companies often
choose to have a very low par value on their stock.
When shares are first issued and sold, the par value of the shares is credited to the common stock account
and the rest of the cash received is credited to the additional paid-in capital-common stock (APIC-CS)
account.
The two types of common shares based on the existence or non-existence of a par value are:
•
Par (or Stated) Value. When stock has a par value, its par value is the maximum amount of a
shareholder’s personal liability to the creditors of the company. As long as the par value has been
paid in to the corporation by the shareholders in the original issue of the stock, the shareholders
obtain the benefits of limited liability, and their potential for loss is limited to the amount they paid
for their shares.
If stock is originally issued at less than its par value (at a discount), the owners of the stock may
be called upon to pay in the amount of the discount to creditors if the corporation is subsequently
liquidated and the creditors would have losses.
Note: In most states a corporation is not permitted to issue shares below par value.
•
No-Par Value. If stock has no par value, the legal capital is the total amount that is received when
the shares are issued, and the whole amount received is credited to the common stock account.
Issuing Common Stock
When common shares are issued for cash, the journal entry for the issuance of common or preferred shares
is:
Dr
Cash .............................................................. cash received
Cr
Common shares .............................. par value of shares issued
Cr
Additional paid-in capital – common shares .... balancing amount
The entry above is the basic journal entry for all sales of stock, including preferred shares. For preferred
shares, the names of the accounts are changed from “common shares” to “preferred shares” and from
“additional paid-in capital-common shares” to “additional paid-in capital-preferred shares.”
It does not matter if the sales price of the shares is above or below the fair value of the shares. Cash is
debited for the amount of cash received and the amount received is allocated between common shares and
APIC. The only amount that will ever go into the common shares or preferred shares account is
the par value of the shares sold.
Dividends
Dividends are the distribution of current profits or of the retained earnings of the company to its owners.
The declaration of cash dividends or property dividends reduces total stockholders’ equity as a result of
either the distribution of an asset (cash or other property) or the incurrence of a liability (dividends payable
if the dividend is not immediately distributed).
Dividends can be paid in a number of different forms, but the most common form is cash. Whichever form
the dividend takes, some asset of the company is distributed to the shareholders.
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CMA Part 1
1) Cash Dividends
A cash dividend is the most common form of dividend, and the journal entries for cash dividends are simpler
than those for other types of dividends. One of the important areas related to dividends is the dates governing payment because those dates determine when journal entries are made. The three dates related to
the payment of a cash dividend are listed below:
1)
The date of declaration is the day the board of directors formally declares the dividend. The
board also announces the date of record and the date of payment. On the date the dividend is
declared, the retained earnings account is debited, thus reducing the retained earnings balance,
and a liability, “dividends payable,” is credited. The amount of the journal entry is an estimated
amount because the exact number of shares to which the dividend will be paid may change between the date of declaration and the date of record.
The declaration of a dividend reduces working capital82 because the entry increases the company’s current liabilities.
The journal entry at the date of declaration is:
Dr
Retained earnings .............................................................. X
Cr
Dividends payable ................................................................ X
2)
The date of record is the date used to determine who actually will receive the dividend. Anyone
who owns shares on the date of record receives the dividend when it is paid. Theoretically, no
journal entry is made on the date of record because the entry on the date of declaration recognized
the liability and the reduction in retained earnings. However, a company may need to make an
entry on the date of record to adjust the estimate that was made on the date of declaration regarding the calculated total of dividends payable.
3)
The date of payment is the date on which the dividend is paid. When the dividend is paid, the
liability is eliminated and the cash account is decreased. The journal entry is:
Dr
Dividends payable .............................................................. X
Cr
Cash ................................................................................... X
Note: A fourth date is also important, though it does not require any journal entry to be made by the
company paying the dividend.
The ex-dividend date is important to shareholders who either buy or sell shares in the days immediately
preceding the date of record because time is required to process stock trades. The date when a stock
begins selling without the purchaser having the right to the dividend is called the ex-dividend date.
Investors buying the stock on or after the ex-dividend date do not receive the subsequent dividend—
the prior owner does.
Currently, the established standard in the U.S. for the ex-dividend date is one business day prior to the
date of record. In order to receive the dividend, a buyer of the stock must purchase the stock before
one business day prior to the date of record, because as of one day prior to the date of record, the stock
goes “ex-dividend.” In other words, in order to receive the dividend, the investor must already own the
stock on the ex-dividend day, and the ex-dividend day is one business day before the date of record.
For example, if the date of record is Thursday, January 11, the ex-dividend date is Wednesday, January
10, and the investor must purchase the stock no later than Tuesday, January 9 in order to receive the
dividend.
Therefore, the ex-dividend date rather than the record date actually determines who the recipients of
the dividend will be.
82
Working capital is calculated as current assets minus current liabilities.
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Section A
3) Equity Transactions
2) Liquidating Dividends
Liquidating dividends are dividends that are a return of capital rather than a return on capital. A liquidating dividend occurs when the dividend distributed is greater than the balance in retained earnings. Any
dividend paid in excess of the balance in retained earnings is classified as a liquidating dividend because it
is not a distribution of profits.
If the balance in the retained earnings account is zero or less than zero because the company has cumulative losses when the dividend is declared, the APIC account is reduced for the full amount of the
liquidating dividend. The journal entry for a dividend that is totally liquidating at the declaration date is:
Dr
APIC ....................................................... amount of dividend
Cr
Dividends payable ...................................... amount of dividend
When the dividend is paid, dividends payable is debited and cash is credited.
A dividend may be a partially liquidating dividend. When there is a balance in retained earnings but the
dividend declared is larger than that balance, the portion of the dividend in excess of the balance in retained
earnings is a liquidating dividend. The part of the dividend that is available in retained earnings is a normal
dividend and takes the retained earnings balance to zero. The portion that is liquidating is a reduction to
APIC. The declaration date journal entry is shown below:
Dr
Retained earnings ...................................................... to zero
Dr
APIC ........................................................ liquidating amount
Cr
Cash ......................................................... amount of dividend
3) Property Dividends
When a company distributes a property dividend, it is distributing an asset other than cash as the dividend.
For example, the company may distribute inventory, fixed assets, or shares in another company that it
holds. The fact that a company declares a property dividend does not mean that a company does not have
cash. A property dividend may be declared because the company is using its cash to finance an expansion
or some other investment opportunity.
When a company declares a property dividend, it restates to fair value as of that date the property it will
distribute and recognizes a gain or loss for the difference between the property’s fair value and its carrying
value.
Example: On July 1, Lemond Company declared a dividend consisting of common stock it owned in
Devery Corporation. The carrying value of the Devery stock on July 1 was $1,000,000 and the market
value of the stock on that date was $1,250,000. Lemond Company records the following journal entry
to recognize the gain and the property dividend declaration:
Dr
Equity investments ...................................................250,000
Cr
Dr
Gain .......................................................................... 250,000
Retained earnings .................................................. 1,250,000
Cr
Property dividends payable ....................................... 1,250,000
When the property dividend is distributed on August 1, Lemond records the distribution as follows:
Dr
Property dividends payable ..................................... 1,250,000
Cr
Equity investments .................................................. 1,250,000
Note: The net result of the property dividend on owners’ equity will be that owners’ equity will decrease
by the book value of the property distributed. In the preceding example, retained earnings will decrease
on the declaration date by the appreciated value of the property dividend ($1,250,000), and then when
the unrealized holding gain is closed to retained earnings, retained earnings will increase by the amount
of the gain ($250,000). The net result is that retained earnings decreases by the book value of the
property distributed ($1,000,000).
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CMA Part 1
Property Dividends for the Shareholder
When the shareholder receives the assets distributed in the property dividend (not when it is declared),
the shareholder recognizes dividend income at the fair value of the asset or assets received. The journal
entry is:
Dr
Asset received ....................................................... fair value
Cr
Dividend income .......................................................fair value
Question 31: Reese Corporation declared a property dividend on January 31 of 1,000 shares of its
investment in Alpha Corporation stock, payable February 15. The stock had a carrying value (cost) of
$75 per share and a market value of $100 per share on the date of declaration. The amount charged
to retained earnings as a result of this dividend declaration would be
a)
$25,000.
b)
$75,000.
c)
$100,000.
d)
$175,000.
(ICMA 2008)
Question 32: On December 1, Noble Inc.’s Board of Directors declared a property dividend, payable in
stock held in the Multon Company. The dividend was payable on January 5. The investment in Multon
stock had an original cost of $100,000 when acquired two years ago. The market value of this investment on December 1 was $150,000, on December 31 it was $175,000, and on January 5 it was
$160,000. The amount to be shown on Noble’s statement of financial position at December 31 as property dividends payable would be
a)
$100,000
b)
$150,000
c)
$160,000
d)
$175,000
(ICMA 2008)
4) Stock Dividends and Stock Splits
Guidance in the Accounting Standards Codification® on accounting for stock dividends and stock splits
is in ASC 505-20.
Stock Dividends
A stock dividend occurs when the company distributes a dividend in the form of additional shares. The
journal entry to record the stock dividend will transfer some amount from retained earnings to the common
stock and APIC accounts. The transfer from retained earnings is necessary because even though no cash is
distributed to the shareholders, some of the earnings of the company are now “owed” to the shareholders
in the form of shares as a result of the shares issued in the stock dividend. Also, the company now has
more shares outstanding, and the increased number of shares outstanding needs to be recognized and
recorded. Recognition and recording are accomplished by reducing retained earnings and increasing common stock and APIC. Because all the changes take place within the equity section of the balance sheet, the
total value of the company’s equity is not changed by a stock dividend, although the amounts in the various
equity accounts are redistributed.
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Section A
3) Equity Transactions
The journal entry required depends on the size of the dividend.
Small Stock Dividend
A small stock dividend is usually less than 20-25% of the total shares outstanding.83
Shares issued in a small stock dividend are valued at the fair value of the shares on the date of declaration:
Dr
Retained earnings ................... fair value of shares to be issued
Cr
Common shares – issuable as a dividend ....... par value of shares
Cr
Additional paid-in capital – common shares ..... balancing amount
The journal entry above is recorded on the date of declaration and no adjustment to the amount is
made for any change in the fair value of the shares between the declaration date and the date of
issuance.
Note: Even if the shares of stock will be distributed at a later date, no dividend payable is set up for
a stock distribution. Rather, the credit is to an account in the equity section called common shares –
issuable as a dividend in the equity section of the balance sheet or some similar name. Thus, no
liability is recorded on the balance sheet for a stock dividend.
On the date the small stock dividend is distributed and the stock is issued, the following entry is recorded:
Dr
Common shares – issuable as a dividend ..... par value of shares
Cr
Common stock ........................................... par value of shares
Large Stock Dividend
A large stock dividend is usually more than 20-25% of the total shares outstanding.
If the stock dividend is a large stock dividend, the journal entry is equal to the par value of the shares:
Dr
Retained earnings ..................................... par value of shares
Cr
Common shares – issuable as a dividend ....... par value of shares
When the stock is issued, the common shares issuable as a dividend account is debited and the common
stock account is credited for the par value of the shares issued.
Question 33: Griffey Corp. declared a 7% stock dividend on its 10,000 issued and outstanding shares
of $3 par value common stock, which had a fair value of $6 per share before the stock dividend was
declared. This stock dividend was distributed 90 days after the declaration date. By what amount did
Griffey’s current liabilities increase as a result of the stock dividend declaration?
a)
$0
b)
$700
c)
$2,100
d)
$4,200
(HOCK)
83
Per ASC 505-20-25-3, “The point at which the relative size of the additional shares issued becomes large enough to
materially influence the unit market price of the stock will vary with individual entities and under differing market conditions and, therefore, no single percentage can be established as a standard for determining when capitalization of
retained earnings in excess of legal requirements is called for and when it is not. Except for a few instances, the issuance
of additional shares of less than 20 or 25 percent of the number of previously outstanding shares would call for treatment
as a stock dividend . . .”
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3) Equity Transactions
CMA Part 1
Question 34: Bertram Company had a balance of $100,000 in retained earnings at the beginning of the
year and $125,000 at the end of the year. Net income for this time period was $40,000. Bertram’s
statement of financial position indicated that dividends payable had decreased by $5,000 throughout
the year, despite the fact that both cash dividends and a stock dividend were declared. The amount of
the stock dividend was $8,000. When preparing its statement of cash flows for the year, Bertram should
show cash paid for dividends as
a)
$20,000
b)
$15,000
c)
$12,000
d)
$5,000
(ICMA 2014)
Stock Splits
A company generally splits its stock because its price per share has become too high and investors may be
hesitant to buy it. To reduce the share’s market price per share and make the stock more attractive as an
investment, the company essentially cuts its shares into smaller pieces. As a result, more shares are outstanding and each share is worth a lower market price. For example, in a 2-for-1 stock split, the owner of
each share becomes the owner of twice as many shares, but each share will have a market price that is
half what it was before the split. Thus, the total fair value of each investor’s holdings will be essentially
unchanged after the split.
In a stock split, the par value of each share of the stock is also reduced in the same ratio. For example,
if before any split the company had 1,000,000 shares outstanding with a par value of $1 each, the balance
in the company’s common stock account would have been $1,000,000. After a 2-for-1 stock split, the
balance in the common stock account would remain $1,000,000, but it would instead represent 2,000,000
shares with a par value of $0.50 each.
When a company splits its stock, no journal entry is made. Instead, a memo entry is made to demonstrate
that (for a 2-for-1 split, for example) twice as many shares are now outstanding and the par value of each
share is half what it was before, but the balances in all of the shareholders’ equity accounts on the balance
sheet remain unchanged.
Note: A company can also effect a reverse stock split. In a reverse stock split, the company consolidates shares so that it has fewer shares. As a result, each share is worth more. In a 1-for-2 reverse
stock split, for example, the owner of two shares becomes the owner of one share, but the market value
of that one share will be worth twice as much as one share was worth before the reverse stock split, and
the investor’s total market value will be unchanged.
A company might perform a reverse stock split if the market price of its shares has dropped so low that
its stock is in danger of being de-listed from the stock exchange or exchanges on which it trades. The
reverse stock split doubles the market price of a share of the stock.
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Section A
3) Equity Transactions
Retained Earnings
The retained earnings account is the final destination for all income statement (revenue and expense)
accounts. The retained earnings account represents the accumulated undistributed income of the corporation from its inception.
In the year-end close, net after-tax income for the year is moved to retained earnings, so retained earnings
increases by the amount of the after-tax net income. The retained earnings account is decreased when
dividends are paid. Retained earnings is a permanent balance sheet account, so the balance in it accumulates from year to year.
The balance in the retained earnings account represents all of the profits of the company since it started
minus any dividends declared and amounts transferred into paid-in-capital accounts.
Treasury Stock
Guidance in the Accounting Standards Codification® on accounting for treasury stock is in ASC 505-30.
Treasury stock is shares of a company that have been sold to investors and later reacquired by the company. The company has become a holder of its own shares and may either retire the shares or hold them
for sale at a later time. Treasury stock is the reacquired shares that have not yet been reissued or retired.
A company may purchase treasury shares for a number of reasons:
•
To temporarily provide a market for its shares.
•
To reconsolidate ownership.
•
As an investment if the company thinks its shares are undervalued.
•
To use the shares for a stock dividend, to re-sell them, or to reissue them as share-based payment.
When a company purchases treasury stock, it recognizes the treasury stock in its financial statements by
debiting the treasury stock account. The treasury stock account is not an asset, nor is it a liability or equity.
Treasury stock is a type of account all by itself. It is usually shown on the balance sheet in owners’ equity
as a reduction of owners’ equity, so it is a contra-equity account.
Classification of Shares
On the balance sheet and in more detail in the notes to the financial statements, shares will be disclosed
by giving the number of shares authorized, issued, and outstanding.
Authorized Shares
The number of authorized shares is the maximum number of shares the company can issue. The number
of authorized shares is initially specified in the company’s charter or articles of incorporation and can be
changed only by filing an amendment to the articles of incorporation with the state where the company is
incorporated. Such an amendment normally requires prior shareholder approval. Authorized shares can be
issued or unissued, or outstanding or not outstanding. Generally, a company has a much greater number
of shares authorized than are issued or outstanding, which gives the company flexibility to issue more stock
as needed.
The number of authorized shares is not affected by stock dividends, stock splits, or treasury share
transactions. If a company wants to issue new stock, split its stock, declare a stock dividend, or issue
stock to its senior management under stock option grants, and if the number of resulting new shares would
exceed the number of authorized but unissued shares, the company must seek shareholder approval to
increase the number of authorized shares and then file the necessary amendment to its articles of incorporation.
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3) Equity Transactions
CMA Part 1
Issued Shares
The number of issued shares is the number of shares that have been sold to investors at any point in the
past and that have not been retired. Issued shares may currently be held either by others or by the company
itself as treasury shares. The number of issued shares is increased by both stock splits and stock
dividends. The number of issued shares is not affected by treasury share transactions. Treasury
stock, or shares that have been issued and later repurchased by the issuer, continue to be issued shares,
but they are not outstanding shares. Thus, treasury shares are issued but not outstanding shares.
Outstanding Shares
The number of outstanding shares is the number of shares that are currently owned by other parties.
Outstanding shares will be equal to the number of issued shares minus the number of shares held as
treasury shares by the company itself. The number of shares outstanding is increased by both stock
splits and stock dividends, decreased by treasury share purchases, and increased if treasury
shares are subsequently re-sold to investors.
The following table summarizes which classifications of shares stock splits, stock dividends, and treasury
shares affect.
Stock Split
Stock Dividend
Treasury Shares
Authorized
No
No
No
Issued
Yes
Yes
No
Outstanding
Yes
Yes
Yes
Note: Treasury shares do not receive dividends, do not get to vote, and are not classified as
outstanding. Treasury shares are issued but are not outstanding. If they are later resold or reissued,
those shares will again become issued and outstanding.
Note: Treasury stock held by the company is stock that is authorized and issued but is not outstanding. Stock that has been retired by the company is authorized but is not issued and is not
outstanding.
Thus, both treasury stock and retired shares are authorized shares that are not outstanding. The difference between treasury stock and stock that has been retired is that treasury stock is included in issued
shares (though it is not presently outstanding), whereas retired stock is not included in issued shares;
it is unissued shares.
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Section A
4) Income Statement
4) Income Statement
4a) Revenue Recognition
Note: Guidance in the Accounting Standards Codification® on revenue recognition is in ASC 606.
The FASB and the IASB evaluated the revenue recognition process for a number of years before a new
standard was announced in 2014, which was needed because the topic of when a transaction becomes
revenue has become increasingly complex in recent years. Many times, a sale includes multiple components
and the seller’s obligations with respect to the various components are fulfilled at different times. Additionally, under previous guidance the same transaction might be accounted for differently by different entities
because of industry-specific guidance. Under the new guidance, principles for recognizing revenue are consistent regardless of industry.
The Objective
The objective of the revenue recognition standard in ASC 606 is to provide a single, comprehensive
revenue recognition model for all contracts with customers to improve comparability across industries,
jurisdictions, and capital markets.
The Principle
The revenue recognition principle is to recognize revenue in the accounting period in which the performance obligation is satisfied. A performance obligation is satisfied when the customer obtains control of
the asset, and the asset is the good or service transferred to the customer. Therefore, revenue should
be recognized to depict the transfer of goods or services to customers in an amount that reflects the
consideration that the company expects to be entitled to in exchange for those goods or services. 84
The new revenue recognition standard is principles-based rather than rules-based. That means
its application will require more management judgment regarding how to handle specific situations. However, once the judgments relating to specific situations have been made, they must be applied consistently
within and across different units of the company. They may not vary according to the judgment of an
individual accountant or operating unit within the company.
Contract Assets and Liabilities
The revenue model focuses on recognizing revenue when control transfers to the buyer. The model is
based on an asset and liability approach that recognizes revenue based on changes in control of assets
and liabilities.
Contract Assets
Contract assets are either unconditional or conditional.
Unconditional contract assets are unconditional rights to receive consideration because the company
has satisfied its performance obligation to a customer and thus recognizes revenue. Unconditional rights to
receive consideration should be reported as receivables on the balance sheet.
Dr
Accounts receivable ........................................ Amount of sale
Cr
84
Sales revenue .................................................. Amount of sale
ASC 606-10-05-3.
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4a) Revenue Recognition
CMA Part 1
At the same time, the company records cost of goods sold:
Dr
Cost of goods sold ................................... Cost of product sold
Cr
Inventory ..................................................Cost of product sold
Conditional contract assets are conditional rights to receive consideration because the company has
satisfied one of, or some of, the performance obligations in the contract and thus recognizes revenue for
the performance obligations that are satisfied, but it must satisfy another performance obligation or obligations before it can invoice the customer. Conditional rights to receive consideration should be reported
on the balance sheet as contract assets.
Dr
Contract asset ............................ Price of obligation A satisfied
Cr
Sales revenue ............................... Price of obligation A satisfied
When the company satisfies its complete performance obligation, invoices the customer, and reports the
remainder of the performance obligation satisfied as revenue, it also reduces the contract asset and reports
the full contract obligation as a receivable:
Dr
Accounts receivable ....................... Price of obligations A and B
Cr
Contract asset ........................................... Price of obligation A
Cr
Sales revenue ............................................ Price of obligation B
Contract Liabilities
A contract liability arises when a company receives consideration from the customer before it transfers
goods or services. The contract liability represents the company’s obligation to transfer the goods or services. The consideration received in advance of fulfillment is recorded as a contract liability.
Dr
Cash ........................................................... Amount received
Cr
Contract liability ............................................. Amount received
When the performance obligation is satisfied, the company records the revenue:
Dr
Contract liability ........................................... Amount received
Cr
Sales revenue ................................................ Amount received
The company also records cost of goods sold at the same time as it records the revenue:
Dr
Cost of goods sold ................................... Cost of product sold
Cr
Inventory ..................................................Cost of product sold
Names for Contract Assets and Contract Liabilities
ASC 606 refers to “contract assets” and “contract liabilities.” However, a company may use other terms for
contract assets and contract liabilities in its statement of financial position, as appropriate, as long as the
terms used provide sufficient information to enable a user of the financial statements to distinguish between
receivables (unconditional contract assets) and contract assets that are conditional.85
85
ASC 606-10-45-5.
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Section A
4a) Revenue Recognition
Five Steps to Revenue Recognition
The new revenue recognition standard includes five steps:
1)
Identify the contract with a customer.
1)
Identify the separate performance obligations in the contract.
2)
Determine the transaction price.
3)
Allocate the transaction price to the separate performance obligations in the contract.
4)
Recognize revenue when or as each performance obligation is satisfied.
A particular transaction may not require all five steps to be completed, and the steps may not always need
to be applied in the order above. The revenue standard is not organized according to the five steps, but the
five steps are provided as a methodology for companies to use to determine how to account for a given
transaction.
Following are each of the steps of the revenue recognition process in more detail.
1) Identify the Contract
Identifying a contract means assessing whether the contract is within the scope of ASC 606 and whether it
meets the criteria for contracts to be accounted for under the Standard.
ASC 606 applies to all revenue transactions as long as a valid contract exists, with the exception of several
items listed in ASC 606-10-15-2, including leases, insurance contracts, various types of financial instruments such as investment securities and derivatives, and some nonmonetary exchanges. Therefore, the
first requirement is to determine whether the contract is within the scope of Topic 606 or whether it is
excluded. After determining that a contract is not specifically excluded, the company determines whether
the contract meets the criteria for a contract to be accounted for under the Standard.
The FASB Accounting Standards Codification® Glossary in ASC 606-10-20 defines a contract as “an agreement between two or more parties that creates enforceable rights and obligations.” A company should
account for a contract under ASC 606 only when the contract
1)
Creates enforceable rights and obligations and
2)
Meets all of the following criteria:
a.
The parties have approved the contract and are committed to perform their obligations under
the contract. The approval may be oral, in writing, or in accordance with other customary
business practices.
b.
The rights of each party regarding the goods or services to be transferred can be identified.
c.
The payment terms for the goods or services to be transferred can be identified.
d.
The contract has commercial substance (that is, the risk, timing, or amount of future cash
flows of the company will change as a result of the contract).
e.
It is probable86 that the company will be able to collect substantially all of the consideration
that it is entitled to receive for the goods or services that will be transferred to the customer
under the contract. This assessment of collectibility must include an assessment of the customer’s credit risk—the customer’s ability to pay and intent to pay. The assessment of the
customer’s credit risk is an important part of determining whether a contract is valid. 87
86
U.S. GAAP defines “probable” as “likely to occur,” generally meaning a 75% to 80% probability of occurrence.
87
ASC 606-10-25-1.
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4a) Revenue Recognition
CMA Part 1
Note: A valid contract to be accounted for under ASC 606 exists only if it creates enforceable rights and
obligations and meets the five conditions above.
It is important to understand that the revenue recognition guidance in ASC 606 is not limited to business
transacted under formal written contracts, nor is it limited to long-term contracts. Business such as longterm construction of an asset is usually transacted on the basis of a formal contract that involves progress
payments made by the customer, but a valid contract can be written, oral, or simply implied by the entity’s
customary business practices. The performance obligations in a contract can be satisfied at a point in time
or over time. For example:
•
A valid contract can be represented when a customer approaches a cashier in a retail establishment
and pays for a purchase. The performance obligation in such a contract is satisfied at a point in
time.
•
A valid contract can be represented by an order for goods to be shipped that is received from a
customer through any of a variety of means and includes payment by credit card, on account after
receiving the invoice, or by some other method such as cash.
•
A valid contract can be represented by a long-term contract, which can be satisfied at a point in
time or over time. Long-term contracts can be construction contract but can also be, for example,
contracts to provide services for an extended period. If the customer obtains control of the asset
as the asset is being constructed, the performance obligations in the contract are satisfied over
time. If the customer obtains control of the asset only at the completion of the contract, the performance obligation is satisfied at a point in time.
2) Identify the Separate Performance Obligations in the Contract
A performance obligation is a promise in a contract with a customer to transfer a good or service to that
customer. A contract may contain only one performance obligation or it may contain multiple separate and
distinct performance obligations. Each distinct performance obligation needs to be identified within the
contract.
Identifying the performance obligation or obligations involves two parts:
1)
Identify the promises in the contract, including all promised goods or services or bundles of
goods or services. A written or oral contract may contain both explicit promises and implicit promises. Promises can be implied by the customary business practices of the industry, the entity’s
published policies, the company’s marketing materials, or oral representations made by the company, if those implied promises create a reasonable expectation on the part of the customer that
the entity will transfer a good or service to the customer. A customer’s expectation may include
things like customer loyalty points granted or other promises made such as a period of free maintenance offered by a car dealership with the purchase of a new car.
2)
Identify the contract’s performance obligations by determining which of the promises are
performance obligations that should be accounted for separately. If a promised good or service is
distinct, it represents a separate performance obligation.
A distinct good or service is (a) one the customer can benefit from either on its own or together
with other resources readily available to the customer and (b) one for which the company’s promise
to transfer the good or service to the customer is separately identifiable from other promises in
the contract. For instance, if the contract is a retail sales transaction, each of the items purchased
by the customer that is separately identifiable is a separate performance obligation. Free items
promised are also performance obligations. However, administrative tasks such as activating a
membership or enrolling a customer for a purchased service are not performance obligations. 88
88
ASC 606-10-25-14 through 25-22.
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3) Determine the Transaction Price
The transaction price is the amount of consideration that the company expects to be entitled to receive in
exchange for transferring the promised goods or services to the customer, and it can include fixed amounts,
variable amounts, or both. The transaction price may be significantly different from the contractual price.
For example, the transaction price excludes any amounts that the company collects on behalf of other
parties such as sales tax, if the company makes an accounting policy election to exclude from the measurement of the transaction price all taxes assessed by a governmental authority that are collected by the
company from a customer and complies with the accounting policy disclosure requirements in ASC 235-1050-1 through 50-6.89
The company should take into account the effects of any of the following that exist:
•
Variable consideration. Whenever any part of or all of the consideration is variable, the company
must estimate the amount it actually expects to be entitled to receive, and that amount may be
different from the contract price. For instance:
o
A portion of the consideration may be variable because it is dependent on meeting a requirement such as a deadline in order to receive a performance bonus.
o
The amount
because the
contract. In
concession
of consideration the company expects to be entitled to could also be variable
company expects to accept an amount that is less than the price stated in the
other words, the company may expect that it will offer the customer a price
outside of its initial contract terms.
The variable consideration can be estimated by either of two methods:
o
The expected value method: The sum of the probability-weighted amounts within a range of
possible amounts.
o
The most likely amount method: The single most likely amount within the range of possible
amounts.
The company recognizes the variable consideration only to the extent it is probable that a significant reversal in the amount of revenue recognized will not occur when the uncertainty associated
with the variable consideration is resolved. Furthermore, at the end of each accounting period, the
company must update the estimated transaction price to represent any changes in circumstances.90
•
•
Any significant financing components. If the customer will make payment over a period
greater than one year, the consideration includes a financing component that should be accounted
for using time value of money concepts and the transaction price should be adjusted.91 When the
contract includes a significant financing component, revenue from the contract and a loan receivable should be presented in the financial statements. The revenue amount should be the
present value of the consideration, discounted at an interest rate that reflects inflation and
the credit risk, including the credit characteristics of the buyer and any secondary repayment
sources.
o
The contract revenue is recognized once a performance obligation is satisfied.
o
The interest income on the financing component is recognized separately in the income statement as interest income over the financing period.92
Noncash consideration. Any noncash consideration such as goods, services, or common stock
that has been promised as payment should be measured at its fair value. If the fair value of the
89
ASC 606-10-32-2 and 32-2A.
90
ASC 606-10-32-5 through 32-10 and 606-10-32-14.
91
ASC 606-10-32-15.
92
ASC 606-10-32-15 through 32-20.
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consideration varies, for example because the market price of the common stock the company is
entitled to receive varies, the measurement date for the noncash consideration is the date of the
contract inception, that is, the date at which all of the criteria for a valid contract are met.
If the company is not able to determine the fair value of the noncash consideration that has been
promised, it should estimate the selling price of the noncash consideration and use that amount
as the revenue from the noncash consideration.
Noncash consideration may be materials, equipment, or labor that the customer provides to facilitate the company’s fulfillment of the contract. If such consideration is provided by the customer,
the company accounts for the contributed goods or services as noncash consideration if the company obtains control of the contributed goods or services.93
4) Allocate the Transaction Price to the Performance Obligations
After the contract has been identified and the performance obligations and amount of consideration have
been determined, the company must allocate the transaction price to the individual performance obligations
if the contract contains more than one performance obligation.
The allocation is based on the fair value of each performance obligation, and the best indicator of the fair
value of each performance obligation is its standalone selling price. Therefore, the company shall allocate
the transaction price to each performance obligation identified in the contract by determining the standalone
price for each individual performance obligation and then allocating the contract price over those obligations
based on the relative standalone price of each component.
If a discount is offered to the customer, for example when a bundle of goods or services is sold at a lower
price than the total price of the individual items in the bundle, the discount should be allocated proportionally based on the relative standalone selling prices of the individual goods or services in the bundle.
If, during the performance of the contract, the price of the contract changes, the change in the price should
be allocated to the individual components on the same basis as the contract price was originally allocated,
even if standalone selling prices of one or more of the performance obligations have changed. 94
Note: Returning to the matter of shipping and handling activities from Step 2: When goods are shipped
FOB Shipping Point, the goods belong to the customer from the moment the seller gives them to the
shipping company, and thus the customer obtains control of them at the shipping point. Thus, the shipping and handling activities will be performed after the customer obtains control of the goods, so the
shipping and handling activities are promises to the customer and may be separate and distinct performance obligations. The company can account for the shipping and handling activities as separate
performance obligations, or the company can make a policy decision to account for all shipping and
handling activities as fulfillment activities.
If management chooses to account for the shipping and handling activities as separate performance
obligations, a portion of the revenue received from each sale is allocated to the shipping and handling
activities.
93
ASC 606-10-32-21 through 32-24. Recall that the criteria for a valid contract are that it creates enforceable rights
and obligations and in addition meets all of the following: (1) The parties to the contract have approved the contract and
are committed to its performance; (2) The entity can identify each party’s rights regarding the goods or services to be
transferred; (3) The entity can identify the payment terms for the goods or services to be transferred; (4) The contract
has commercial substance; and (5) It is probable that the entity will collect substantially all of the consideration to which
it will be entitled in exchange for the goods or services that will be transferred to the customer.
94
ASC 606-10-32-31 through 32-41.
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Example: ABC Industries ships an order FOB Shipping Point for 1,000 widgets to XYZ Corporation on
December 31, the end of ABC’s fiscal year. ABC charges $1,000 for the widgets and does not add a
charge for shipping them to XYZ (in other words, shipping is “free” to the customer).
If ABC accounts for shipping services for goods shipped FOB Shipping Point as separate performance
obligations, ABC must allocate the $1,000 revenue from the sale between the widgets and the shipping
services. The portion of the revenue allocated to the widgets is recognized on December 31, because
that is when control is transferred to the customer. However, the portion of the revenue allocated to the
shipping will be recognized as the services occur (that is, as the performance obligation is satisfied),
most likely over the days the product is in transit. Since shipping occurred on the last day of the fiscal
year, most of the revenue allocated to shipping will be revenue of the next fiscal year. The shipping costs
paid by ABC will be costs of the next fiscal year.
If ABC makes a policy decision to account for shipping services for goods shipped FOB Shipping Point as
fulfillment activities rather than as promised services and performance obligations, then ABC recognizes
the entire amount of the $1,000 revenue to which it is entitled when the product is shipped on December
31. The company also needs to accrue its costs related to the shipping as of December 31.
Probably most companies will choose to make the policy decision to recognize shipping and handling activities performed after the customer obtains control of the goods (that is, when the goods are shipped FOB
Shipping Point) as fulfillment activities and thus will recognize revenue for the shipping when the product
is shipped.
Note that whenever goods are shipped FOB Destination, shipping and handling activities are always fulfillment activities and revenue for the shipping and handling is recognized upon shipment, so no policy election
is needed.
5) Recognize Revenue When or As Each Performance Obligation is Satisfied
Revenue should be recognized when or as the entity satisfies a performance obligation. Generally, a performance obligation is considered satisfied when the promised good or service (that is, an asset) has
been transferred to the customer. An asset is transferred when or as the customer obtains control of
the asset.
A customer has control of an asset when it has the ability to
1)
Direct the use of the asset, and
2)
Obtain substantially all of the remaining benefits of the asset.
Special Revenue Recognition Issues
Several special situations are covered by ASC 606. The situations covered that are relevant for the CMA
Exam are:
A. Contract with a Right of Return
B. Consigned Goods
C. Long-term Contracts
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A. Contract with a Right of Return
If a contract with a customer provides for the right to return goods for a refund or to obtain a refund for
services, the contract consideration is variable and the contract’s transaction price should exclude the
consideration related to products expected to be returned or amounts expected to be refunded. The company should recognize revenue from the contract at the amount it expects to be entitled to receive, which
is the revenue only for goods or services not expected to be returned and refunded.95
Rather than adjusting the journal entries recording sales revenue, accounts receivable, cost of goods sold,
and inventory for each individual sale, companies usually record revenue and accounts receivable for such
sales at their gross amounts and record returns when they occur without reference to any adjustments. At
the end of each reporting period, they analyze the accounts and record adjusting entries to reflect estimated
returns and allowances. At the end of the next reporting period, they reverse the previous adjusting entries
and recalculate and record the needed adjusting entries for that reporting period. That simplifies the process
while still achieving the FASB’s objective of reporting accounts receivable and sales revenue at the amount
the company is entitled to receive while reflecting in cost of goods sold and the reduction to inventory the
costs related only to sales revenue the company estimates it is entitled to receive.
B. Consigned Goods
Consigned goods were covered in Topic C, Inventory. In Topic C the coverage was only about what goods
are included in inventory. Here, the revenue recognition issues of consigned goods are covered.
Consignment involves an entity shipping goods to a distributor while retaining control of the goods until a
predetermined event occurs. Because control has not passed to the consignee, the consignor does not
recognize revenue upon shipment or delivery to the consignee. The consignor recognizes revenue only
when control transfers. Usually the transfer of control occurs and thus the revenue is recognized when the
goods are sold to the final customer.
The two main points in respect to revenue recognition and consigned goods are:
1)
The consignor recognizes revenue for the entire selling price for which the consignee sells
the goods, even if some of it is paid to the consignee as a commission.
2)
The consignee recognizes as revenue any commission that it is entitled to receive only when the
goods are sold. The commission will be treated as a selling expense by the consignor.
Following are the journal entries that both the consignor and consignee will record in respect to the consigned goods.
Accounting by the Consignor
When the goods are sent to the consignee the consignor makes the following entry:
Dr
Goods out on consignment96 ................................original cost
Cr
Inventory ............................................................. original cost
Freight costs paid by the consignor to transfer the goods to the consignee are inventoriable costs. The entry
to record the shipping charges is:
Dr
Costs out on consignment ..................................... freight cost
Cr
Cash ..................................................................... freight cost
95
ASC 606-10-32-10.
96
“Goods out on consignment” is essentially a second inventory account and its balance is reported as a current asset.
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The next entry the consignor makes will be made after a good is sold and the cash is received from the
consignee. At this point, the consignor needs to make the following entry:
Dr
Cash ............................................................... cash received
Dr
Commission expense (if applicable) ....................... commission
Dr
Cost of goods sold ........................................... inventory cost
Cr
Revenue from consignment sales .............. the selling price
Cr
Goods out on consignment.................................. inventory cost
Note that the revenue and cost of goods sold are recognized only after the item has been sold to the final
customer.
Accounting by the Consignee
The consignee makes entries only when it sells some of the product held on consignment. At that time, the
consignee recognizes the cash received from the buyer, a payable to the consignor, and any commission
revenue that it is entitled to receive.
Dr
Cash ............................................................... total received
Cr
Payable to consignor ........................ to be remitted to consignor
Cr
Commission revenue ............................... commission entitled to
When the amount due to the consignor is paid, the payable is reduced.
Dr
Payable to consignor .............................. remitted to consignor
Cr
Cash ..................................................... remitted to consignor
Note: The main point to remember in respect to revenue recognition and consigned goods is that the
amount of revenue recognized by the consignor is equal to the total sales price. Any commission or other
fees are treated as an expense, not as a reduction of the revenue from the sale.
C. Accounting for Long-Term Contracts
Some contracts include performance obligations that require a period of time to satisfy. Under ASC 606,
the obligation is satisfied when or as the customer obtains control of the asset. In some cases, the customer
obtains control of the asset at a point in time, usually when all the performance obligations in the contract
have been satisfied, even though the contract requires time to perform. In other cases, the customer
obtains control over time, as the performance obligations in the contract are being satisfied.
The most common situation for long-term contracts is construction contracts, but long-term contracts also
include government contracts (such as for the military), contracts for the construction of very large items
such as airliners and space exploration equipment, or contracts for a group of assets such as office furniture
to be delivered over a period of time.
Recall that according to Topic 606, a company satisfies a performance obligation over time and recognizes
the revenue (and costs) over time if at least one of the following three criteria is met:
1)
The customer simultaneously receives and consumes the benefits provided by the company’s performance as the company is performing its obligations under the contract.
Example: An annual contract to provide a service such as office cleaning or grounds maintenance. If the benefits of the contract are transferred to the customer on a straight-line basis
throughout the contract, the customer is invoiced periodically and the revenue is recognized as
the invoices are issued, usually monthly. Costs are recognized as they are incurred.
2)
The company’s performance creates or enhances an asset such as work in process that the customer controls as the work is being done.
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Example: A contract to build a structure on land the customer already owns. Invoices for progress payments are usually issued to the customer, but the amounts of the progress billings do
not necessarily represent the progress toward satisfaction of the performance obligations in the
contract.
3)
The company’s performance does not create an asset with an alternative use to the company, and
the company has an enforceable right to payment for performance completed to date.97
Example: Any asset manufactured or built to the customer’s specifications that could not be
sold to another customer without significant loss to the company if the customer terminates the
contract prior to its completion for any reason other than the failure of the company to perform.
In situations 2) and 3) above, the accounting is done in a manner similar to what was called the percentageof-completion method in legacy GAAP, although that term is not used in ASC 606. The term is now “over
time.”98
Note: There are important differences between over-time revenue and profit recognized on a long-term
contract and the legacy percentage-of-completion method. For example, a contract might be 50% complete as to costs but less than 50% complete with respect to the elements in the contract to be satisfied.
Since ASC 606 is principles-based rather than rules-based, it may not be appropriate to record 50% of
the contract revenue as would typically be done under use of the percentage-of-completion method in
legacy GAAP. Management judgment is necessary.
If the long-term contract does not meet any one of the three criteria for recognizing revenue over time,
the company recognizes revenue and gross profit only when the performance obligation or obligations in
the contract have been satisfied and the customer has obtained control of the asset or assets, in other
words, at a point in time. The accounting is similar what was formerly called the completed contract method,
though again, that term is not used in ASC 606. The term is now “point in time.”
Point-in-Time Recognition
When a long-term contract does not meet any of the criteria for over-time recognition, the contract is
recognized on the company’s balance sheet as it is being satisfied, but the revenue, cost, and gross profit
are recognized at a point in time—when the customer has obtained control of the asset. The amount of
gross profit recognized when the customer obtains control of the asset equals the difference between the
contract price (the revenue) and the total cost to complete the project.
However, if a loss is projected on the contract at any point as it is being satisfied, that loss must be
recognized in full immediately, consistent with guidance in ASC 450-20, Loss Contingencies.
97
ASC 606-10-25-27.
98
The term “percentage-of-completion” may be used if that methodology conforms to the determination of transfer of
control and complete satisfaction of the performance obligation in accordance with ASC 606. However, the term “percentage-of-completion” is no longer codified in U.S. GAAP.
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Recognition of Losses
At the end of each reporting period, the company determines the final estimated gross profit or loss on the
contract as follows:
Contract price
−
−
=
Costs actually incurred to date
Costs estimated to be incurred in the future
Estimated profit (loss) on the project
If the cost and gross profit estimates made at the end of the reporting period indicate that a loss on the
entire contract will result, the company must recognize the entire estimated contract loss in the
current period.
Note: When point-in-time revenue is recognized on a contract:
•
No revenue or profit is recognized until the performance obligation is satisfied.
•
However, an estimated loss on the contract as a whole (projected to the point at which the customer
will obtain control of the asset) should be recognized in the period when it becomes known.
Journal entries for recognizing an estimated loss on a point-in-time contract are covered later in this topic.
Recognizing the Incurrence of Contract Costs
The costs of construction incurred during the work-in-process period are debited as they are incurred to a
contract assets account, construction in process (CIP). The CIP account is used whether the costs are
paid for in cash, on account, as accrued wages, or other types of costs.
Dr
Construction in process (CIP) ...............................................x
Cr
Cash (or accounts payable or accrued wages, as appropriate) .... x
The CIP asset account is in some ways similar to a work-in-process inventory account in a manufacturing company. However, the CIP account is different from a work-in-process inventory account in an
important way: the costs in the CIP account do not move to finished goods and then to cost of goods sold
as the costs in a WIP inventory account do. Instead, the CIP account is a temporary “holding” account.
Note: For a given contract, the CIP asset account may be a current asset or a non-current asset, or
both, depending on the facts and circumstances of the contract with the customer.
Recognizing Invoice Issuance
Invoices are generally sent periodically to the client as work progresses on the contract because progress
payments are usually required even though the revenue will not be recognized until the point in time when
the customer obtains control of the asset. The journal entry to record an invoice issued is:
Dr
Accounts receivable ...........................................................x
Cr
Billings on construction in process (BCP) ................................ x
The BCP account is not a revenue account because revenue is not recognized when invoices are issued.
Rather, the BCP account is a contract liability account because once an invoice is issued and the client
pays the invoice, the company constructing the asset owes the customer a building or whatever is being
constructed. The BCP account may also be a contra-asset to the CIP account in the general ledger.
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Note: For a given contract, the BCP liability or contra-asset account may be current or non-current, or
both, depending on the facts and circumstances such as when the entity expects to satisfy its performance obligations under the contract.
Reporting a Point-in-Time Contract on the Balance Sheet
Even though no revenue or gross profit will be recognized until the customer obtains control of the asset,
the point-in-time contract must be recognized on the balance sheet to the extent that it represents a net
contract asset or a net contract liability.
In the CIP and BCP journal entries, the company has created both an asset and a liability: the CIP account
is the asset and the BCP account is the liability. Therefore, the BCP liability account is netted together with
the CIP asset account for presentation on the balance sheet. The difference between the construction in
process (CIP) asset account and the billings on construction in process (BCP) liability account is reported
on the balance sheet as either a net contract asset or a net contract liability.
•
If CIP > BCP, the difference is reported as a contract asset. The line item used is called costs of
in-process point-in-time contracts in excess of related billings or something similar.
•
If CIP < BCP the difference is reported as a contract liability. The line item used is called billings
on in-process point-in-time contracts in excess of related costs or something similar.
Recognizing an Estimated Loss
When an estimated loss on a point-in-time contract as a whole is anticipated, the amount of the estimated loss must be recognized immediately. Recognizing the estimated loss is relatively straightforward
because no revenue, expense, or gross profit will have yet been recognized on the contract. The journal
entry to record the estimated loss is:
Dr
Loss on long-term contract (income statement) .. amount of loss
Cr
Construction in process (reduces the asset) .......... amount of loss
In subsequent periods, losses on the point-in-time contract will be recognized only to the extent that the
total estimated loss on the contract exceeds losses that have been previously recognized on the contract.
Closing Out a Point-in-Time Contract
When the performance obligations in the contract have been satisfied and the customer has obtained control
of the asset, contract revenue is recognized by closing out the billings on construction in process (BCP)
liability account to revenue on point-in-time contracts, and contract expense is recognized by closing out
the construction in process (CIP) asset account to construction expense, as follows:
Dr
Billings on construction in Process (BCP) ................total billings
Cr
Dr
Construction expense .......................... total construction costs
Cr
158
Revenue on point-in-time contracts ......................... total billings
Construction in process (CIP) .................. total construction costs
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4a) Revenue Recognition
Over-Time Recognition
When a contract meets any one of the three criteria for recognizing revenue over time, the contract revenue, cost of sales, and gross profit are recognized as the company makes progress toward satisfaction
of its performance obligations on the project. The criteria are:
1)
The customer simultaneously receives and consumes the benefits provided by the company’s performance as the company is performing its contract obligations.
2)
The company’s performance creates or enhances an asset such as work in process that the customer controls as the work is being done.
3)
The company’s performance does not create an asset with an alternative use to the company, and
the company has an enforceable right to payment for performance completed to date.99
If the contract is a service contract with revenue recognized on a generally straight-line basis and costs
expensed as incurred, it is simple to account for. Invoices are issued periodically throughout the term of
the contract as the service is provided and revenue is recognized as the invoices are issued.
However, if the progress toward full satisfaction of the performance obligations depends on construction
progress, for instance on a building constructed on land owned by the client, the accounting is more complex.
The construction in process (CIP) contract asset account is used to accumulate costs and the billings on
construction in process (BCP) contract liability account is used for invoices, similar to the way the costs and
invoices are accounted for on point-in-time contracts. However, revenue, costs, and gross profit are also
recognized on the income statement as the contract progresses. In addition, the amount of gross profit
recognized each period is debited to the construction in process (CIP) asset account along with
the construction costs incurred, thereby increasing it.
In order to make this recognition, three calculations must be made at the end of each period:
1)
The amount of the total estimated gross profit on the whole contract as of the reporting date.
2)
What percentage of the performance obligation has been satisfied.
3)
How much revenue, cost, and gross profit on the contract should be recognized in the current
period.
1) Calculation of Estimated Gross Profit
The first calculation is to determine the estimated gross profit on the contract as a whole as of the
reporting date.
Contract price
99
−
Costs actually incurred to date
−
Estimated costs to be incurred in the future
=
Estimated gross profit (loss)
ASC 606-10-25-27.
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The estimated gross profit (loss) is the amount of gross profit or loss the company expects from the entire
contract as of the reporting date. However, because the performance obligation in the contract is not yet
completely satisfied, the entire amount of the estimated gross profit should not be recognized in the current
period, nor should the percentage of the estimated gross profit represented by the percentage satisfied be
recognized in the current period, if some has already been recognized. The amount to recognize in the
current period is determined by the percentage of the performance obligation that has been satisfied less
any amounts recognized during previous periods.
2) Calculation of the Progress Toward Satisfaction of the Performance Obligation
The second calculation measures the extent of the entity’s progress as of the reporting date toward complete satisfaction of the performance obligation in the contract. Methods that can be used to determine the
extent of this progress include output measures and input measures. The best method to use depends on
the circumstances, and choosing the most appropriate method requires judgment.
•
Output measures recognize revenue on the basis of direct measurements of the value to the
customer of the goods or services transferred to the customer to date, relative to the remaining
goods or services promised. Examples are surveys of performance to date, milestones reached,
and appraisals of results achieved such as number of units produced or delivered. When the contract is for a long-term construction project, an engineering estimation or other method may be
used to make the determination.
•
Input measures measure the efforts or inputs expended—for example, resources consumed,
costs incurred, labor hours expended, time elapsed, or machine hours used—toward satisfying a
performance obligation relative to the remaining goods or services promised under the contract.
Note: The cost-to-cost method as presented in the following pages is an example of an input method
and exemplifies the basic calculations only. If an output measure is used, the calculations would be
based on the output measure instead.
The Cost-to-Cost Input Method
When the cost-to-cost method is used to determine the extent of a company’s progress toward complete
satisfaction of a contract, the percentage satisfied is the ratio between the actual cost incurred to date on
the contract and the total cost estimated for the contract. The total cost estimated for the contract is the
actual cost incurred to date plus the estimated cost to complete as of the reporting date.
The calculation for the percentage satisfied using the cost-to-cost method is as follows:
Cost Incurred to Date (including prior periods)
Cost Incurred to Date + Estimated Cost to Complete
= Percentage Satisfied
Note: The denominator of the formula, Cost Incurred to Date + Estimated Cost to Complete, is the total
estimated cost for the contract as of that date.
If an exam question gives the cost incurred to date and the estimated cost to complete, candidates will
need to sum the two amounts to calculate the denominator of the formula. However, an exam question
might simply give the total estimated cost for the contract as of the relevant date. If so, no calculation
of the denominator of the formula will be required. The information given as the total estimated cost
should just be used in the denominator of the formula as given.
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4a) Revenue Recognition
3) Calculation of the Gross Profit to Recognize This Period
Using the estimated gross profit calculated in Step 1 and the percentage satisfied calculated in Step 2, the
company can now calculate the amount of gross profit that should be recognized in total to date. The
formula is:
Estimated Gross Profit
×
Percentage Satisfied
=
Total Gross Profit to be Recognized to Date
However, the company has not yet calculated the amount of gross profit that should be recognized as
income this period. The “total gross profit to be recognized to date” is the amount of gross profit the
company should have recognized in all periods that the contract has been in process. In order to determine
the amount of profit to recognize in this period, the company subtracts gross profit previously recognized
from the total gross profit to be recognized to date, as follows.
Total Gross Profit to be Recognized to Date
−
Profit Previously Recognized
=
Gross Profit to Recognize This Period
Unless the previously recognized gross profit is eliminated, the profit from previous periods will be recognized twice (or several times) as the project progresses.
All of the preceding calculations and formulas can be combined into one formula for the calculation of gross
profit to recognize in the current period under the cost-to-cost method, as follows:
Costs Incurred to Date
Total Costs Incurred
to Date + Estimated
Costs to Complete
× Estimated Profit
−
Profit
Previously
Recognized
=
Profit to
Recognize This
Period
Note: The preceding formula can be used for all over-time contracts to determine the amount of gross
profit to recognize in a given period. Even when there are losses (discussed below), the formula can be
used as long as it is remembered that losses are always 100% complete.
In a situation where the level of estimated profit falls from one period to the next, it is possible that the
above formula will result in a negative number. This negative number is the loss that the company needs
to recognize in the current period. If the contract in total is not expected to result in a loss, however, the
loss in the current period does not eliminate all profit recognized to date on the contract. The contract as a
whole can remain profitable, even when there is a loss in the current period. If the contract remains profitable, by recording a loss in the current period the company is simply “de-recognizing” some of the profit
that was recognized in a previous period or periods.
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161
4a) Revenue Recognition
CMA Part 1
Recognition of Losses
At any point during the contract’s fulfillment, the company may estimate that the entire contract will result
in a loss by its completion because costs on the whole contract will be greater than revenue from the whole
contract. Any estimated loss on an entire project is recognized in full in the period when it becomes apparent that there will be a loss.
Candidates can still use the formula that is given above for the profit (or rather, loss) to recognize in the
current period, as long as they remember that if a loss is estimated for the contract as a whole, it is as if
the performance obligations in the contract are 100% satisfied.
The actual calculation of the loss to recognize this period will be
Total Estimated Loss − Profit Previously Recognized = Loss to Recognize This Period
For example, if the total estimated loss from the contract (Contract Price − Estimated Total Cost) is
$(100,000) and $150,000 of gross profit has been previously recognized, the loss to recognize this period
is
$(100,000) − $150,000 = $(250,000)
The above formula works as long as the negative numbers are used correctly in the calculation. The same
loss amount can be calculated more simply without using negative numbers, as follows:
Total Estimated Loss + Profit Previously Recognized = Loss to Recognize This Period
Using the same example, the loss to recognize is
$100,000 + $150,000 = $250,000
Note: If in the early years of an over-time contract it is estimated that there will be a profit, a percentage
of that profit will have been recognized previously. If, however, in later years the amount of estimated
profit decreases or becomes an estimated loss, previously-recognized profit will need to be de-recognized. The company does this by recognizing a large loss in the period when the estimated loss becomes
known.
Recording Losses on Over-Time Contracts
When a company realizes that an over-time contract will produce an overall loss, the amount of the estimated loss must be recognized immediately in the period in which it arises, just as it is for a point-in-time
contract.
However, because gross profit may have already been recognized on the contract in previous periods, the
journal entry is different from the journal entry used to recognize an estimated loss on a point-in-time
contract because for a point-in-time contract, no profit will have been previously recognized. When an overtime contract as a whole is estimated to be ultimately unprofitable, not only does the ultimate loss (the
total estimated loss for the whole contract) need to be recognized immediately, but any previouslyrecognized gross profit on the contract needs to be reversed, as well. Therefore, if the company
has recognized any gross profit during the contract’s earlier periods, the amount of the loss to recognize in
the period when the estimated loss arises will be larger than the estimated loss on the whole contract
because the company needs to de-recognize all of the profit recognized earlier and then recognize the
total estimated loss.
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Section A
4a) Revenue Recognition
Reporting Over-Time Contracts on the Balance Sheet
Just as is done for point-in-time contracts, an over-time contract must be recognized on the balance sheet
to the extent that it represents a net contract asset or a net contract liability.
The CIP account represents the contract asset, while the BCP account represents the contract liability. The
difference between the construction in process (CIP) and the billings on construction in process (BCP)
accounts is reported on the balance sheet as either a contract asset or a contract liability. Thus, the BCP
liability account is netted together with the CIP asset account for presentation on the balance sheet.
•
If CIP > BCP, the difference is reported as a contract asset. The line item used will be called
costs and estimated earnings of in-process over-time contracts in excess of related
billings or something similar.
•
If CIP < BCP the difference is reported as a contract liability. The line item used will be called
billings on in-process over-time contracts in excess of related costs and estimated earnings or something similar.
Note: If a company has several projects in process at the same time, costs will exceed billings on
some contracts and billings will exceed costs on other contracts. The company should segregate the
contracts on the balance sheet according to whether each individual contract is a net asset or a net
liability. The asset side of the balance sheet should include only contracts on which the CIP asset is
greater than the BCP liability, and the liability side should include only contracts on which the BCP liability
is greater than the CIP asset.
Note: In an exam question, candidates may need to simply calculate the amount of profit to be recognized in a period. However, it may also be necessary to use the formulas to solve for the amount of costs
incurred, estimated costs to be incurred, revenue to recognize in a period, or the contract price. To solve
for each of these items, simply use the formulas but solve for a different variable.
Disclosures for Revenue Recognition
According to ASC 606-10-50-1, disclosures about revenue recognition should provide sufficient information
to enable users of the financial statements to understand the nature, amount, timing, and uncertainty of
revenue and cash flows arising from contracts with customers. To achieve that objective, quantitative and
qualitative information should be disclosed. The examples provided below are not all inclusive and will vary
depending on the nature of the company’s business.
The company is required to provide information about:
1)
Revenue recognized from contracts with customers, including the disaggregation of revenue into
appropriate categories, presentation of opening and closing balances in contract assets and contract liabilities, and significant information related to performance obligations in the contracts.
2)
The significant judgments made and changes in the judgments made in applying the guidance in
ASC 606 to contracts, including judgments that affect the determination of the transaction price,
the allocation of the transaction price, and the determination of the timing of the revenue.
3)
Any assets recognized from the costs to obtain or fulfill a contract with a customer, including the
closing balances of assets recognized to obtain or fulfill a contract, the amount of amortization
recognized, and the method used for amortization.
If the company has elected to exclude from the measurement of the transaction price all taxes assessed
by a governmental authority that are both imposed on and concurrent with a specific revenue-producing
transaction and collected by the company from a customer per ASC 606-10-32-2 and 32-2A (for example,
sales tax, use tax, value added tax, and some excise taxes), that accounting policy election shall be disclosed in accordance with accounting policy disclosure requirements in ASC 235-10-50-1 through 50-6.
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163
4a) Revenue Recognition
CMA Part 1
Question 35: Rose Construction Company had the following year-end data on a long-term construction
contract started in 20X2 with a contract price of $100,000.
Construction cost
Estimated completion costs
Selling, general and administrative expenses
20X2
20X3
$30,000
50,000
10,000
$40,000
0
10,000
What amount of revenue will be reported in 20X3 if Rose recognizes revenue and gross profit over
time on the contract using the cost-to-cost method?
a)
$37,500
b)
$40,000
c)
$50,000
d)
$62,500
(ICMA 2003)
The following information is for the next three questions. Carefree Construction recognizes construction revenue and gross profit over time using the cost-to-cost method on a long-term project for
a contract price of $1,500,000. Carefree began the project in 20X0 and the project continued through
20X3. Information on the project follows:
20X0
20X1
20X2
20X3
Total Costs Incurred
$ 400,000
600,000
1,350,000
1,550,000
Estimated Cost to Complete
$800,000
700,000
200,000
0
Question 36: For the year 20X0, what is the amount Carefree should recognize as gross profit from this
project?
a)
$0
b)
$75,000
c)
$100,000
d)
$375,000
Question 37: For the year 20X1, what is the amount Carefree should recognize as gross profit from this
project?
a)
$7,692 loss
b)
$33,000 loss
c)
$0
d)
$92,308
(Continued)
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Section A
4b) Income Measurement
Question 38: For 20X2, what is the amount Carefree should recognize as gross profit from this project?
a)
$142,308 loss
b)
$92,308 loss
c)
$50,000 loss
d)
$0
(Source Unknown)
Question 39: Paulson Company recognizes revenue and gross profit over time on long-term contract
#0732 using the cost-to-cost method. The contract was awarded at a price of $700,000. The estimated
costs were $500,000, and the contract duration was three years.
Year 1
Cumulative cost to date
Estimated cost to complete at year end
Progress billings
Collections on account
$300,000
250,000
325,000
300,000
Year 2
$390,000
130,000
220,000
200,000
Year 3
$530,000
0
155,000
200,000
Assuming that $65,000 was recognized as gross profit in Year 1, the amount of gross profit Paulson
recognized in Year 2 was
a)
$49,950
b)
$70,000
c)
$124,950
d)
$135,000
(ICMA 2008)
4b) Income Measurement
Income is revenues and gains less expenses and losses, reduced by provision for income taxes. The various
classifications on a multiple-step income statement are covered in this volume in the topic The Income
Statement.
Expense Recognition
The expense recognition principle, commonly called the matching principle, states that recognition of
expenses is related to net changes in assets and the earning of revenues. Expenses should be recognized
during a period as a result of transferring control of goods or services to customers and recognizing the
associated revenue during that period. Thus, expenses should be recognized when the work or product
contributes to revenue. The expense recognition principle is implemented by matching efforts (or expenses)
with accomplishments (revenues).
Expenses are recognized based on one of the following three methods:
1)
Cause and effect: the cost of an item sold is recognized as cost of goods sold when the sale of the
item contributes to revenue.
2)
Systematic and rational allocation such as depreciation, related to net changes in assets.
3)
Immediate recognition: if an expense will not provide future benefit, it is immediately recognized.
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165
4b) Income Measurement
CMA Part 1
Gains and Losses
Gains are increases in equity as a result of transactions that are not part of the company’s main or central
operations and that do not result from revenues or investments by the owners of the entity.
Losses are decreases in equity as a result of transactions that are not part of the company’s main or central
operations and that do not result from expenses or distributions made to owners of the entity.
The difference between revenues and gains and between expenses and losses depends on the company’s
typical activities. For example, the sale of a product as part of a company’s normal operations constitutes
revenue. However, the sale of a fixed asset formerly used in the company’s operations is not part of the
company’s regular operations, so the excess of the amount received for the asset over its net book value
is a gain, not revenue. If the amount received for the asset is less than its net book value, the deficit is a
loss, not an expense.
Gains and Losses on the Disposal of Fixed Assets
According to ASC 360-10-45-9, long-lived assets or asset disposal groups100 should be reclassified from
held-for-use to held-for-sale when all of the following criteria are met:
•
Management commits to a plan to sell the asset or disposal group.
•
The asset or disposal group to be sold is available for immediate sale.
•
An active program to locate a buyer or buyers and other actions required to complete the plan to
sell the asset or disposal group have been initiated.
•
The sale is probable within one year unless events beyond the entity’s control occur.
•
The asset or disposal group is being actively marketed at a reasonable price in relation to its fair
value.
•
Actions required to complete the plan to sell the asset or disposal group make it unlikely that the
plan will be withdrawn or significantly changed.
Per ASC 360-10-35-43, when an asset or a disposal group is reclassified as held-for-sale, it should be
measured at the lower of its carrying amount or its fair value less cost to sell.101 If a write-down is
necessary, an impairment loss is recognized for the write-down to fair value less cost to sell. While a longlived asset or disposal group is classified as held-for-sale, it is not to be depreciated.
If the asset or disposal group being held for sale increases in its fair value less cost to sell during the period
before it is sold, a gain should be recognized but only to the extent of cumulative losses previously recognized for that asset or disposal group. In other words, the asset or disposal group cannot be written up to
a book value greater than the last book value it had when it was classified as held-and-used.
Assets in the disposal group classified as held-for-sale should be presented on the balance sheet as held
for sale. If any liabilities associated with the held-for-sale assets will be transferred along with the assets,
the liabilities should be presented separately on the balance sheet as liabilities held-for-sale. The assets
and liabilities should not be netted and presented on the same line.
When the sale of the long-lived asset or asset disposal group takes place, any gain or loss not previously
recognized that results from the sale should be recognized at the date of sale.
100
A disposal group represents long-lived assets to be disposed of, by sale or otherwise, together as a group in a single
transaction. If liabilities associated with those assets will be transferred in the transaction, those liabilities are also part
of the disposal group.
101
Costs to sell are costs that result directly from the sale transaction that would not have been incurred if the decision
to sell had not been made. They include broker commissions, legal fees, title transfer fees, and closing costs that must
be incurred before title can be transferred.
166
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Section A
4b) Income Measurement
Example: Archer Company provides contracting services. It owns thirty 8,000-watt generators for construction sites. Management has decided the 8,000-watt generators are insufficient for its needs and has
replaced them with new, 12,000-watt generators. Archer is actively seeking a buyer or buyers for the
used generators and meets all of the criteria to reclassify the generators from held-for-use equipment
to held-for-sale equipment. The carrying value of the used generators is $40,000, presently recorded in
the accounting system as follows:
Held-for-use equipment
$65,000
Less: Accumulated depreciation - equipment
(25,000)
At the time Archer decides to sell the generators, management determines that the fair value less selling
costs of the used generators is $30,000. Archer records the following journal entry to transfer the generators to the held-for-sale category and record the $10,000 loss:
Dr
Held-for-sale equipment ............................................. 30,000
Dr
Accumulated depreciation – equipment ........................ 25,000
Dr
Loss on decline of fair value – held-for-sale equipment... 10,000
Cr
Held-for-use equipment ................................................ 65,000
The loss is a loss from continuing operations. While Archer seeks a buyer or buyers for the used 8,000watt generators and completes their sale, it will not record any further depreciation on the 8,000-wat
generators.
Three months later, Archer completes the sale of the 8,000-watt generators for $28,000 less the broker’s
fee of $1,000. Archer records the sale as follows:
Dr
Cash ........................................................................ 27,000
Dr
Loss on sale of equipment ............................................ 3,000
Cr
Held-for-sale equipment ............................................... 30,000
If a fixed asset is sold while it is still classified as held-and-used (an asset that has not been previously
reclassified as held-for-sale), the journal entry to record the disposal for cash and to recognize any gain or
loss is as follows:
Dr
Cash ........................................................... amount received
Dr
Accumulated depreciation ............................. amount on books
Dr/Cr Loss/gain on disposal ...................................................... balance
Cr
Fixed assets ........................................... historical cost of asset
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167
4b) Income Measurement
CMA Part 1
Presentation of Gains and Losses on the Income Statement
A gain or loss on an asset or a disposal group that is not a discontinued component should be included in
income from continuing operations before taxes. Gains and losses are not part of operating income because
they do not arise from the company’s main or central operations. However, if the company also has discontinued operations, a gain or a loss that is not part of the discontinued component should be included on
the income statement in income from continuing operations (but below operating income) to distinguish it
from gains or losses from discontinued operations. For more information on the format of the income statement, please see The Income Statement in this volume.
All gains or losses incurred by a discontinued component are reported in the period in which the gain or
loss occurred. The gain or loss from operations of the discontinued component and the gain or loss from
the disposal, when the disposal takes place, are combined and reported on one line, followed by the income
tax effect on the next line, either a tax benefit (for a loss) or a tax expense (for a gain). The gain/loss and
the tax expense or tax benefit associated with the gain or loss of the discontinued component should be
reported below income from continuing operations, as follows.
Income from continuing operations
+/−
Gain/(loss) from operations of discontinued Component X
+/−
Income tax benefit or (income tax expense) on discontinued Component X
including gain/(loss) on disposal of $XXXX
Net Income
In other words, all gains and losses from the discontinued component and their related tax effects should
be removed from income from continuing operations so users of the financial statements can see what
income from continuing operations is without the operations of the component that was or is to be disposed
of.
More information on discontinued operations is included in this volume in the topic The Income Statement.
Involuntary Disposals
An involuntary disposal, or an involuntary conversion, occurs when an asset is stolen or otherwise
destroyed, condemned, or seized by the government for a public purpose. The condemnation settlement
or insurance settlement, if any, constitute the proceeds received for the asset, just as if the asset had been
sold.
If the condemnation settlement or insurance proceeds are greater than the carrying value of the asset, a
gain will be recognized on the disposal. If the settlement or insurance proceeds are less than the carrying
value of the asset, a loss will be recognized. The subsequent use of the funds received, whether or not they
are used to purchase a replacement asset, does not impact the gain or loss that is recognized on the
involuntary disposal of the fixed asset.
The entire gain or loss is recognized in the period in which the conversion occurred. The journal entry to
record the involuntary disposal is the same as the journal entry for a voluntary disposal.
Note: The costs of cleanup and removal of an asset as well as any costs associated with determining
the fair value of condemned property or the condemnation agreement itself are added to the book
value of the old asset in determining the gain or loss on the involuntary disposal.
Any costs associated with the search for and purchase of a replacement asset are included in the capitalized cost of the new asset, to be depreciated over its estimated useful life.
168
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Section A
4b) Income Measurement
Comprehensive Income
Comprehensive income is the change in equity (net assets) of an entity from non-owner sources that arise
during a period from transactions and other events. It includes all changes in equity during a period except
those resulting from investments by owners and distributions to owners.
Net income (loss) for a period is closed to retained earnings at the end of the reporting period, so net
income (loss) increases or decreases equity. Comprehensive income includes everything on the income
statement plus the amount of change during the period in accumulated other comprehensive income (OCI),
another equity account. The specific items reported on the accumulated other comprehensive line in equity
are covered in this volume in the topic Statement of Comprehensive Income.
Total comprehensive income for a year includes everything on the income statement (that is, net income
for the year) plus the transactions for the year in the accumulated other comprehensive income account.
The accumulated other comprehensive income account is a permanent balance sheet account, so it is not
closed out at the end of each year the way the temporary, income statement, accounts are. Thus, total
comprehensive income for a year is net income plus the amount of change during the year in accumulated
other comprehensive income.
Comprehensive Income = Net Income (Loss) + ∆ in Accumulated OCI
•
If the balance in accumulated OCI increases during a period (a net credit), comprehensive income
will be greater than net income for the period.
•
If the balance in accumulated OCI decreases during a period (a net debit), comprehensive income
will be less than net income for the period.
•
In the event of a net loss for the period, comprehensive income or loss for the period will depend
on whether the transactions in accumulated OCI for the period represent a net credit or a net
debit.
Comprehensive income is more inclusive than net income. In other words, net income is a part of comprehensive income, but it does not constitute the whole of comprehensive income.
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169
Section B – Planning, Budgeting and Forecasting
CMA Part 1
Section B – Planning, Budgeting and Forecasting
Planning, Budgeting and Forecasting represents 20% of the CMA Part 1 exam. Part 1 is a four-hour exam
that will contain 100 multiple-choice questions and 8 to 10 written-response or calculation questions based
on two scenarios. Topics within an examination part and the subject areas within topics may be combined
in individual questions. Therefore, the number of multiple-choice questions on Planning, Budgeting and
Forecasting in any one exam cannot be predicted, nor can it be predicted whether or not an individual exam
will have any essay questions on the topic. The best approach to preparing for the exam is to know and
understand the concepts very well and be ready for anything.
This section focuses on the budgeting process in a business and its inseparable connection with the planning
process. Candidates need to understand the benefits of planning, the goals of planning, and the general
steps in the planning process. Additionally, candidates should be familiar with the different types of planning
a business does. Exam questions may address the theories and process of planning and budgeting as well
as the different types of planning and budgeting. Top-level planning and the use of pro forma financial
statements in the planning process are important topics.
Numerical questions may relate to how much should be budgeted or expected during a period. Questions
may also involve a more detailed calculation of the expected cash balance at some period in time, or the
cash inflows or outflows during a period. The scope of the numerical questions in planning and budgeting
is large, requiring the ability to apply principles and ideas to different situations.
In the area of budgeting, it is important to understand the budget process, the order in which the different
budgets are prepared, and to be able to make different budgeting calculations. These calculations are not
necessarily intuitive at the beginning of the study process, but after answering some questions and memorizing the required formulas, the calculations should become much easier.
Forecasting techniques, learning curves and other quantitative analysis tools are included because of their
usefulness in planning and budgeting. Another topic in this section, top-level planning and analysis, deals
with pro forma financial statements and their use in strategic planning.
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Section B
B.1. Strategic Planning
B.1. Strategic Planning
Planning in general refers to the process that provides guidance and direction regarding what an organization needs to do throughout its operations. It determines the answers to the “who, what, when, where, and
how” questions of a business operation. Planning is the first activity management must undertake when
creating yearly budgets and making other critical decisions that will affect the company’s future. A company’s plan serves as its guide or compass for the activities and decisions made by individuals throughout
the entire organization. The planning process not only defines the company’s objectives and goals, it sets
the stage for prioritizing how to develop, communicate and carry out accomplishing them.
Planning is usually not a popular activity. Many people think of planning as a waste of time, because it
takes time away from day-to-day activities. Other people believe that the environment the company operates in changes too quickly for a plan to be useful, since soon the situation will change, anyway. However,
planning is an important management function for several reasons.
The process of planning can be as important as the resulting plan, because the process forces management
to think about where the company is and where the company wants to be. A plan brings about better
coordination of company efforts, since everyone is working toward the same goals. And it provides clear
performance standards, enabling better monitoring and control of results. Furthermore, good planning puts
the company in a better position to anticipate and respond quickly to sudden changes in its environment.
And finally, one of the primary success factors in a company is management’s competence in planning and
controlling the firm’s activities. Management’s responsibility is to plan and control the long-range destiny
of the company through decisions that either create or seize a positive opportunity or escape a decline.
Planning in Order to Achieve Superior Performance
For most companies, if not all, the ultimate objective is to achieve superior performance in comparison
with the performance of their competitors. When superior performance is achieved, company profitability
will increase. When profits are growing, shareholder value will grow. A publicly-owned for-profit company
must have maximizing shareholder value as its ultimate goal. The shareholders are the owners. They have
provided risk capital with the expectation that the managers will pursue strategies that will give them a
good return on their investment. Thus, managers have an obligation to invest company profits in such a
way as to maximize shareholder value.
Shareholders want to see profitable growth: high profitability and also sustainable profit growth. A company with profits but whose profits are not growing will be not be valued as highly by shareholders as a
company with profitability and profit growth. Attaining and maintaining both short-term profitability and
long-term profit growth is one of the greatest challenges facing managers.
Example: If a company decreases its Research and Development expenses, its short-term profit will
increase as a result of reduced expenses. However, its ability to generate profits in the future may be
reduced because it will not have the products it needs to sell.
Note: Shareholder value is the returns that shareholders earn as a result of having purchased shares
in a company. Shareholders’ returns come from both capital appreciation of their shares’ value and from
dividends received. Profitability and profit growth are the primary means by which shareholder value
increases.
Strategic leaders are responsible for effectively managing the company’s strategy-making process to increase company performance and maximize shareholder value. The strategies a company’s management
follows will determine the company’s performance in relation to the performance of its competitors.
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171
B.1. Strategic Planning
CMA Part 1
Note: A strategy is a set of actions taken by managers of a company to increase the company’s performance. The strategy-making process includes both strategy formulation and strategy implementation.
Strategy formulation is the process of selecting strategies. Strategy implementation is the process
of putting the selected strategies into action. It involves designing, delivering and supporting products;
improving efficiency and effectiveness of operations; and designing the organization structure, control
systems, and culture.
The result of attaining superior performance will be competitive advantage. Competitive advantage is an
advantage a company has over its competitors that it gains by offering consumers greater value than they
can get from its competitors. The greater value may be in lower prices for the same product or service; or
it may be in offering greater benefits and service than its competitors do, thereby justifying higher prices;
or it may be offering greater benefits at the same or even at a lower price than its competitors charge.
Competitive advantage may be derived from attributes that enable an organization to outperform its competitors such as access to natural resources, highly-skilled personnel, a favorable geographic location, high
entry barriers, and so forth.
A company that has competitive advantage will usually be more profitable than the companies it competes
with. The higher its profits are in comparison to its competitors, the greater its competitive advantage will
be. Competitive advantage leads to increased profitability; and greater profitability leads to increased competitive advantage. Competitive advantage makes the difference between a company that succeeds and a
company that fails.
In order to increase profitability and sustain profit growth, managers need to formulate strategies that
will give their companies competitive advantage. Strategic planning is this formulation of strategies. The
strategies that managers pursue create the activities that together can set the company apart from its
competitors and cause it to consistently outperform them.
A company’s business model is its managers’ idea of how the set of strategies and capital investments
the company makes should fit together to generate above-average profitability and, at the same time,
profit growth.
A company can outperform its competition even if the company and its competition are all pursuing the
same business model. One company may implement the business model more efficiently than its competitors, or its strategies may differ in key areas. The business model along with the strategies that managers
select and implement can lead to higher profitability and therefore to competitive advantage, and also to
increased profitability. On the other hand, they may not be so successful.
In addition to its business model and strategies, a company’s performance is impacted by the competitive
conditions in the industry in which it operates. In some industries, demand is growing, while in others,
demand is shrinking. Some industries might have excess capacity, while others have excess demand. Some
industries may be having price wars leading to lower prices because of an excess of supply over demand,
while prices in other industries may be rising persistently due to an excess of demand over supply. The list
of variables goes on and on. Conditions vary from industry to industry. While an individual company cannot
change the external variables that affect its industry, it must take them into consideration in its strategic
planning process.
Thus, profitability and profit growth for any individual company are determined by two things:
1)
its success relative to other firms in its same industry, and
2)
the overall performance of the industry the company is in compared with the performance of other
industries.
Internal factors as well as external factors affect a company’s performance.
Note: The purpose of strategic planning is to guide the company in its efforts to achieve superior
performance, competitive advantage, and maximized shareholder value.
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Strategic plans are usually developed for a period of five years or longer. The plan is updated, or rolled
forward, each year. The results of this annual planning process are usually used, along with tactical and
operational planning, in developing the budget for the coming year. Thus, the strategic plan is used to
determine resource allocation within the company.
Note: Strategic plans are long-term, usually for a period of five years or more.
The Role of Management in Attaining Profitable Growth
Two opposing philosophies with respect to the role of management in achieving profit growth are recognized:
1)
The market theory gives management a passive role and views its function basically as making
reactive decisions in response to environmental events as they occur.
2)
The “planning and control” theory gives management an active role that emphasizes its planning function and its ability to control the activities of the business.
Most companies’ managements operate somewhere between these two extremes. At times, events will
occur that are outside the control of management and may even be important enough to determine the
firm’s destiny. But in virtually all situations when non-controllable variables become dominant, a competent
management team can almost always manage and use the situation to move the company to an environment where the variables are controllable again.
When management operates more closely to the planning and control theory, it has more ability to
reduce the randomness of events and to deal productively with those that do occur.
Types of Plans and General Principles
In order for plans to be as effective as possible, they must be coordinated among the different units and
departments in the company so that the individual segments’ plans are in alignment with the larger goals
of the company. If plans are not coordinated and aligned with the corporate goals, different parts of the
company may be working at cross-purposes, and the company will not move in a positive direction. Various
types of plans are used to match what is being planned with the company’s goals.
Strategic Plans (Long-Term Plans)
Planning is done initially on a long-term basis. Long-term planning is also called strategic planning. Strategic
plans are broad, general, long-term plans (usually five years or longer) and are based on the objectives of
the organization. The company’s top management leads the strategic planning effort and makes the final
decisions. However, top management should seek input from employees at all levels of the organization.
Sometimes the best ideas for change come from lower level managers, engineers, or customer service
employees because those people are closest to what is going on. Furthermore, inclusion of lower-level
managers and employees in the planning process promotes their understanding and ownership of the strategic plan, motivates them to participate in its implementation, and promotes an understanding on their
part that the decision-making process is fair and inclusive.
Note: The longer the time frame of the plan, the higher up in the organization the planning should be
done. Similarly, the shorter the time frame of the plan, the lower in the organizational hierarchy the
planning should be prepared.
Strategic planning is neither detailed nor focused on specific financial targets, but instead looks at the
strategies, objectives and goals of the company by examining both the internal and external factors affecting the company. Internal factors include current facilities, current products and market share,
corporate goals and objectives, long-term targets, technology investment, and anything else within the
direct control of the company itself.
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External factors also need to be taken into account in strategic planning. Some of the external factors are
the economy, labor market, domestic and international competition, environmental issues, technological
developments, developing new markets, and political risk in other countries (or the home country).
The process of reviewing the long-term objectives and economic environment of the firm (both internally
and externally) will enable the company to identify the threats, opportunities, or limitations it faces. By
identifying threats and limitations early, the company will be better prepared to prevent them from occurring or to limit their negative effects. By identifying opportunities early, the company will be in a better
position to act appropriately and capitalize on these situations.
Part of the strategic plan will be a review of the capacity and the capital resources of the company. Capacity
is the ability of the company to produce its products or services. Capital resources are the company’s
fixed assets. In the long term, the company will need to make certain its capacity will be able to meet the
expected demand and also decide how to obtain the needed capacity. This type of planning is the process
of capital budgeting.102 The firm may either purchase or lease the necessary fixed assets, but a plan is
also required to determine how the company will obtain the necessary financing for whatever option it
chooses.
By taking all of this information into account, the company is in a position to make long-term business
plans. These long-term plans may involve dropping or adding product lines or specific products, or making
long-term capital investments in increasing capacity or capital resources, or decreasing capacity or capital
resources. The company may also generate a plan that will lead it into a different business model altogether
(for example, a shift from production of a product to servicing and supporting the product, leaving production to another company).
Note: Strategic planning is directional, rather than operational. This means that the company focuses on where it wants to go instead of specifically how it will get there.
Intermediate and Short-Term Plans
The strategic plan is then broken down into intermediate or tactical plans (one to five years), which are
designed to implement specific parts of the strategic plan. Upper and middle managers develop tactical
plans.
Short-term or operational plans (one week to one year) are developed from the tactical plans. Operational plans focus on implementing the tactical plans to achieve operational goals, and operational plans
include budgeted amounts. Operational plans drive the day-to-day operations of the company. Middle and
lower-level managers develop operational plans.
As noted earlier, the shorter the time frame, the lower the level of management that should make the plan.
Thus, strategic plans are developed by top management (with input from all levels of the organization),
tactical plans are developed by upper and middle managers, and operational plans are developed by middle
and lower-level managers. For example, the board of directors should not be involved in developing weekly
production plans for an assembly line.
All shorter-term plans need to work toward the strategic plans of the company. If the tactical and operational plans are not working toward that goal, the company will not be able to meet the longer-term,
strategic goals that its senior management has developed.
Short-term or operational plans are the primary basis of budgets. Operational plans refine the overall objectives from the strategic and tactical plans in order to develop the programs, policies, and
performance expectations required to achieve the company’s long-term strategic goals.
Most budgets are developed for a period of one year or less. Thus, the budget formulates action steps from
the organization’s short-term objectives. The budget reflects the company’s operating and financing plans
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for a specific period (generally a year or a quarter or a month). The budget contains the action plans to
achieve the short-term objectives.
The one exception to the above is the capital expenditures budget. The capital expenditures budget is
generally developed for a long period of time and the relevant impact for each year is incorporated each
year into the operating and financial budgets. The capital expenditures budget needs to be a long-term
budget because it may not be possible to quickly increase the capacity of the company. The company needs
time to plan for capacity increases.
Other Types of Plans
Plans may also be single-purpose plans, which are developed for a specific item such as construction of
a fixed asset, the development of a new product, or the implementation of a new accounting system. These
are also incorporated into the operating and financial budgets during the relevant years.
Standing-purpose plans have relevance and use for many different items. Plans such as marketing and
operation plans are standing-purpose plans.
Contingency planning is planning that a company develops to prepare for possible future events (especially negative events). Contingency planning is “what if?” planning. Preparing different plans for different
situations is more expensive because it entails developing multiple plans. However, multiple plans for different situations enable the company to be better prepared for what may occur. A company prepares
multiple plans when management thinks that the contingency planning will eventually lead to greater savings than the cost of the planning itself.
Contingency plans are much more important for companies that are more likely to be significantly influenced
by outside events. If the company has no plan for responding to a negative event that may occur, the
damage will be much greater to the company because it will not be able to react quickly, and its immediate
reaction may not be the correct one. A contingency plan enables companies to respond quickly and in the
best possible manner.
Note: Despite the benefits of having a formal plan, formal planning also has some drawbacks. A plan
that is too formal can constrain creativity, or a strict dedication to the plan can cause management to
miss some opportunities that could be beneficial to the company.
Question 40: Which of the following is not a significant reason for planning in an organization?
a)
Promoting coordination among operating units.
b)
Forcing managers to consider expected future trends and conditions.
c)
Developing a basis for controlling operations.
d)
Enabling selection of personnel for open positions.
(CMA Adapted)
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Question 41: Certain phases of the planning process should be formalized for all of the following reasons
except:
a)
Informal plans and goals lack the necessary precision, understanding, and consistency.
b)
Formal plans can act as a constraint on the decision-making freedom of managers and supervisors.
c)
Formalization requires the establishment and observance of deadlines for decision-making and
planning.
d)
Formalization provides a logical basis for rational flexibility and planning.
(CMA Adapted)
Question 42: “Strategy” is a broad term that usually means the selection of overall objectives. Strategic
analysis ordinarily excludes the:
a)
Trends that will affect the entity’s markets.
b)
Target production mix and schedule to be maintained during the year.
c)
Forms of organization structure that would best serve the entity.
d)
Best ways to invest in research, design, production, distribution, marketing, and administrative
activities.
(CMA Adapted)
The Strategic Planning Process
The formal strategic planning process consists of five steps, as follows:
1)
Defining the company’s mission, vision, values, and goals.
2)
Analyzing the organization’s external competitive environment in order to identify opportunities
and threats.
3)
Analyzing the internal operating environment to identify strengths, weaknesses and limitations of
the organization.
4)
Formulating and selecting strategies that, consistent with the organization’s mission and goals, will
optimize the organization’s strengths and correct its weaknesses and limitations for the purpose
of taking advantage of external opportunities while countering external threats (SWOT analysis).
5)
Developing and implementing the chosen strategies.
These steps are discussed in detail in the following pages.
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1) Defining the Company’s Mission, Vision, Values, and Goals
Note: This is the first of the five steps in the strategic planning process.
The Mission Statement
The company’s mission statement provides the context within which its strategies will be formulated. The
mission statement includes four components:
1)
A statement of the company’s mission, or its “reason to be.”
2)
Its vision, or a statement of a desired future state.
3)
A statement of the organization’s values.
4)
A statement of its major goals.
Statement of the Company’s Mission or “Reason to Be”
A company’s mission is what the company does. In writing the mission statement, management should
ask itself, “What is our business? What will it be? What should it be?” In answering the questions, management should think in terms of the customer:
•
What customer groups are being served?
•
What customer needs are being served?
•
And by what means (skills, knowledge or distinctive competencies) are customers’ needs being
served?
The answers should be customer-centered rather than product-centered. In other words, the company
should be in business not to sell widgets, but to satisfy its customers’ needs for the benefits the company
can supply through its widgets.
For instance, this company is not in business to sell study materials for the CMA exams. Rather, this company is in business to help professionals advance in their careers and in their earning capacity by getting
certified. This company is applying a particular skill (the ability to teach) in order to satisfy a particular need (the need to get certified in order to advance professionally) for a particular group of people
(financial professionals).
Here is another example: Merck & Co., a pharmaceutical company, says in its mission statement, “Our
business is preserving and improving human life.”
A company’s mission statement should be very broad, because customer demands can shift quickly, and a
given need can be served in more than one way. A company that limits itself to serving a need in just one
way will find itself obsolete when technological change passes it by. It needs to be flexible and ready to
adapt to changing conditions and new ways of serving its customers’ needs.
Statement of the Company’s Vision
The next part of the mission statement is the company’s vision. The vision is what the company would like
to achieve or become, and it should be challenging. A good vision statement should challenge the company
by stating an ambitious future state that will (1) motivate employees at all levels and (2) drive the strategies
that the company’s management will formulate and implement in order to achieve the vision. For example,
Du Pont’s mission statement says, “Our vision is to be the world's most dynamic science company, creating
sustainable solutions essential to a better, safer and healthier life for people everywhere.”
Exam Tip: The difference between a company’s mission and its vision is that a company’s mission is
what it does, whereas its vision is what it wants to achieve. The mission is what is, whereas the vision
is a desired future state.
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Statement of the Company’s Values
After the vision comes the company’s values, or how managers and employees should behave and do
business. A company’s values are the foundation of its organizational culture. The organizational culture
consists of the values, norms and standards that govern how the company’s employees work to achieve
the company’s mission and goals. These standards are in turn associated with the company’s performance—
either good performance or poor performance. A deep respect for the interests of customers, employees,
suppliers and shareholders has been associated with high performance in firms. On the other hand, a lack
of respect for the same groups (values not expressed in the company’s mission statement) has been associated with poor performance in firms. Thus, the company must not only “talk the talk” but it must also
“walk the walk.”
Statement of the Company’s Goals
The final step in the development of a mission statement is the statement of the company’s major goals.
A goal is a precise and measurable future state that the company wants to achieve. The purpose of goalsetting is to specify what needs to be done in order to attain the company’s mission and vision. Wellconstructed goals provide a means for managers’ performance to be evaluated.
The characteristics of well-constructed goals are:
1)
They are precise and measurable.
2)
They should be crucial and address important issues.
3)
The number of goals should be limited so managers can maintain their focus on them.
4)
They should be challenging while at the same time being realistic. A goal that is too unrealistic
may cause employees to either give up or embark upon unethical behavior in an attempt to meet
the goal. On the other hand, a goal that is not challenging enough may not be motivating enough.
5)
They specify when they should be achieved in order to create a sense of urgency.
The goals that are developed must be clearly stated in specific terms to prevent “interpretation” of the
objectives by employees.
Example: A company goal “to become financially stronger” is ambiguous and could lead to different
decisions depending on how it is interpreted and how a person understands it as an objective. The goal
should be more specific. For example, “reduce debt by $X” or “increase cash reserves by $Y” are both
specific and not open for interpretation.
Additionally, goals must be communicated to all individuals who will be impacted by them.
Finally, for any goal to be effective, individuals within the organization must accept the goal. Though it is
not possible for everyone in the organization to agree with every goal, it is essential that the goals be
clearly understood and communicated, allowing people to address whatever concerns they have about the
goals. Whether they agree with them or not, all the employees need to work toward accomplishing the
company’s goals.
The primary goal of most companies is to maximize shareholder returns. Maximizing shareholder returns
is accomplished through high profitability and sustained profit growth. Therefore, most companies’
goals include goals for profitability and profit growth. However, pursuit of current profits should not be
permitted to lead to management actions that will be detrimental to long-term profitability and profit
growth. For instance, cutting expenditures for research and development, marketing, and new capital investments will increase short-term profits, but it will do so at the expense of long-term profits. Furthermore,
too much pressure to increase current profits can lead managers to take actions that are unethical, such
as misrepresenting the true performance of the company to shareholders and others.
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Goals and Objectives
The terms “goals” and “objectives” are often used interchangeably. Furthermore, sources disagree on how
the two terms differ. Some sources identify a goal as that which is developed and implemented at the unit
or department level while an objective is developed at the organizational, or enterprise level. Other sources
say just the opposite: an objective is developed at the lower level while a goal is developed at the enterprise
level. However, the fact is that both goals and objectives exist at all levels of the organization.
Generally, a corporate goal is a measurable future state that the company wants to achieve. Goals
specify precisely what needs to be done for the company to achieve its mission or vision. Objectives are
the series of steps taken to attain the goal. Objectives are the smaller targets that need to be hit in
order to achieve the goal. Units or departments within the organization have goals and objectives they
need to meet in order to make their contributions to attaining the corporate goal, and individuals within the
organization also have their individual goals and objectives. In all cases, the goals are met through attaining
the smaller targets that are the objectives. The goals and objectives of the corporation are met through
accomplishment of the goals and objectives of the divisions, and the goals and objectives of the divisions
are met through accomplishment of the goals and objectives of the people in the divisions.
Planning is the process that enables a company to achieve its goals and objectives. It is the
responsibility of management to make sure that all of the smaller goals and objectives work toward the
ultimate achievement of the corporate-level goals and objectives. Management must make certain that
harmonization of goals is done as efficiently and effectively as possible.
Note: Because people in each department are most closely connected with the goals of their own departments, the risk is present that the employees will develop tunnel vision. Tunnel vision occurs when
employees become so concerned with their own goals that they fail to notice or care about the larger
goals of the company. If in doing their jobs they hamper others in the performance of their jobs, the
company not only does not benefit, it can actually be hurt. Managers need to be certain they do not lose
sight of the company’s goals.
When the goals of one level of the company fit with the goals of the next highest level, the company has
achieved a means-end relationship. A means-end relationship results when the achievement of the goals
of one level enables the next highest level to achieve its goals as well.
Two terms that are related to the accomplishments of goals and objectives are efficiency and effectiveness.
•
Efficiency is the attempt to fulfill the goals and objectives of the company while using the least
amount of inputs.
•
Effectiveness has to do with the actual accomplishment of goals. If goals are achieved, the effort
has been effective.
Though both efficiency and effectiveness are important, effectiveness is of ultimate importance. If a company is efficient but does not accomplish what is needed, then the efforts and resources used are wasted.
Example: Passing the CMA exam with the minimum passing score is both effective and efficient. Passing
with a very high score is effective but not efficient because more time was spent than was required to
achieve the goal of passing. Failing the exam by one question is neither effective nor efficient.
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Question 43: Which one of the following management considerations is usually addressed first in strategic planning?
a)
Outsourcing.
b)
Overall objectives of the firm.
c)
Organization structure.
d)
Recent annual budgets.
(CMA Adapted)
2) Analyzing the External Environment
Note: This is the second of the five steps in the strategic planning process.
After defining the company’s mission and developing its goals, the first step in developing a strategic plan
is to analyze the forces that shape the industry in which the company operates and the competition within
that industry in order to understand the opportunities available to the firm and any threats confronting
the firm that can affect it in the pursuit of its mission. Understanding its opportunities and threats will
enable the company to outperform the competition.
•
Opportunities arise when companies can leverage103 external conditions to develop and implement strategies that will make them more profitable.
•
Threats include conditions in the external environment that pose a danger to profitability.
Three environments should be examined, and the three environments are interrelated:
1)
The industry in which the company operates,
2)
The country or the national environment in which the company operates as well as the international environment,
3)
And the wider environment, or macroenvironment in which the company operates.
An industry is a group of companies that offer similar products or services to satisfy the same basic needs
of their customers. Other companies in the same industry that serve the same basic needs are a company’s
closest competitors. Identifying the industry in which the company competes is the first step in external
analysis.
An industry analysis involves assessing the company’s industry as a whole, the company’s competitive
position within the industry, and the competitive positions of its major rivals. The nature of the industry,
the stage the industry is in, the dynamics and the history are all part of an industry analysis. For example,
the industry the company operates in may be highly competitive, or it may be less competitive. The amount
of competition the company faces will impact the prices it can charge, the marketing effort needed, research
and development needs, and so forth. Likewise, if the industry is growing, the company can expect and
plan to benefit from that growth; or, if the industry is in a decline, the company should plan how it needs
to respond.
Analyzing the national and international environment includes assessing domestic as well as international political risk and the impact of globalization on competition within the industry. International political
risks include the obvious risks of government expropriation (government seizure of private property with
some minimal compensation offered, generally not an adequate amount) and war (which can affect employee safety and create additional costs to ensure employees’ safety).
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“Leverage” as it is used here means “to gain advantage through the use of something.”
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The macroenvironment includes macroeconomic factors that will affect the entire industry or the economy
as a whole. The most important macroeconomic factors in planning and budgeting are:
•
Economic growth leads to more consumer spending and gives companies the opportunity to
expand their operations and increase their profits. Economic recession leads to a reduction in
consumer spending and, in a mature industry, may cause price wars. Both will affect demand and
thus sales revenue and net income in the future. All companies in the industry will feel the impact
of economic growth and economic recession.
•
The level of interest rates can affect a company’s sales and net income if the company is in an
industry where demand is affected by interest rates, such as the housing market or the manufacture of capital goods. Rising interest rates will cause demand to decrease, while falling interest
rates will cause demand to increase. Interest rates also affect any company’s cost of capital and
thus its ability to raise capital and invest and expand.
•
Changes in currency exchange rates affect the competitiveness of companies in international
trade. A depreciating (declining) local currency creates opportunities for increased international
sales while decreasing foreign competition. An appreciating (increasing) local currency causes the
opposite condition.
•
Both inflation and deflation cause businesses to be less willing to make investments in new
projects. When inflation increases, it is difficult to plan on what the real return will be from an
investment. Deflation also causes a lack of stability in the economy, because when prices are
deflating, companies with high levels of debt and the obligation to make regular fixed payments
on the debt can find themselves unable to service that debt. Those companies will be reluctant to
commit to new investment projects.
The macroenvironment also includes social factors such as environmental issues and government, legal,
international, and technological factors that affect the industry and the company. A couple of the many
possible examples are:
•
The extent to which environmental protection laws are enforced by the Environmental Protection
Agency depends to a great degree upon the position of the administration in charge at any given
time, since the President of the United States appoints the head of the EPA. The extent to which
new laws are passed by Congress and approved by the President depends upon the positions of
the parties in power in the two houses of Congress and the position of the administration.
•
Current or future anticipated tax credits can affect an entire industry by creating demand, and
when the tax credits expire, demand falls. A recent example is tax credits for installation of solar
electricity-generating panels. Companies affected included firms manufacturing the materials used
by solar panel manufacturers, the manufacturers of the solar panels, and the companies that installed them.
Note: The two above examples are based on the situation in the United States. Governmental units
similar to the EPA and similar tax issues will exist in other countries.
Michael Porter, a leading authority on competitive strategy from Harvard Business School, provided a
well-known framework, known as the five forces model, which can help managers analyze competitive
forces in the environment to identify opportunities and threats.
According to Porter, when one or more of these five competitive forces is strong, it creates limitations on
the company’s ability to raise prices and earn greater profits. Thus, a strong competitive force depresses
profits and so is a threat. A weak competitive force allows the company to raise prices, thereby improving
profits, and so is an opportunity. The strength of the five forces can change over time as conditions in the
industry change. Managers need to be able to recognize changes in these five competitive forces when they
occur and to formulate appropriate strategic responses.
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Furthermore, Porter says, it is possible for a company to proactively change the strength of one or more of
the five forces through its choice of strategy.
According to Porter, the five forces that shape competition within an industry are:
1)
The risk of entry by potential competitors. Potential competitors are companies not presently
in an industry but that could enter it. The height of barriers to entry, such as costs or regulatory
requirements that make it difficult for new companies to enter an industry, is a major determinant
of the risk of entry by potential competitors. Economies of scale constitute a high entry barrier as
well, since a new competitor would not have the volume to enable it to compete profitably against
the established players in the industry.
2)
The intensity of rivalry among established companies within an industry. Rivalry is the
competition among companies in an industry to gain market share from one another. Weapons in
the competition include prices, product design, promotional efforts, selling efforts, and service and
support after the sale. If rivalry is intense, it leads to lower prices and higher costs, both of which
decrease profits. Thus, intense rivalry is a strong threat. However, if rivalry is not intense, companies in the industry can raise their prices or reduce their costs, and industry profits will increase.
The height of exit barriers can influence the intensity of rivalry among established companies within
an industry. Exit barriers are factors that prevent companies from leaving an industry. If exit
barriers are high, companies may find themselves locked into an industry with declining demand,
causing excess capacity that leads to price wars. An example of a high exit barrier is a large
investment in assets that are specific to the industry. A company leaving an industry when the
industry has overcapacity would not be able to sell its assets or would have to sell them at a very
low price resulting in a large loss.
3)
The bargaining power of buyers. If buyers such as large discount store chains have the ability
to bargain down prices or to demand better product quality and service that would increase manufacturers’ costs, an industry can become less profitable. Therefore, powerful buyers are a threat.
4)
The bargaining power of suppliers. Powerful suppliers are also a threat. If suppliers have the
ability to raise the prices of inputs such as materials or direct labor (through labor unions, for
instance) or to lower quality, it will raise the costs of companies in the industry.
5)
The closeness of substitutes to an industry’s products. The existence of close substitutes for
an industry’s product is a threat because it limits the prices that can be charged for the product.
If a product has few or no close substitutes, then any company producing or selling it has the
opportunity to raise prices without fear that its customers will switch to a substitute.
3) Analyzing the Internal Environment
Note: This is the third of the five steps in the strategic planning process.
The purpose of internal analysis is to identify strengths, weaknesses and limitations within the organization. The company’s resources and capabilities need to be assessed. Strengths lead to superior
performance. Weaknesses and limitations lead to inferior performance.
Competitive Advantage
The primary objective of strategy is to create a sustained competitive advantage, because that
will lead to superior profitability and profit growth.
A firm creates competitive advantage when it is able to use its resources and its capabilities to achieve
either a differentiation advantage or a cost advantage (or both) to create superior value for its customers and superior profits for the company.
1)
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A differentiation advantage creates value for a firm’s customers because it provides their customers with benefits that exceed those provided by the firm’s competitors. A differentiation
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advantage gives the firm more flexibility in pricing because it can price its product or service higher
than the prices of its competitors, leading to greater profits than the competition.
2)
A cost advantage creates the same value and benefits for the firm’s customers as its competitors
do but at a lower cost, also leading to greater profits than the competition.
Resources, Capabilities, and Distinctive Competencies
Distinctive competencies are strengths a company has that enable it to have either a differentiation advantage or a cost advantage, or both, leading to competitive advantage.
Distinctive competencies stem from two sources: resources and capabilities.
Resources
Resources are factors that enable a company to create value for its customers. They can be financial,
physical, social/human, technological, or organizational factors. Resources can be tangible or intangible.
•
Tangible resources are things such as land, buildings, inventory, and cash.
•
Intangible resources are nonphysical resources like brand names, company reputation, intellectual property such as patents and trademarks, and employees’ knowledge.
As long as a company’s distinctive competency leads to a strong demand for the company’s products, then
that distinctive competency has value. The more difficult a resource is to imitate or replace, the more
valuable it is.
For example, if a company has a distinctive competency in a patented product and the patent expires, the
value of its distinctive competency will disappear. Or if a superior technology comes along that replaces the
company’s technology, then its distinctive competency will become far less valuable.
Capabilities
Capabilities refer to the company’s ability to coordinate its resources and to put them to productive use.
These capabilities are a function of the way in which management makes decisions and manages its internal
rules, routines and procedures to achieve its organizational objectives. A company’s capabilities are thus
the result of its organizational structure, processes, and control systems. Capabilities are intangible, because they are a function of the way individuals within the organization interact, cooperate, and make
decisions.
Note: A company might have valuable resources, but without the capability to use them effectively, it
may not be able to create a distinctive competency.
On the other hand, if a company has capabilities that its competitors do not have, it may not need to
have any special resources. If a company has the same resources as its competitors have but it has the
ability to manage them more productively than its competitors, it will have a distinctive competency.
Therefore, capabilities are essential for distinctive competency, whereas special resources are not always
necessary.
The strategies a company pursues can build new resources and capabilities or strengthen existing
ones and thus can enhance the company’s distinctive competencies. At the same time, distinctive competencies shape the strategies that a company uses, and those strategies in turn lead to a competitive
advantage and superior profitability. Therefore, the relationship between a company’s distinctive competencies and its strategies is a circular one. Strategies help build and create distinctive competencies, and
distinctive competencies in turn shape strategies.
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Strategies
Distinctive
Competencies
Distinctive Competencies, Profitability, and Competitive Advantage
In order to have competitive advantage, a company must have or create:
1)
Distinctive competencies.
2)
The profitability that is derived from the value customers place on its products, the price that it
charges for its products, and the costs of creating those products.
Distinctive Competencies
Four generic distinctive competencies create competitive advantage. These four factors are called “generic”
distinctive competences because any company can pursue them. The four generic distinctive competencies
are:
•
Superior efficiency. Efficiency is the relationship between inputs and outputs. The more efficient
the company is, the fewer inputs will be required to produce a given output. Therefore, superior
efficiency leads to lower costs, which in turn lead to higher profitability and competitive advantage.
•
Superior quality. A product has superior quality when customers consider that its attributes give
them higher utility than the attributes of competing products. This enables the company to charge
a higher price for its product, leading to higher profits.
•
Superior innovation. Innovation is the creation of new products or new processes. Product
innovation creates value by developing products that customers perceive as having more utility,
and thus the company’s pricing options for the products are increased. Process innovation can
create value by decreasing costs.
•
Superior customer responsiveness. Superior customer responsiveness occurs when a company
is able to do a better job than its competitors of identifying customer needs and satisfying them.
Customers attribute more utility to the product, and this greater utility differentiates the product
from that of the competition. Customer response time, or the time required to deliver a product or
perform a service, is also an important aspect of customer responsiveness.
Utility and Profitability
The other thing that a company must have in order to have a competitive advantage is profitability that
is derived from the value customers place on its products, the price it charges for its products, and the
costs of creating those products.
The utility that customers receive from a product or service, in other words, the satisfaction they gain from
it, determines the value they place on the product or service. This utility is not the same thing as the
price of the good or service. Utility is what customers get from the product or service, not what they
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pay for it. Utility comes from the attributes of the product, such as the way the product performs, the way
it is designed, its quality and service after the sale.
If a company can increase the utility, or value, of its products in the eyes of its customers, it will have more
pricing options. It will be able to raise its prices to reflect the increased utility, or it can keep prices low to
increase its sales.
Regardless of what pricing a company chooses, the price the company charges usually needs to
be less than the utility (value) that its customers place on the good or service.
Note: The greater the utility that customers receive from a company’s products or services, the greater
the number of pricing options the company has.
A company is creating value for its customers when it produces and sells its product or performs and sells
its service. The value created is the difference between the utility (U) the customer gets from the product
and the company’s costs (C) to produce it.
U − C = Created Value
The difference between the customer’s utility and the price charged is called consumer surplus by economists.
U − P = Consumer Surplus
If the company is able to lower its costs, then it can create more value for its customers. Or, alternatively,
if the company makes the product or service more valuable through superior design, performance, quality
and service, the company is also creating more value for its customers. And when customers assign more
value, or utility, to a product or service, they are willing to pay a higher price. Thus, a company has a
competitive advantage over its competition if it can create more value for its customers than its competitors
are able to.
Durability of Competitive Advantage
The durability of the company’s competitive advantage, or how long any competitive advantage the company has will last, is an important consideration in internal analysis. Since other companies are also seeking
to develop distinctive competencies, competitors will imitate a successful company. Competitors’ imitation
will limit the successful company’s ability to profit from its competitive advantages.
The durability of a company’s competitive advantage depends on three factors:
1)
Barriers to imitation, or factors that make it difficult for a competitor to imitate the company’s
distinctive competencies, such as patents.
2)
The capability of competitors to imitate the company’s competitive advantage, based upon
their prior strategic commitments and their absorptive capacity.
Competitors’ prior strategic commitments are commitments to specific ways of doing business.
Once a company makes a strategic commitment, it will be difficult for it to respond to new competition if it would require changing its commitments.
Competitors’ absorptive capacity means their ability to make use of new knowledge.
3)
The dynamism of the industry environment, or how rapidly the industry is changing. The dynamism of the industry is a part of the external environment. When an industry is changing rapidly,
a company with competitive advantage may quickly find its market position overtaken by a competitor with a new innovation.
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If barriers to imitation are low, if competitors have the ability to imitate the company’s innovations and
innovations are being developed all the time, then competitive advantage is likely to be short-lived. And
when a company loses its competitive advantage, its profitability falls. In its most extreme form, loss of
competitive advantage can lead to complete failure of the company.
A company that has competitive advantage will be more profitable than the average company in its industry.
If it has a sustained competitive advantage, it will be able to continue having above-average profitability
over several years.
Note: A sustained competitive advantage is the primary objective of strategy. A sustained competitive advantage will lead to superior profitability and profit growth.
The Use of Internal Analysis to Avoid Failure
Three factors are thought to contribute to failure of a company:
1)
Inertia, or reluctance to change strategies in order to adapt to changing conditions in the company’s competitive environment.
2)
The company’s prior strategic commitments such as investments that may limit its ability to
imitate rivals and to be flexible, causing a competitive disadvantage.
3)
The Icarus paradox. The Icarus paradox is based on a Greek myth. Icarus used a pair of wings
that he stuck to his body with wax to escape from an imprisonment. But he flew so well that he
flew too close to the sun. The heat of the sun melted the wax holding his wings together and he
plunged to his death. The same paradox can be applied to many companies if they become too
dazzled by their own success. They believe the way to attain future success is to follow the same
strategies that made them successful in the past. They can become so specialized and inner directed that they lose sight of reality and of what is needed to maintain their competitive advantage.
In order to avoid failure, managers can use several tactics:
•
Focus on all four generic building blocks of competitive advantage: superior efficiency, quality,
innovation, and responsiveness to customers. Develop distinctive competencies in those areas
that will result in superior performance. Do not become so focused on one of them that the others
are neglected.
•
Practice continuous improvement and continuous learning. Things change so quickly that the
only way to maintain a competitive advantage over time is to continually improve the four generic
building blocks: efficiency, quality, innovation, and responsiveness to customers. To maintain continuous improvement, it is necessary to focus on learning―seeking ways to improve
operations and create new competencies. A company needs to continually analyze the processes
that underlie its efficiency, quality, innovation, and responsiveness to customers. It needs
to be able to learn from its mistakes and continually seek out ways to improve its processes.
•
Identify and adopt best practices through benchmarking104 in order to contribute to superior
efficiency, quality, innovation, and responsiveness to customers. Benchmarking is the way
a company builds and maintains the resources and capabilities that support efficiency, quality,
innovation, and responsiveness to customers.
•
Overcome the internal forces of inertia within the organization that create barriers to change. Once
the barriers to change have been identified, good leadership and appropriate changes in organizational structure and control systems are required in order to implement the changes.
104
Benchmarks are current practices of other firms, current practices of the best-performing divisions within the same
company, or the company’s own historical performance that serve as a standard against which a company can compare
its current practices.
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Importance of a Company’s Business Model in Strategic Planning
A company’s business model is its managers’ idea of how the set of strategies and capital investments the
company makes should fit together to generate above-average profitability and, at the same time, profit
growth. Following is an example.
Example: Two restaurants in the same neighborhood are both serving meals, but they have very different business models. Restaurant A targets the upscale segment, with plush decorating, an extremely
competent and solicitous wait staff, and a high value menu. Restaurant B targets families who want good
food at a very reasonable price. Restaurant B is a cafeteria where diners select their own food and carry
it to their tables.
Each restaurant’s business model dictates the way each restaurant’s value chain will be configured and
the investments that will be made to support that configuration. Each restaurant will build the distinctive
competencies it needs to accomplish the efficiency, quality, innovation and customer responsiveness
needed to support its business model. In doing so, each restaurant can achieve a competitive advantage
and generate superior profitability. Their value chain activities and investments will be very different,
however.
Restaurant A will invest in decorating and furnishing its premises, in training its staff to provide outstanding service, in buying high quality cuts of meat and the freshest possible vegetables, and in hiring
a top chef. Restaurant B will invest more in the physical facilities and the serving staff needed to speed
clients through the line and to make sure that adequate seating is available so that everyone will be able
to find a table.
For both restaurants, the circular flow of activities will be:

Each restaurant develops a business model that makes use of its distinctive competencies to differentiate its products or lower its costs.

Each restaurant determines the set of strategies to use to configure its value chain so that it will be
able to develop the distinctive competencies that will give it a competitive advantage.

Each restaurant’s distinctive competencies give it the ability to achieve superior efficiency, quality,
innovation or customer responsiveness.

These distinctive competencies in turn are used to further develop the business model to make better
use of the competencies.
Analyzing Financial Performance
An important part of the internal analysis is analysis of the company’s financial performance to identify how
its strategies contribute or do not contribute to its profitability. Comparing, or benchmarking, the company’s current financial performance against that of its competitors as well as against the company’s own
historical performance using financial statement analysis can help management to understand what is going
on in the company and identify its strengths and weaknesses.
By analyzing its financial performance, management can see whether the company is more or less profitable
than its competitors and whether its profitability has been improving or deteriorating. Analysis of financial
performance will also help management to see whether the strategies the company is pursuing are maximizing value creation, whether the company’s costs are in line with those of its competitors, and whether
the company’s resources are being used effectively.
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efham CMA
4) Formulating Strategies (SWOT Analysis)
Note: This is the fourth of the five steps in the strategic planning process.
Once the company’s external opportunities and threats and internal strengths and weaknesses have been
identified, the next step is to perform SWOT analysis.
SWOT stands for Strengths, Weaknesses, Opportunities, and Threats. The purpose of SWOT analysis is to
optimize the organization’s strengths and correct or minimize its weaknesses in order to take advantage of
external opportunities while countering external threats.
SWOT analysis consists of generating a series of strategic alternatives that could be pursued given the
company’s strengths, weaknesses, opportunities and threats. The strategic alternatives are used to select
the strategies that will do the most to align the company’s resources and capabilities to the demands of its
environment.
Management selects a set of strategies that will create and sustain a competitive advantage for the company. It considers a range of strategies. The general classifications of strategies considered are:
•
Functional-level strategy, for the purpose of improving operations inside the company. These
operations include areas such as manufacturing, marketing, materials management, product development, and customer service.
•
Business-level strategy, which includes the position of the business in the marketplace as well
as different positioning strategies that could be used. Some examples are (1) cost leadership, (2)
differentiation, (3) focusing on a particular marketing niche or segment, or (4) a combination of
more than one of these.
•
Global strategy, or considering how to expand operations outside the home country.
•
Corporate-level strategy, considering what business or businesses the company should be in so
as to maximize its long-run profitability and profit growth.
The strategies that emerge from SWOT analysis should be compatible with each other. Functional-level
strategies should support the company’s business-level and global strategies. And corporate-level strategies should also support business-level strategies.
The strategies selected by the company will constitute its business model. Remember that a company’s
business model is its managers’ idea of how the set of strategies and capital investments the company
makes should fit together to generate above-average profitability and, at the same time, profit growth.
SWOT analysis enables management to choose among possible business models and to fine-tune the
business model selected.
The four classifications of strategies―functional-level, business-level, global, and corporate-level―are discussed below.
Functional-Level Strategy
Functional-level strategies are developed to improve the effectiveness of a company’s operations. Improved
effectiveness of operations improves the company’s ability to achieve superior efficiency, quality, innovation, and customer responsiveness.
A company’s distinctive competencies determine the functional-level strategies it can pursue. Remember
that when companies increase the utility their customers receive from their products through differentiation
while at the same time lowering their costs, the result is superior profitability and profit growth. And superior profitability and profit growth go along with competitive advantage.
A company’s ability to achieve competitive advantage depends upon its ability to attain superior efficiency, quality, innovation, and customer responsiveness. Those four generic distinctive
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competencies will determine whether the company’s products and services will be differentiated from
those of its competitors. They will also determine whether the company will have a low-cost structure.
Managers can build resources and capabilities that will enhance the company’s distinctive competencies by
means of their choices with regard to functional-level strategies.
Superior efficiency can be increased by:
•
Taking advantage of economies of scale and the effect that learning has on efficiency.
•
Using flexible manufacturing technologies.
•
Reducing customer loss rates.
•
Adopting just-in-time inventory systems.
•
Designing new products that are easy to manufacture.
•
Training employees.
•
Utilizing self-managing teams.
•
Linking pay to performance.
•
Making use of technology such as web-based information systems to reduce the costs of coordination between the company and its suppliers and the company and its customers.
•
Building a commitment to efficiency throughout the organization.
•
Designing facilities that will foster cooperation among the various functions in order to improve
efficiency.
Superior quality consists of reliability and excellence. A reputation for quality gives a company a means
to differentiate its products from those of its competitors. Higher quality creates more utility in the opinion
of its customers and so gives the company more options with respect to pricing. Furthermore, eliminating
defects from the production process lowers the costs for the company and thus increases its profitability.
Improvement of reliability can be accomplished through the use of Six Sigma. Six Sigma is an approach
to quality that strives to virtually eliminate defects. To achieve Six Sigma, a process must produce no more
than 3.4 defects per million opportunities. “Opportunities” refers to the number of opportunities for nonconformance or for not meeting the required specifications. “Opportunities” are the total number of parts,
components, and designs in a product, any of which could be defective. If a product has 10,000 parts,
components, and designs, for example, 3.4 defects per million would amount to 34 products out of every
1,000 that would have some defect. The goal of Six Sigma is to improve customer satisfaction by reducing
and eliminating defects, which will lead to greater profitability.
Six Sigma is a descendant of the Total Quality Management (TQM) techniques that were used by companies
during the 1980s and early 1990s. TQM is discussed in more detail in Business Process Improvement in
Section D, Cost Management, in Vol. 2 of this textbook.
Improvement of excellence involves improving not only the product attributes, but also the service
attributes and personnel attributes associated with the company’s product. First, the company needs
to identify the attributes that are important to its customers. It then needs to design its products and
services to embody those attributes. It also needs to make sure its personnel are trained so that the correct
attributes will be emphasized.
Although the product may have several different attributes that differentiate it, the company cannot cover
all of them in its communication messages. To do so would lead to an unfocused message. Therefore, the
company’s management needs to decide which of these attributes to promote and how to position its
products. In other words, management needs to decide how to craft the marketing message so as to create
the image the company wants to have in the minds of its customers. The attribute or attributes the company
emphasizes will determine the position the company and its products will occupy in the minds of its customers.
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And finally, excellence requires a company to continually improve its product attributes. Therefore, it is
important to have a strong R&D department that can work to continually upgrade the attributes designed
into the company’s products.
Superior innovation is in many ways the most important source of competitive advantage. Innovation
can result in improvements to the excellence of existing products as well as result in new products. It can
also result in finding ways to reduce costs. Therefore, the ability to innovate in order to develop new products and new processes gives a company a major competitive advantage that allows the company to (1)
differentiate its products and charge a premium price, or (2) lower its costs below those of its competitors,
or both. However, maintaining this competitive advantage requires continuing innovation, because competitors will imitate successful innovations. Furthermore, only about 10% to 20% of R&D projects actually
become commercially successful products. To be successful, a company must be able to coordinate its R&D
efforts with its marketing, production, and finance efforts. Top management must be primarily responsible
for overseeing the development process.
Superior responsiveness to customers means giving customers what they want when they want it at a
price they are willing to pay, and doing it profitably. Responsiveness to customers is an important way for
a company to build brand loyalty and thus differentiate itself from its competitors. If a company has strong
product differentiation and enjoys strong brand loyalty it will have more pricing options. It can charge a
premium price or it can keep its prices low in order to sell more.
The factors of efficiency and quality go along with being responsive to customers. In addition, giving customers what they want includes innovation in the development of new products or new features of existing
products.
Thus, superior efficiency, quality and innovation are all part of superior responsiveness to customers.
Business-Level Strategy
Business-level strategy relates to the business’s position in the market. Successful selection and pursuit
of a business model permits a company to compete effectively. Business-level strategies that create competitive advantage contribute to a successful business model.
In developing its business model, a company must define its business first. Defining its business includes
three sets of decisions. The decisions managers make about these issues determine the strategies they will
formulate and implement in order to put the company’s business model into action. Those decisions are:
•
Decisions about customers’ needs and what needs are to be satisfied. This decision entails
decisions about how much to differentiate the company’s products versus the need to minimize
costs so that its products can be offered at competitive prices. Some companies will choose to
differentiate their products to a great degree through innovation, excellent quality, or responsiveness to customers. These managers are investing their resources to create something distinct
and different, and as a result they can often charge a premium price. Other managers will base
their business models on increasing efficiency and reliability in order to reduce costs. These managers are choosing to offer customers low-priced products.
Regardless of what level of differentiation a company chooses for its business model, it will need
to recognize that its cost structure will vary as a result of the level of differentiation it chooses.
Alternatively, a choice to offer low-priced products will affect the amount of differentiation the
company can pursue. There will always be a trade-off between differentiating products
and achieving cost leadership, or having the lowest cost structure.
•
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Decisions about what products should be offered and to which customer groups they
should be offered. Many different customer groups exist. The company needs to group customers
according to their needs in order to determine what products to develop for each different kind of
customer. Customer groups that have been identified are treated as market segments. The company must then decide whether to offer a product that will satisfy the needs of each identified
market segment. The company might choose to offer products targeted at the average customer.
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If the company targets the average customer, customer responsiveness is at a minimum and the
company is focusing on price, not differentiation. Or, the company might choose to recognize
differences among customer groups and offer products targeted toward most of the market segments. For a company targeting most of the market segments, customer responsiveness is high
and the focus is on differentiation, not on price. Or third, the company might decide to target just
one or two of the identified market segments and offer products for customers in only these segments. The company targeting just one or two market segments is being highly responsive to
customer needs in only those segments.
•
Decisions about how customer needs are to be satisfied, using the company’s distinctive
competencies. The task is to implement the chosen business model. Implementing the business
model involves choosing strategies to create products or services that will provide customers the
most value while keeping the cost structure at a level that will permit the products or services to
be price competitive. The company’s capital is invested in order to shape the company’s distinctive
competencies in a way that will result in a competitive advantage based on superior efficiency,
quality, innovation, and responsiveness to customers.
A company’s choices with respect to its competitive positioning will be affected by the competitive structure
of the industry in which it operates. If competitors move into new market segments, the company may
need to do the same in order to remain competitive. And because differentiation increases costs, increased
industry competition can drive up costs for all companies in the industry. When costs go up, a company’s
continued profitability will depend upon its ability to charge a premium price to cover its costs.
Therefore, the profitability of a company is dependent on making the right choices with respect to differentiation, costs, and pricing in light of conditions in the company’s market and industry. The variables are
market demand, competition within the industry, differentiation, pricing options, and cost structure. As one
variable changes, the other variables will change in response to the changes in the first variable. Therefore,
managers can never be certain about the outcomes of their decisions.
In order to achieve profitability that is greater than the average in its industry, a company must formulate
and implement a business model that will give it a specific competitive position in relation to its
competition. Four generic competitive strategies will give a company competitive advantage. They are
called “generic” because any company can pursue them, regardless of what kind of business or industry
they are in.
The four generic competitive strategies are:
1)
Cost leadership, or having a lower cost structure than all of its competitors. The cost leader can
charge a lower price than the competition, thus attracting more business, and the increased sales
will lead to higher profits. Even if its competitors match its lower prices, the cost leader will still
have the advantage because its costs will be lower.
The cost leader must choose strategies that will increase its efficiency and lower its cost structure,
compared with its competition. It must have distinctive competencies in manufacturing, materials
management, and information technology or an organizational structure and culture that will allow
it to implement a cost leadership strategy, or both.
The danger in a cost leadership strategy is that competitors may find ways to lower their cost
structures, too. For example, more and more companies are outsourcing manufacturing and other
aspects of their businesses overseas, where costs are much lower. The cost leaders started the
practice and their competition followed suit in order to remain competitive. Another risk is that in
their zeal to cut costs, managers might make decisions that cause quality or service or both to
suffer, leading to customer dissatisfaction and in turn, to decreases in demand and sales. The
resulting decreased profitability will be the opposite of what the company hoped for, not to mention the long-term damage done to the company’s reputation and position in the marketplace.
2)
Focused cost leadership, or competing within a narrow market segment using the strategy
of cost leadership. A company using focused cost leadership may be a local business reaching a
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local market. The company competes with the national cost leader only in markets where it does
not have a cost disadvantage because of its smaller size. The focused cost leader might concentrate
on low volume products for which it has a cost advantage over a national chain because it purchases its materials locally and economies of scale do not exist in that market. An example of a
focused cost leader might be a local brickyard, where bricks are manufactured on site and delivered
directly to local construction sites. That company might very well have a cost advantage over a
brick manufacturer marketing nationally. The national brick manufacturer could have very high
costs to transport its bricks to distributors for further sale and delivery to construction sites.
3)
Differentiation, which is based on achieving competitive advantage by providing a product that
is different or unique in some important way. The differentiation is due to superior innovation,
excellent quality, or superior responsiveness to customer needs, because those are the
three principal ways to achieve product differentiation. A differentiator can charge a higher price
than its closest competitors because of its perceived advantages to the customer.
However, the true differentiator has no close competitors, because it strives to differentiate itself
from the competition in as many ways as possible. The less its product or service resembles that
of its competition, the more protected it will be from competition. A differentiator frequently uses
niche marketing ― segmenting its markets into niches and providing products specifically for each
niche ― so that in each of its market niches, it will attract customers who are willing to pay a
premium price for something they can get nowhere else.
A differentiated company develops distinctive competencies in whatever functions provide the
source of its competitive advantage. For instance, differentiation on the basis of innovation requires an effective R&D function. The differentiator must control its costs so that the price of the
product is not greater than its customers will pay, but it must not minimize them so much that it
loses its source of differentiation. The danger with a differentiation strategy is that competitors
may imitate successful differentiation, eliminating the advantage.
4)
Focused differentiation, or a business model that specializes in serving the needs of just one or
two market segments or niches. The focused differentiator positions itself to compete with the
primary differentiator in the market but in only one or two of the market’s segments by focusing
on one type of customer, such as babies or elderly people, or on one type of product, such as
organic foods. The company can have greater knowledge of the needs of a small group of customers and can provide superior responsiveness to those customers. Or, concentration on just a few
products can allow the focuser to be more innovative than a larger company could be.
A focuser limits its market segments because if it is too successful in too many market segments,
the primary differentiator in the market will imitate its business model. The primary differentiator
would have more resources available than the focused differentiator would have. A company that
starts out as a focused differentiator may grow to become the leading differentiator in its industry,
however, through expansion.
A focused differentiator can protect its competitive advantage if it can continue to provide a product or a service better than its competitors can. However, its risk is that its niche may disappear
over time because of technological changes or changes in customers’ tastes. One of the reasons
so many small companies go out of business is that their niches disappear.
A company must continually work to improve its business model by identifying and responding to changing
opportunities and threats. Its business-level strategies need to work together and continue to work together
if the company is to achieve and maintain competitive advantage. Ensuring that the company is optimally
positioned against its competitors is one of management’s most important tasks.
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Corporate-Level Strategy
Corporate-level strategy involves a long-term perspective. Managers need to continually consider how
changes taking place in an industry, in technology, in customer preferences, and among competitors will
affect the company’s current business model. Focusing on corporate-level strategies can help managers
recognize trends and future opportunities, so that they can position the company to compete successfully
in the changing environment. Corporate-level managers need to constantly be analyzing how emerging
technologies might impact their business models, how customer needs and customer groups might change
as a result, and what new distinctive competencies will be needed.
Thus, corporate-level strategy is used to redefine and reposition the company’s business model as needed
to achieve and maintain its position in the changing environment through taking advantage of opportunities
and defending against threats.
Some companies are better off staying in one industry, while others will do better if they enter other
industries. Managers use corporate-level strategy to determine which industries the company
should enter to maximize its long-run profitability. The company’s corporate-level strategies should
support the company’s business model so that it can achieve a sustainable competitive advantage at the
business level. And having a competitive advantage leads to increased profits.
Horizontal integration is a corporate-level strategy that involves acquiring or merging with competitors
to achieve competitive advantages such as economies of scale. Mergers and acquisitions can also occur
between companies in different countries. Horizontal integration can increase profitability if the integration
lowers the cost structure of the resulting company, increases product differentiation, replicates a company’s
successful business model in new market segments, reduces rivalry in an industry, and increases the company’s bargaining power with suppliers and customers. However, horizontal integration has problems. There
is significant evidence that most horizontal mergers and acquisitions do not create value for shareholders
but, in fact, actually destroy it. In the majority of cases, the resulting company is not more profitable than
the separate companies were and may even be less profitable than the separate companies were. Some of
the reasons for the decreased profitability are problems associated with differences in company cultures
and management turnover in the acquired company.
Vertical integration is used to strengthen a company’s business model and improve its competitive position for many of the same reasons that horizontal integration is used. In vertical integration, a company
expands its operations either into an industry producing inputs to the company’s operations or forward into
an industry that uses the company’s products. Companies at different stages in the value chain add value
at each stage of the process as the product moves from raw materials to the customer. For example, if a
company’s business is the final assembly of purchased parts, backward integration would be merging with
or acquiring a company that produces component parts for its final assembly. Vertical integration can increase product differentiation, lower costs, or reduce industry competition if it facilitates investments in
specialized assets that enhance efficiency, enhance product quality, and result in improved production
scheduling that enable the company to respond more quickly to sudden changes in demand. However,
when vertical integration results in an increased cost structure, disadvantages arise when demand is unpredictable. Disadvantages also can develop when technology is changing quickly. When technology is
changing quickly, vertical integration can make the company less flexible if the company is locked into outof-date technology because it has acquired a company that produces obsolete components.
Strategic alliances are an alternative to vertical integration. Strategic alliances are long-term cooperative
relationships between two or more companies to work together to develop a new product that will benefit
all of the parties to the strategic alliance. Generally, the companies agree that one will supply the other,
and the one doing the purchasing commits to continue purchasing from that supplier. A strategic alliance
creates a stable, long-term relationship that lets both companies capture some of the benefits that vertical
integration supplies while avoiding the problems of having to manage a merged company.
Strategic outsourcing involves the performance of one or more of a company’s value-chain activities by
an independent specialist company. These independent companies focus on just one activity, and the company can, in turn, focus on fewer value-chain creation activities. Companies often outsource activities where
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the company does not have a distinctive competency. Because companies offering outsourced services
specialize in a particular activity, they can frequently perform it in a cost-effective way or in a way that will
improve the company’s differentiation. Outsourcing can help a company lower its costs, better differentiate
its product, and focus on its distinctive competencies. A risk of outsourcing is holdup, which occurs when
the company becomes too dependent on the outsourcer and the outsourcer uses this dependency to increase its prices. Another risk is the loss of valuable information, such as a loss of awareness of customer
complaints when customer service is outsourced.
Diversification, or entering one or more new industries to take advantage of the company’s distinctive
competencies and business model, is another corporate-level strategy. Diversification can be in a related
industry or in an unrelated industry. Companies that remain in one industry may use horizontal integration
and strategic outsourcing to strengthen their business models. However, the company’s fortunes are tied
to the fortunes of its single industry, which can be dangerous if that industry matures and goes into decline.
Management of a company can identify new product opportunities by thinking of the company as a portfolio
of distinctive competencies and then considering how to leverage (take advantage of) those distinctive
competencies to create more value and profit in the new industry. The new business or product line might
be in an industry that is related to its existing activities because of some kind of attribute shared by the
businesses that allows them to create more value by adding the product line.
5) Developing and Implementing the Chosen Strategies
Note: This is the fifth of the five steps in the strategic planning process.
Once a set of strategies has been chosen to achieve competitive advantage and increase performance, the
strategies must be translated into action. Translating strategy into action is strategy implementation, or
taking the actions necessary to execute the strategic plan.
Strategy implementation takes place in the context of the organization’s organizational design. Organizational design involves determining how a company should create, combine and use three elements to
pursue its business model successfully:
1)
Its organizational structure
2)
Its control systems
3)
Its organizational culture
The above three elements of organizational design are the means by which the organization motivates and
coordinates its members to work toward achieving competitive advantage through its distinctive competencies. Remember that those distinctive competencies are superior efficiency, superior quality,
superior innovation, and superior responsiveness to customers.
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•
Organizational structure specifies who should do what, how it should be done, and how the
various people and groups should work together to increase efficiency, quality, innovation, and
responsiveness to customers. Specific employees are assigned to specific value creation tasks
and other roles. A company’s organizational structure coordinates and integrates employee efforts
at all levels—corporate, business, and functional. It also coordinates and integrates employee efforts across the company’s functions and business units so that employees work together to
achieve the strategies specified by the business model.
•
Control systems provide managers with incentives to motivate their employees to work to increase efficiency, quality, innovation, and responsiveness to customers. Control systems
also provide feedback to managers on how well the company and its employees are succeeding in
increasing these building blocks of competitive advantage. Feedback from control systems enables
management to take action when needed to strengthen the business model.
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B.1. Strategic Planning
Organizational culture includes all of the norms, values, beliefs and attitudes that people in an
organization share. It is the company’s way of doing things, and it controls the way its members
interact with one another and also with outside stakeholders. Different norms and values are appropriate in different types of organizations, and managers need to be intentional about cultivating
and developing the organizational norms and values that are appropriate in their organizations.
Furthermore, the structure of an organization affects its culture. In order to change the culture, it
may be necessary to change the structure.
Note: The three elements of organizational design—organizational structure, control systems, and
organizational culture—are extremely important factors in a company’s success. They determine its
members’ behaviors, values, and attitudes and how the members will implement the organization’s
business model and strategies.
Analysis of a company’s organizational design can lead top management to devise ways to restructure
the company’s culture, organizational structure, and control systems in order to improve coordination and
motivation among its people. Effective organizational design can give a company the means to obtain
competitive advantage and above-average profitability. Therefore, the next priority after formulation of the
business model and strategies is organizational design.
Question 44: Which of the following should not be included in a company’s internal analysis process?
a)
Issues relating to creating value for the company’s customers.
b)
Understanding the company’s capacity for innovation.
c)
Evaluation of environmental issues that may affect the company’s profitability.
d)
Weak areas within the internal organization that should be improved.
(HOCK)
Other Planning Tools and Techniques
Situation Analysis and PEST Analysis
Situation analysis is the systematic collection and evaluation of external and internal forces that can
affect the organization’s performance and choice of strategies and assessing the organization’s current and
future strengths, weaknesses, opportunities and threats. Steps 2, 3 and 4 of the strategic planning process
outlined in this book—analyzing the organization’s external and internal environment and formulating and
selecting strategies to optimize the organization’s strengths and correct for its weaknesses and limitations
to take advantage of opportunities while countering threats (SWOT analysis)—is a type of situation analysis.
PEST analysis is another type of situation analysis. “PEST” stands for Political, Economic, Social, and Technological factors that are examined in the process of doing strategic planning for an organization.
Political factors involve the way a government of a country behaves. Political factors are outside the control
of a business, so the business must understand how political changes can affect it. Some political factors
that should be considered are:
•
Trade regulations, pricing regulations, and tariffs.
•
Wage legislation, such as minimum wage requirements.
•
Political stability or instability of the country, because when a country is politically unstable, its
citizens’ spending habits change.
•
Product labeling requirements that must be adhered to.
•
Industrial health and safety regulations.
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Economic factors include exchange rates, inflation rates, interest rates and economic growth or contraction
and the effects they can have on a business. Analyzing the economic factors can help a business forecast
demand and costs. Other examples of economic factors that should be considered are:
•
The skill levels of the workforce and the cost of labor.
•
The unemployment rate within the market, because if unemployment is high, demand will be depressed.
•
The stage in the business cycle the country is in, since that also determines how great the demand
will be.
•
The economic system in the countries where the business operates.
•
Any intervention by the government in the market.
Social factors refer to the culture in a country, its population growth rate, the average age of the population
and the age distribution, and the attitudes of its citizens toward things such as health and careers. Social
trends can have a great effect on demand for a business’s products and services. Other social considerations
include:
•
Demographics can be used to see where in the country people live and work.
•
Education level, as education plays a major role in what kind of work people do and how much
disposable income they have.
•
Attitudes of the population toward the environment.
•
Leisure interests of the population.
Technological factors help a business determine what technology to focus on in the future:
•
New developments in technology affect how the business operates on a day-to-day basis and how
it delivers its services and interacts with its customers and suppliers.
•
Technology can impact the structure of the company’s value chain.
•
Technology can affect the cost structure of the business. Technological advancements can help a
business reduce its costs and become more profitable.105
Different companies will need to focus on different factors in performing their PEST analyses, depending on
the industry each company is in and the products it produces and sells. For example, a defense contractor
would be more affected by political factors than would a consumer-goods company, and companies in
cyclical industries will be more affected by economic factors than will those that are less affected by economic cycles.
Competitive Analysis
Competitive analysis is also similar to SWOT analysis in some ways. It involves analyzing the competitive
environment in which a business operates or is considering operating in to determine the following:
105
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•
Strengths and weaknesses of competitors.
•
Demographics and needs of the market in which the business operates.
•
Strategies to improve the company’s position in the marketplace.
•
Impediments to the company’s entering new markets.
•
Barriers the company can erect to limit competitors’ ability to erode the company’s place in the
market.
Source: www.pestanalysis.net. Accessed June 14, 2014.
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Competitive analysis includes:
•
Defining the competitors.
•
Analyzing the competitors’ strengths and weaknesses.
•
Analyzing the company’s own internal strengths and weaknesses.
•
Analyzing customer needs and wants.
•
Studying impediments to the market for both the company and its competitors, such as patents,
high start-up costs, or a high level of knowledge required for success.
•
Developing a strategic plan that reflects the findings from the above activities.106
Contingency Planning and Scenario Planning
Contingency planning is planning that a company develops to prepare for possible events. In a way, it is
“what if” planning. This widely-used approach is also called “scenario planning” and, as its name implies,
involves considering alternatives that enable an organization to respond quickly to future events, generally external, that are often unpredictable.
External events, called external contingencies, are factors that are not within the control of the organization but that influence the strategic planning process. External contingencies include changes in the
competitive environment, changing government regulations, political issues, changing demographic trends,
advances in technology, and changes in the physical environment.
Internal contingencies may also affect the strategic plan, although internal contingencies are usually
within the control of the organization. Internal contingencies include changes in the mission of the organization, changes in organizational objectives, changes in organizational culture, and organizational design
issues.
Contingency planning involves developing two or more plans, each based on a different set of strategic and
operating conditions. Then, the plan that is implemented is the one for the specific circumstances that
actually occur. When a plan is already in place for a potential negative event or threat, the company can
quickly implement an appropriate alternative to waylay or mitigate the damage.
Contingency plans are especially critical for companies that are likely to be significantly influenced by external events. A contingency plan enables companies to respond quickly and in the best possible manner
when changes in external factors might adversely impact strategic plans.
Preparing different plans for different situations increases costs because it entails developing multiple plans.
A company will undertake this approach when its management thinks that the action of the contingency
planning will eventually lead to greater savings than the cost of the planning itself.
Contingency planning is an approach that organizations often use in financial planning and analysis because
it considers several alternative possibilities, specifically those concerning external variables.
106
Source: http://www.referenceforbusiness.com/small/Bo-Co/Competitive-Analysis.html. Accessed June 14, 2014.
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Question 45: Contingency planning is a process that companies undertake to:
a)
Make certain that their capacity will be able to meet the expected demand as well as decide how
to obtain this capacity.
b)
Determine how to obtain the necessary financing for the future.
c)
Understand how customer expectations have changed.
d)
Prepare for future, external events.
(HOCK)
The Boston Consulting Group (BCG) Growth-Share Matrix
The BCG Growth-Share Matrix is a method of analyzing a company’s portfolio of products to determine
where each product is in its life cycle. It was developed by the Boston Consulting Group in the 1970s to
assist corporations in analyzing the life cycles of their product lines in order to make better decisions about
allocation of resources in planning.
The BCG Matrix classifies products into four categories based on the growth of the markets they are in and
their share of those markets. The matrix is a two-by-two grid. Market growth rate is shown on the vertical
(left) axis and relative market share is displayed along the horizontal (top) axis. A product’s position on the
relative market share scale, either high or low, indicates its cash generation capability and its position on
the market growth rate scale, either high or low, indicates its need for cash for investment.
BCG GROWTH-SHARE MATRIX
Relative Market Share (Cash Generation)
HIGH
HIGH
QUESTION MARK
LOW
Market Growth Rate (Cash Usage)
STAR
LOW
CASH COW
DOG
A star is a product in an industry that has a high market growth rate and the product has a high market
share and is capable of generating substantial revenue. Robust market growth leads to rapidly growing
sales, which in turn create a need for working capital to support the required increases in accounts receivable and inventory. Therefore, a star product requires high levels of cash for investment.
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If a star can maintain a high market share when the market’s growth rate declines, it will become a cash
cow (see below). When managed properly, star products can ensure future cash generation. The company
may adjust the price of a star several times, decreasing it to claim market share and then increasing it to
maximize revenue as the product’s market share and popularity grow.
A question mark is a product in an industry that has a high market growth rate but the product has a
low market share. In a rapidly growing market, the question mark’s sales also grow rapidly, so questionmark products consume a great deal of cash for investment but, conversely, the cash generated by the
product is low because of its low market share.
A question mark has potential to gain market share and become a star and then eventually a cash cow
when the growth rate of the market slows. But for the present, a question-mark product is problematic in
that it generates negative net cash flow. Furthermore, if the question mark does not attain a greater share
of its market, it will turn into a dog (see below) when the growth rate of the market declines. A question
mark may or may not be worthy of the additional investment that would be required to increase its market
share. It needs careful analysis to determine whether or not to invest more money in it. Because the market
share of a question-mark product needs to be increased quickly in order to prevent the product’s turning
into a dog, pricing of a question-mark product should be aggressive.
A cash cow is a product in a mature industry that has a low market growth rate but the product has a
high market share. Cash cows generate more cash than they consume. They are regarded as boring, but
any company would be glad to have them. They should be “milked” to extract maximum profits. Investment
in a cash cow should be minimal because the slow growth of the market means very little return. Cash-cow
products are fairly stable, in terms of features and price.
A dog is a product in a mature industry with a low market growth rate and the product has a low
market share. A dog neither consumes many resources nor does it generate much cash. It is usually
barely breaking even. Investing in such a product is not effective or efficient, because it depresses the
company’s return on assets. Pricing for dogs is not a major concern, and dogs should be sold off.
According to the BCG Matrix, the natural life cycle for a business unit or a product is question mark, then
star, then cash cow. At the end of its life cycle, the cash cow turns into a dog. However, if the question
mark fails to achieve star status (stardom), it falls to dog level (dogdom) when the market’s growth rate
slows.
A diversified company with a balanced portfolio will have some stars, some question marks, and some cash
cows, while eliminating the dogs. The stars’ high market share and high growth rate create a sense of
future income stability, the question marks have the potential to become stars if they receive the necessary
investment, and the cash cows supply the cash to fund the future growth of the stars and the question
marks.
Characteristics of Successful Strategic Plans
•
Strategic planning should be an ongoing process, not just a one-time or even a once-a-year or
once-every-five-years activity. It should be integrated into the organization as a core business
practice that keeps the company focused on its strategic direction.
•
A successful strategic plan is integrated throughout the organization. Strategies should be
balanced across all of the dimensions that will drive growth in the organization. All of the different
areas of the business need to be in alignment and operating together. The plan should not focus
only on specific areas such as financial results or marketing programs. Instead, it should address
the whole company’s strategy. For example, the marketing program should support the strategic
initiatives of the organization.
•
In developing a strategic plan, all former assumptions should be challenged. The strategy
should be based on a clear understanding of the current direction of the business environment and
the company’s markets, not just a reiteration of the previous plan.
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•
Strategies should be long-term in nature. However, if an idea or a discovery that could lead to
a new product or a new market is brought forth or if a disruptive change occurs in the market after
the plan has been formalized, the plan should be flexible enough to enable the company to respond
to the change or the new opportunity. If the plan cannot be changed and if the company cannot
change its direction when necessary, the company’s actual results may diverge more and more
from the strategic plan, and the plan may become irrelevant.
•
Employees at all levels should have input into the strategic planning process. Although top
management must take the lead and make the final decisions, input should not be limited to top
management. Sometimes the best ideas for change come from lower level managers, engineers,
or customer service employees because those people are closest to what is going on. Furthermore,
inclusion of lower-level managers and employees in the planning process promotes their understanding and ownership of the plan, motivates them to participate in its implementation, and helps
them to perceive that the decision-making process is fair and inclusive.
•
Everyone in the organization needs to know what the firm is trying to achieve. The strategy should
be communicated clearly and often to everyone in the organization. The strategy should be
viewed as a roadmap to take the firm from vision to reality.
•
The success of the strategy lies in its execution. The organization and its people need to have
the tools to properly execute the strategy. Performance objectives should be developed, and employees at all levels should have performance incentives linked to the company’s strategy.
•
The strategic planning process should be viewed as an opportunity to develop a shared vision,
increase the sense of joint-ownership among the staff, and build a leadership team that
is focused on moving the business in the right direction.
Benefits of Planning
•
Objectives are formally expressed and the methods of attaining the objectives are clearly defined.
The plan focuses employees’ attention on the company’s stated objectives and facilitates coordination
of efforts.
•
If the plans are communicated properly throughout the organization, employees may feel more motivated to take part in carrying them out.
•
When planning is done in advance, risk and uncertainty can be minimized, backup plans can be
prepared, and decisions can be made in a measured, disciplined manner rather than spontaneously.
•
Planning can improve a company’s competitive advantage. The company can plan ahead and find the
best prices for resources it needs and it can use those resources more effectively, leading to reduced
costs and higher profitability.
•
Planning helps the company to efficiently effect changes in its procedures, product line, and facilities.
•
Planning provides the objectives against which actual performance can be measured, facilitating controlling.
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Limitations of Planning
•
Planning is time-consuming and costly. The services of outside professionals such as accountants and
marketing experts may be needed, and the planning process itself takes managers’ time away from
other responsibilities. The costs versus the benefits need to be weighed before embarking upon a
complex planning process.
•
Following a plan too rigidly can cause the business to be unable to adapt to new threats or to take
advantage of new opportunities. Plans can hinder managers’ creativity and innovation if they are not
flexible enough to accommodate changes that may be suggested by new ideas.
•
Planning is based on forecasts that may be inaccurate. A large variance between actual circumstances
and planned circumstances, such as an unplanned recession, natural disaster, labor strike, or technological change may cause the plan to become ineffective or unworkable. Excessive reliance on a
plan in the face of obviously changed circumstances can cause severe problems.
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B.2. Budgeting Concepts
Most people in business are familiar with budgets in at least an informal manner. People often see them at
work or are impacted by them when something cannot be done because it is “not in the budget.” The
budget is developed in advance of the period it covers, and it is based on forecasts and assumptions. But
the budget is not something that is primarily for the purpose of restricting what can be done. It is intended
as a planning tool and is a guideline to follow in order to achieve the company’s planned goals and objectives.
The budgeting process is inseparably linked to the planning process in an organization. Major planning
decisions by management are required before the budget can be developed for the coming period. Furthermore, the development of the budget may cause previously developed short-term plans by management
to require adjustment. As the projected quantitative results of the plans become clear in the developing
budget, management may need to revise its plans. After the plans and the budget have been adopted, as
the period unfolds the budget provides control and feedback.
Budgeting Concepts covers the different types of planning and budgets and how the planning and budgeting
process within a company works. The reports that come about as a result of the budget and the different
types of budgets that may be prepared will also be discussed.
The Relationship Among Planning, Budgeting, and Performance Evaluation
Planning, budgeting, and performance evaluation are interrelated and inseparable. Following is an overview
of the process:
1)
Management develops the plan, which consists of goals, objectives, and a proposed plan of action
for the future. The plan includes the company’s short-term as well as long-term goals and objectives and its business opportunities and risks. For example, a plan may look at the future from the
perspective of expanding sales, increasing profit margin, or whatever the company sees as longterm goals. The plan is a guide showing where the company needs to be in the future.
2)
The plan developed by management leads to the formulation of the annual profit plan, also called
the budget. These two terms will be used interchangeably throughout this section. The profit plan
expresses management’s plans for the future in quantitative terms. The profit plan also identifies
the resources that will be required in order to fulfill management’s goals and objectives and how
the resources will be allocated. The budget should include performance of the company as a whole
as well as the performance of its individual departments or divisions. Managers at all levels need
to reach an understanding of what is expected.
3)
Budgets can lead to changes in plans and strategies. Budgets provide feedback to the planning
process because they quantify the likely effects of plans that are under consideration. This feedback may then be used by managers to revise their plans and possibly their strategies as well,
which will then cause revisions to the profit plan during the budgeting process. This back and forth
exchange may go on for several iterations before the plans and the budget are adopted.
4)
Once the plans and the budget have been coordinated and the budget has been adopted for the
coming period, as the organization carries out its plans to achieve the goals it has set, the master
budget is the document the organization relies upon as its operating plan. By budgeting how much
money the company expects to make and spend, the company creates a series of ground rules for
people within the organization to follow throughout the year.
5)
Actual results are compared to the profit plan. The profit plan is a control tool. “Controlling” is
defined as the process of measuring and evaluating actual performance of each organizational unit
of an enterprise and taking corrective action when necessary to ensure accomplishment of the
firm’s goals and objectives. The profit plan functions as a control tool because it expresses what
measures will be used to evaluate progress. A regular (monthly or quarterly) comparison of
the actual results—both revenues and expenditures—with the profit plan will give the
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company’s management information on whether the company’s goals are being met. This
comparison should include narrative explanations for variances and discuss the reasons for the
differences so that mid-course corrections can be made if necessary.
6)
Sometimes, the comparison of actual results to the profit plan will result in the revision of prior
plans and goals or the formulation of new plans, changes in operations, and revisions to the budget.
For example, if changes in the company’s external environment cause variances in revenues or
costs to become extreme, a revised short-term profit plan covering the remainder of the year may
be necessary.
7)
Changed conditions during the year will be used in planning for the next period. For example, if
sales decline, the company may plan changes in its product line for the next period in order to
reverse the trend.
Advantages of Budgets
When properly developed and administered, budgets:
1)
Promote coordination and communication among organization units and activities.
2)
Provide a framework for measuring performance.
3)
Provide motivation for managers and employees to achieve the company’s plans.
4)
Promote the efficient allocation of organizational resources.
5)
Provide a means for controlling operations.
6)
Provide a means to check on progress toward the organization’s goals.
1) Coordination and Communication
Coordination means balancing the activities of all the individual units of the company in the best way so
that the company will meet its goals and the individual units of the company will meet their goals. Communication means imparting knowledge of those goals to all employees.
For example, when the sales manager shares sales projections with the production manager, the production
manager can plan and budget to produce the inventory that is to be sold. And the sales manager can make
better forecasts of future sales by coordinating and communicating with branch managers, who may be
closer to the customers and know what the customers want.
2) Measuring Performance
Budgets make it possible for managers to measure actual performance against planned performance. The
current year’s budget is a better benchmark than last year’s results for measuring current performance.
Last year’s results may have been negatively impacted by poor performance and the causes may have now
been corrected, so comparing current results with the previous year’s results would set the bar too low.
Furthermore, the past is never a good predictor of the future, and the profit plan should reflect the conditions anticipated for the coming period, not the conditions that existed during the past period or periods.
However, performance should not be compared against the current budget only, because that can
result in lower-level managers setting budgets that are too easy to achieve. It is also important to measure
performance relative to the performance of the industry and even relative to performance in prior years.
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3) Motivating Managers and Employees
A challenging budget improves employee performance because no one wants to fail, and falling short of
achieving the budgeted numbers is perceived as failure. The goals quantified in the budget should be demanding but achievable. If goals are so high that they are impossible to achieve, however, they are demotivating.
4) Efficient Allocation of Resources
The process of developing the operating budgets for the individual units in an organization includes identifying the resources each unit will need to carry out the planned activities. For example, the process of
developing the production budget requires projections for direct materials and direct labor that will be
required to produce the planned output. The process of budgeting for administrative salaries requires forecasts of administrative employees that will be needed by each department. If funds will be available for
only a certain number of administrative employees in the organization, some units’ projections may need
to be adjusted. This process leads to efficient allocation of organizational resources.
Efficient allocation of organizational resources during the budgeting process may also include making decisions about the most profitable way to utilize the resources available. A decision about what product or
products to produce may need to be made under a situation of constraint. A constraint exists when one
or more of the factors of production are limited in some way. This type of decision would be required if a
plant were operating at full capacity and management wanted to maximize net income without increasing
capacity.
Decisions made under situations of constraint are usually short-run decisions. In the short run, managers
must do the best they can with the resources they have. When a company is operating at capacity, it
maximizes its operating income by maximizing the contribution margin per unit of the resource that is
limiting either the production or the sale of products.107
In the long run, however, capacity can be expanded and constraints eliminated, or at least reduced.
Note: Contribution margin is sales revenue minus variable costs. A company or division’s contribution
margin is the amount from sales that the company is able to put toward covering its fixed costs or profit
after the variable costs have been covered. Contribution margin per unit is the selling price of one unit
minus the variable cost of one unit. The concepts of contribution margin and contribution margin per
unit are covered more fully in Section D, Cost Management, in Vol. 2 of this textbook.
Example: Carl Corporation has only 3,000 machine hours available to produce its products. It is operating at full capacity and can sell all the products it manufactures. Carl Corporation produces two
products: racks for electronic equipment and file cabinets. The price and variable costs and the number
of machine hours required to produce each product are as follows:
Per Unit Data
Racks
File Cabinets
Selling Price
Variable Costs
Contribution margin
Machine hours/unit
$450.00
200.00
$250.00
2
$600.00
300.00
$300.00
4
Which product should Carl Corporation budget to produce, using its available 3,000 machine hours,
assuming fixed costs are the same under either option?
(Continued)
107
Short-run decisions made under conditions of constraint are tested on the CMA Part 2 exam and are covered in more
detail in study materials for that exam.
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Solution:
Since the constraint is the number of available machine hours, and since Carl Corporation can sell all it
manufactures of either product, Carl should produce the product that provides the highest contribution per machine hour.
The rack’s contribution margin per machine hour is $250 ÷ 2, or $125.
The file cabinet’s contribution margin per machine hour is $300 ÷ 4, or $75.
Even though the contribution margin for one file cabinet is higher than the contribution margin for one
rack, since the racks have the higher contribution per machine hour required to produce them, Carl
should produce only racks. Racks return a higher contribution per unit of the scarce resource.
Proof:
Using 3,000 machine hours, Carl Corporation would be able to produce 1,500 racks, since each rack
requires 2 machine hours. Thus, the total contribution margin for racks during a month’s time would be
1500 × $250, or $375,000.
Using the same 3,000 machine hours, Carl Corporation would be able to produce 750 file cabinets, since
each file cabinet requires 4 machine hours. The total contribution margin for file cabinets during a
month’s time would be 750 × $300, or only $225,000.
Therefore, in the short run, under the existing constraint of 3,000 machine hours available per month,
producing only racks will maximize operating income.
Question 46: A company is preparing the sales budget for two potential products. Both products require
the use of the same manufacturing equipment, which is available for only 60 hours each month. The
contribution margin of product A is $95 per unit and the contribution margin of product B is $55 per
unit. Product A requires 4 hours of machine time per unit and product B requires 2.5 hours per unit. In
order to efficiently allocate the equipment resources, the company should manufacture
a)
product A, because the contribution margin is more per unit than product B.
b)
product B, because they can produce more units of that product than product A.
c)
product A, because it will make better use of the equipment than product B.
d)
product B, because it will make better use of the equipment than product A.
(ICMA 2013)
5) and 6) Controlling Operations and Checking on Progress Toward Goals
Control refers generally to the set of procedures, tools and systems that a company uses to ensure that
progress is being made toward accomplishing its goals and objectives. Financial control is achieved by
comparing actual results to budgeted financial amounts. Thus, budgets provide the standard against which
actual financial results are compared. Differences between the actual and the budget are called variances,
and variance analysis is performed to determine whether the variances are favorable or unfavorable.
Variance analysis is covered in this book in Section C, Performance Measures.
Time Frames for Budgets
A profit plan is generally prepared for a set period of time, commonly for one year, and the annual profit
plan is subdivided into months or possibly quarters. Usually the profit plan is developed for the same time
period covered by a company’s fiscal year. When the budget period is the same as the fiscal year, budget
preparation is easier and comparisons between actual results and planned results are facilitated. This comparison is called a variance report. Variance reporting will be covered in detail in the next major section,
Performance Management.
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Budgets can also be prepared on a continuous basis. At all times, the budget covers a set number of
months, quarters, or years into the future. Each month or quarter, the month or quarter just completed is
dropped and a new monthly or quarterly budget is added to the end of the budget.
For example, in September 20X3, the rolling budget will cover the months of October 20X3 through September 20X4. In October 20X3, the rolling budget will cover the months of November 20X3 through October
20X4.
At the same time as a month or quarter is dropped and a new month or quarter is added, the other periods
in the budget can be revised to reflect any new information that has become available. Thus, the budget is
continuously being updated and always covers the same amount of time in the future. This type of budget
is called a rolling budget or a continuous budget.
When continuous budgeting is used, budgeting and planning are always being done. Advantages are:
•
Budgets are no longer done just once a year.
•
A budget for the next full period (usually 12 months) is always in place.
•
The budget is more likely to be up to date, particularly in an environment that is changing rapidly.
A rolling budget helps management to be more responsive to unexpected changes in circumstances, because it allows management to adjust the budget for those changes. As a new quarter
or month is added at the end, management has an opportunity to review the other periods in the
budget, as well, for potential revisions incorporating the new information.
•
Managers are more likely to pay attention to budgeted operations for the full budget period.
Firms usually have longer-term budgets, as well. Budgets for the years beyond the coming year usually
contain only essential operating data and do not attempt to present a full operating and financial budget.
Having a long-term budget along with the coming year’s master budget enables management to quantify
the effect of its strategic plans on future short-term operations.
Methods of Developing the Budget
Budget development can be done using a participative process, an authoritative process, or a consultative
process.
•
A participative budget is developed from the bottom up. All the people affected by the budget are
involved in the budget development process, even lower-level employees. This type of budget development involves negotiation between lower-level managers and senior managers.
•
An authoritative budget is developed from the top down. Senior management prepares all the
budgets for every segment of the organization. The budgets are imposed upon the lower-level
managers and employees.
•
A consultative budget is a combination of authoritative and participative budget development
methods. Senior management asks for input from lower-level managers but then develops the
budget with no joint decision-making or negotiation involved.
These methods all have their benefits and limitations. Since consultative budget development is a compromise between participative and authoritative budgeting, it has many of the benefits and limitations of both.
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Benefits of Participative Budget Development
•
A participative budget is a good communication device. The process of preparing the budget participatively gives senior managers a better grasp of the problems their employees face. The employees’
knowledge is more specialized and they have the hands-on experience of running the business on a
day-to-day basis. At the same time, employees gain a better understanding of the problems experienced by top management.
•
A participative budget is more likely to gain employee commitment to fulfill budgetary goals. People
are more willing to devote extra effort to attain goals they perceive as their own.
•
A participative budget is more likely to be achievable because it was developed with input from the
people responsible for achieving it.
Limitations of Participative Budget Development
•
Unless senior management controls the budget process properly, a participative budget can lead to
budget targets that are too easy to achieve, or budgetary slack. Budgetary slack, which will be
discussed later in more depth, is the practice of underestimating planned revenues and overestimating planned costs to make the overall budgeted profit more achievable. It is the difference between
the amount budgeted and the amount the manager actually expects.
•
Integrating corporate strategic plans into the budget can be more difficult when it has a bottom-up
process.
•
Participative budgeting is more time-consuming than authoritative budgeting because lower-level
managers and employees need to meet and negotiate their budgets.
Benefits of Authoritative Budget Development
•
An authoritative budget process gives senior management better control over the decision-making
process than participative budgeting.
•
Authoritative budgeting places more emphasis on the achievement of the strategic plans developed
by top management.
•
Authoritative budget development can be done more rapidly and with greater flexibility than participative budgeting because it eliminates the need to meet with lower-level managers to negotiate their
budgets.
•
Budgetary slack is not a problem.
Limitations of Authoritative Budget Development
•
Because lower-level managers and employees (that is, those responsible for implementing the
budget) have no input into the budget development process, they will usually have less commitment
to the budget and be less accepting of it.
•
An authoritative budget is used to issue, or dictate, orders. People are likely to resent being given
orders and a morale problem may result.
•
Because an authoritative budget lacks input from lower-level managers, its objectives may not be
practical or possible to achieve because it does not take into account existing limitations that senior
management might not be aware of.
•
Communication between senior management and lower-level management and employees is reduced
with an authoritative budgeting process.
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Benefits of Consultative Budget Development
•
Since senior management makes the final decisions without any negotiation, management maintains
control over the process. As a result, senior management’s strategic plans are integrated into the
budget and budgetary slack is not a problem.
•
The amount of time required to develop a consultative budget is less than the time required for a
participative budget.
•
If lower-level managers see the input they provided incorporated into the final budget, they may be
nearly as accepting and committed to the budget as they would have been had it been developed
participatively.
Limitations of Consultative Budget Development
•
The amount of time required to develop a consultative budget is greater than the time required for
an authoritative budget.
•
If lower-level managers feel their input has been disregarded, they may be even more resentful than
if they had never been asked to provide input in the first place. To ask for input and then not use it
is dismissive. The lower-level managers whose input has been ignored could probably not be expected
to provide much input into future budget development processes.
Who Should Participate in the Budgeting Process?
An effective budgeting process usually combines various approaches: bottom-up, top-down, and negotiation. Either senior management or a budget committee made up of senior managers provides budget
guidelines based on their strategic plans, assumptions about the economy, and other relevant factors.
Department and division heads prepare initial budgets based on those guidelines and send them to senior
management for compilation into an initial consolidated budget and for review. Senior managers review the
initial consolidated budget and initial individual budgets and send the individual budgets back to the department heads for revision. After several rounds of negotiations, the budget is finalized.
The importance of senior management’s involvement cannot be over-emphasized. The support of top management is crucial in order to obtain successful development and administration of the budget. Furthermore,
top management support is necessary in order to gain lower-level management participation. If lower-level
managers feel that top management does not support the effort, the lower-level managers are not likely
to support it either.
Different organizations will structure their budget development processes differently, depending on each
organization’s needs and culture. The budget development process that follows is a general one and is not
prescriptive.
The Budget Development Process
Specific budgets and their development will be discussed later. However, the process for developing each
budget is similar. The main steps in the budget development process are as follows:
1)
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Budget guidelines are set and communicated. Setting the guidelines and communicating them
may be done by a budget committee or by senior management. The initial budget guidelines govern the preparation of the profit plan. Information considered in the development of the budget
guidelines includes the general outlook for the economy and the markets the company serves,
strategic objectives and long-term plans, expected operating results for the current period (since
a budget for the coming period is developed toward the end of the current period before the current
period has been completed), specific corporate decisions for the coming period (such as corporate
downsizing), response to environmental requirements, and short-term objectives.
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2)
Initial budget proposals are prepared by responsibility centers. Each responsibility center
manager prepares an initial budget proposal using the budget guidelines as well as his or her own
knowledge about his or her own area (such as introduction of new products or changes to be made
in product design or manufacturing processes).
3)
Negotiation, review, and approval. The responsibility center managers submit their initial
budget proposals to the next level up for review. The initial proposals are reviewed for their adherence to the budget guidelines and to determine whether the budget goals are reasonable and
in line with the goals of the next higher unit and with those of other units. Any changes needed
are negotiated between the responsibility center managers and their superiors. Budgets go through
successive levels of management, and at each point they may be renegotiated. These negotiations
are the most important part of the budget preparation process and also the most time-consuming
part. Eventually, all of the individual unit budgets are combined into the consolidated master
budget (first draft). The consolidated master budget will consist of a set of budgeted financial
statements: balance sheet, income statement, and statement of cash flows. The consolidated master budget is reviewed at the topmost level to determine whether it meets the requirements without
being unachievable, and negotiations begin again for revisions. Finally, when the consolidated
master budget meets the approval of the budget committee or senior management, the CEO approves the entire profit plan and submits it to the board of directors for final approval.
4)
Revisions. Even after the profit plan has finally been adopted, it should be able to be changed if
the assumptions upon which it was built change significantly. New information about internal or
external factors may make revision of the profit plan necessary. In addition, periodic review of the
approved budget for possible changes or use of a continuous budget that is continually being
updated might be advisable. Although updating the budget provides better operating guidelines,
budget revisions that are too easy or too frequent might encourage responsibility centers to not
take the budgeting process seriously. The budget should be revised only when circumstances have
changed significantly and the changes are beyond the control of the responsibility center manager
or the organization.
5)
Reporting on variances. A budget is meaningless unless actual results are compared to the
planned results for the same period. The budget needs to be used to monitor and control operations
to meet the company’s strategic objectives. The comparison between actual results and planned
results is called variance reporting, and it should take place at every budget unit level. Responsibility center managers should report on variances within their responsibility centers at the end
of each reporting period (monthly or quarterly) to their superiors, who then compile the reports
they receive into a variance report that is sent to the next level up, and so on. Variance reporting
should include not only the amounts of the variances but also the causes of the variances that can
be identified. Variance reporting is covered in Section C of this volume, Performance Management.
6)
Use of the variance reports. Variance reports should be used at every level to identify problem
areas and to make adjustments to operations, if necessary. For example, a production variance
report might reveal that direct materials usage during the past month was greater than planned
for the actual output that was produced. The production manager should investigate and determine
the cause. Inferior materials may have caused the variance and if so, the purchasing manager
may need to get involved in the variance reporting. If a change in supplier is needed to correct the
situation, that change should be made immediately.
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Budgetary Slack and Its Impact on Goal Congruence
Goal congruence is defined as “aligning the goals of two or more groups.” As used in planning and budgeting, it refers to the aligning of goals of the individual managers with the goals of the organization as a
whole. Sometimes the performance of an individual manager’s unit will benefit from an action the manager
takes, but the overall performance of the company is either not impacted at all or it may actually be negatively impacted. An individual division manager may reject a capital investment that would improve the
company’s total profits because the proposed project’s return on investment would cause his own division’s
return on investment to decrease. Situations like these occur because the goals of the individual managers
are not aligned with the goals of the company.
The company’s strategic objectives are communicated to individual managers as part of the planning and
budgeting process. However, a hazard in budgeting is that it may lead to behaviors on the part of managers
that benefit them or their departments but are not congruent with the goals of the company. These behaviors are more likely to occur if managers’ performance will be evaluated according to whether they meet
their budget targets. When managers are evaluated according to whether they meet their budgets, managers who develop the budgets they are going to be accountable to meet may build in budgetary slack in
order to make sure their budgets are achievable without any risk of failure. Budgetary slack is the difference
between the amount budgeted and the amount the manager actually expects. Building in budgetary slack
is the practice of underestimating planned revenues and overestimating planned costs to make the
overall budgeted profit more achievable.
On the positive side, budgetary slack can provide managers with a cushion against unforeseen circumstances, which can limit managers’ exposure to uncertainty and thereby reduce their risk aversion. The
reduced anxiety about risk may help the managers make decisions that are more closely congruent with
the goals of senior management.
However, budgetary slack often creates more problems than it solves.
For example, budgetary slack can misrepresent the true profit potential of the company and can lead to
inefficient resource allocation and poor coordination of activities within the company. As a result, planning
inaccuracy spreads throughout the company. Furthermore, if sales are planned too low, production will also
be planned too low, possibly leading to product shortages because budgeted demand has been understated.
The advertising program and distribution expense budgets may be planned incorrectly, and the cash budget
might be inaccurate.
The best way to avoid the problems caused by budgetary slack is to use the profit plan as a planning and
control tool but not for managerial performance evaluation. If the company does use the budget to evaluate
managers, it could reward them based on the accuracy of the forecasts they used in developing their
budgets. For example, the company’s senior management could say that the more accurate a division
manager’s budgeted profit forecast is and the greater the amount by which it is exceeded, the higher the
manager’s bonus will be.
Responsibility Centers and Controllable Costs
Control in an organization is exercised through responsibility centers. Therefore, budgeting must also be
done at the responsibility center level. However, responsibility center managers should be responsible for
budgeting only the costs that they can control.
Some costs are controllable by a given manager and some costs are not. Controllable costs are costs for
which the manager has the authority to make the decisions about how money will be spent. Non-controllable costs are costs that are ordinarily controlled at a higher level in the organization, such as the
manager’s salary or bonus. The manager’s salary or bonus is controllable, but not by the manager. The
manager’s salary will usually be assigned to his or her responsibility center’s budget and will appear on
reports comparing actual results to the budgeted amount, but the manager should not be held responsible
for it.
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The allocation of the indirect costs of the organization as a whole may be another non-controllable cost,
since indirect costs may be allocated on any of a number of bases, some of which may be controllable by
the manager of the responsibility center and some of which may not.
Each budgeted cost assigned to a responsibility center should be identified as either controllable or noncontrollable by that responsibility center’s management. For example, salaries in the accounting system
may be segregated in two accounts: controllable salaries and non-controllable salaries. Each would then be
budgeted by the person who has control over it, and that person would be responsible for explaining the
variances.
All costs should be included on some manager’s variance report and identified as the responsibility of the
manager on whose report they appear. If an expense is classified as non-controllable on a given manager’s
budget reports, then that expense should be included as a controllable expense on the report of the higherlevel manager who makes the decisions that affect that expense.
Note: All costs should be controlled by someone. Whenever no one is responsible for a cost, the uncontrolled cost creates great risk for the company.
It is also important to recognize that fixed costs and indirect costs are not always uncontrollable, and
variable costs and direct costs are not always controllable. The nature of each cost will vary according to
its characteristics and each cost should be analyzed to determine who controls it.
The distinction between controllable and non-controllable costs is especially important if managers’ performance evaluations will be dependent on their meeting budgetary targets. (Although evaluating managers
only on their ability to meet budgetary targets is not a good idea, it may be done in some organizations.)
If other performance measures are used to evaluate managers, the distinction between controllable and
non-controllable costs may be less important.
Regardless of whether or not managers’ evaluations are affected by their meeting budgetary targets, the
person who is responsible for making the decisions that affect a cost should still be the person who reports
on variances between the actual and planned costs, because that person is responsible for budgeting for
the cost and for making spending decisions. That person should also make any operational adjustments
that those variances may identify as needed.
Standard Costs Used in Budgeting
When standard costing is used in manufacturing, the terms standard cost, budgeted cost, and planned
cost are used interchangeably. Standard costing will be discussed in more detail later, because a standard
cost system is a common method of cost measurement for manufacturing costs. For now, a few basic
concepts are important because when standard costs are used, standard costs are also budgeted costs.
Standard costs are the estimated manufacturing costs for direct materials, direct labor, and manufacturing
overhead that are predetermined or estimated as they would occur under the conditions in the budget.
Standards are usually set based on interviews, analyses and engineering studies that identify the time
needed for the various activities required to manufacture a product, the amount of direct materials needed
for each product, and the cost for each unit of time or unit of direct materials.
A standard cost specification is developed for each product in process manufacturing or for each job in joborder manufacturing. It consists of the standard costs for material, labor, and overhead for the product or
job. The standard cost analysis includes the costs for materials, labor, and overhead in each of the various
responsibility centers through which the work flows. Standard cost specifications are designed in accordance
with each individual situation.
•
A standard input is the quantity of the input (such the number of units of direct material or hours
of direct labor) required to produce one unit of output.
•
A standard price is the price the company expects to pay for one unit of an input.
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•
CMA Part 1
A standard cost is the cost of producing one unit of output. It is the sum of the products of each
standard input multiplied by its standard price.
o
The standard direct material cost per unit of output is the standard material input allowed for one unit of output multiplied by the standard price per unit of that direct material
input.
o
The standard direct labor cost per unit of output is the standard direct labor hours allowed for one unit of output multiplied by the standard price per direct labor hour.
Standard costing is used to apply costs to production. Although standard costing is not the only method
available for applying costs to production, most manufacturers use standard costing. For a manufacturer
using standard costing, standard costs are a fundamental element of the budgeting process. They are used
to develop the budgeted costs per unit for manufactured goods.
Note: Without standard costs, it would be very difficult to budget, since managers would not know how
much it costs to produce the company’s products. Also, without standard costs it would be very difficult
to evaluate a company’s performance because at the end of the year there would be no way to know
how much it should have cost to produce what was produced.
Standard costs are based on assumptions about the quantity of direct inputs needed to produce one unit
of product and the cost per unit of those direct inputs. Standard costs also include assumptions about the
cost for manufacturing overheads that should be allocated to each unit produced. The assumptions used,
such as the number of direct labor hours allowed for each unit produced, should be challenging but attainable under normal conditions. If the standards are too rigorous, they will not be attained and the company
will have large variances in its reporting that may cause inventory and cost of goods sold to be reported
improperly.
The standard cost application rate per unit is the standard, or predetermined, cost per unit based on
budgeted total cost divided by budgeted production. These estimated costs are applied to the actual production as production takes place throughout the year. Differences between actual incurred costs and costs
applied to production are reported as variances. Variance analysis is covered in Section C, Performance
Management, in this volume. The application of standard costs to production is covered in Section D, Cost
Management, in Vol. 2 of this textbook.
Note: A static budget is a budget prepared using the standard costs and the planned level of activity
(sales or production, as appropriate).
A flexible budget is a budget that is prepared using the standard costs and the actual level of activity;
it is essentially what the budget would have been if the company had known what the actual level of
activity would be in advance and had used that information when it developed the budget instead of the
planned activity. Flexible budgets are used with standard cost systems.
Static budgets and flexible budgets are covered in much more detail in this section in the topic Budget
Methodologies.
The standard cost system provides data for the computation of the cost per unit for direct inputs (direct
materials and direct labor) and the predetermined overhead rates to be applied to the actual production,
to use in the static and flexible budgets, and for variance analysis of all manufacturing costs. As stated
above, variance analysis is covered in Section C, Performance Management.
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efham CMA
Setting Standard Costs
Because so much of a company’s budget is based on the standards that have been set (both usage standards and cost standards), it is critical for these standards be as accurate and as realistic as possible. A
number of different methods can be used to establish the standards. In most cases, a company will use a
combination of methods such as:
1)
Activity analysis
2)
Historical data
3)
Target costing
4)
Strategic decisions
5)
Benchmarking
1) Activity Analysis
Activity analysis involves identifying and evaluating all the input factors and activities required to complete
a job, a project, or an operation efficiently. Activity analysis is the most accurate way of determining
standard costs if it is properly executed. Activity analysis should be performed by people from several
different areas, including product engineers, industrial engineers, management accountants, and the production workers.
Product engineers specify the components to be used in the manufacturing of a product. Industrial engineers analyze the procedures required to complete the manufacturing process. Production workers are
interviewed to gain their input. Management accountants work with the engineers to complete the analysis.
The activity analysis specifies the quantity and the quality of the direct materials, the required skills and
experience of the employees who will produce the product, and the equipment to be used in producing the
product. Management accountants calculate the costs of the direct materials, the labor, the overhead, and
other items to determine the total standard cost.
Note: The standard costs as developed should include not only the quantity of each direct material or
direct labor input that should be used but also its quality (in the case of materials) or its skill level (in
the case of labor). The quality of the materials and the skill of the labor required are directly connected
to the cost, so a minimum level of quality for materials and a minimum skill level for labor must be
established as part of each standard cost.
2) Historical Data
While activity analysis is the most accurate means to determine standard costs, the cost of the activity
analysis itself can be prohibitively high. If a firm cannot justify the high cost of activity analysis, it can use
historical data instead. Data on costs involved in the manufacture of a similar product in prior periods can be used to determine the standard cost of an operation, if accurate data are available.
Analysis of historical data is much less expensive than an activity analysis for determining standard costs.
However, a standard cost based on the past may perpetuate past inefficiencies. A standard based on the
past does not incorporate continuous improvements, which are an important consideration in the competitive environment in which businesses operate today.
3) Target Costing
Target costing is used when a firm has a specific selling price at which it desires to sell its product in order
to be competitive. The target cost is the cost that yields the required profit margin for the product,
given a set selling price. Standards are then determined that would allow the product can be manufactured
at the target cost. Of course, management then needs to figure out how to actually produce the product at
that cost because if the standards that are set are unachievable, the resulting variances will be unacceptably
high.
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4) Strategic Decisions
Strategic decisions can also affect a product’s standard cost. If management has made a strategic decision
to pursue kaizen, the Japanese term for continuous improvement, that decision will impact the standard
because the standard will be set at the most challenging level at all times in order to effect continuous
improvement.
Other strategic decisions can affect a product’s standard cost. For example, a management decision to
replace an obsolete piece of equipment with a new machine would require an updating of standards and
standard costs.
5) Benchmarking
Input into the standard-setting process may come from benchmarks, or industry information about current
practices of other firms or current practices of the best-performing divisions within the same company.
If data from other firms are used to set standards, the other firms do not always need to be in the same
industry or country. If the other firms have similar operations, they can offer good guidelines even if they
are from a different industry or country.
Benchmarking data can also come from associations of manufacturers that collect information from their
members.
In benchmarking, the best performance anywhere can be chosen as the attainable standard. Using the
best-performing company as a standard can help a firm maintain its competitive edge. However, the benchmark must be evaluated in light of the company’s own unique situation.
Who Should Set the Standards?
The question of who should set the standards is similar to the question about who should prepare a budget.
The answer is also very similar to that for budgeting. Standards can be established by top management,
by the workers on the assembly line, by some level of management between the two, or by any combination
of levels in the organization. A company can use an authoritative, a participative, or a consultative
approach to setting the standard costs that will be used in the standard cost system and in the flexible
budget.
When following an authoritative standard-setting process, management sets the standards and they are
handed down to those charged with their execution. A participative standard-setting process involves the
lower-level managers and other employees who will be affected by the standards and involves negotiation.
A consultative approach combines the authoritative and participating processes. Senior management asks
for recommendations from lower-level managers but then sets the standards on its own and presents them
to those affected by them.
The authoritative, participative, and consultative methods all have benefits and limitations.
Benefits of an Authoritative Standard-Setting Process
•
All the factors that affect the costs will receive proper consideration.
•
Management’s expectations will be reflected in the resulting standard costs.
•
The standard-setting process can be handled more expeditiously than is possible when more individuals are involved.
Limitations of an Authoritative Standard-Setting Process
•
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The affected employees will not see the standards as their own and will be less likely to accept them,
which in turn reduces their motivation to achieve the standards.
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Benefits of a Participative Standard-Setting Process
•
When employees participate in setting the standards, they are more likely to accept them and not
see them as unreasonable.
Limitations of a Participative Standard-Setting Process
•
The standards may not support achievement of the firm’s strategic goals or operating objectives.
Benefits of a Consultative Standard-Setting Process
•
Since senior management sets the standards, it can make certain that all the factors affecting costs
will be considered.
•
Input from the affected employees may give senior management some added perspectives to consider.
•
Management’s expectations will be incorporated into the resulting standard costs, and the standards
will support achievement of the firm’s strategic goals and objectives.
•
The time required to set the standards consultatively is less than the time required to set them
participatively since no negotiation is required.
•
Employees may be nearly as accepting of the final standards prepared consultatively as they would
be if the standards were set participatively since they have had some input, if they perceive that
management has included their recommendations in the decision-making process.
Limitations of a Consultative Standard-Setting Process
•
The amount of time required to develop standards consultatively is greater than the amount of time
required to set them using an authoritative process.
•
If employees feel their recommendations have been disregarded in the standards set, they may be
more likely to view the standards as unreasonable then they would have been if they had never been
asked to provide input. To ask for input and then not use it is dismissive.
Even when an authoritative standard-setting process is followed, production employees and supervisors
must be involved in some aspects of the process. These people are close to the production process and
their input is important if management expects to do a good job of setting the standards. The actual standard setting is accomplished through the efforts of management, product design engineers, industrial
engineers, management accountants, production supervisors, purchasing, personnel, and employees affected by the standards.
Establishing Direct Materials Standards
Three considerations go into establishing a standard cost for direct materials:
1)
Required quality of materials.
2)
The quantity needed per unit of output.
3)
The price per unit of materials.
Specifying the quality is the first step, because the quality of the direct materials will affect all phases of
production, such as the quantity of the materials that will be required, the time required for processing,
and the amount of supervision that will be needed during the production process. The marketing department, engineering department, production department, and management accountants all need to be
involved in making the determination of the quality in order to assess the trade-offs that will be involved
as well as determine the optimum quality that will produce the lowest overall cost and still meet
the demands of the market.
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After the quality has been specified, the standard for the quantity of direct materials needed to manufacture each unit of the product is set. The quantity standard is based on the product design, the cost drivers108
of the manufacturing activities, the quality of the direct materials, and the condition of the plant and equipment that will be used to manufacture the product. The industrial engineering department, the production
department, and the management accountants work together to develop the quantity standard.
The price standard is developed after the quality and quantity standards, because the quality and quantity
standards are considerations in setting the price standard. Timing of the purchases and quantity purchased
at one time are considerations, as well. A vendor’s record of reliability for delivering the product on time is
often more important than finding the lowest price, because missed deliveries may cost more than the
savings that would result from ordering the lowest-priced materials.
Establishing Direct Labor Standards
The standard for direct labor depends on the type of work, the nature of the manufacturing process, the
type of equipment that will be used, and the required skill level of the employee.
The quantity standard for direct labor is determined by the industrial engineers, the production department, the labor union, the personnel department, and the management accountants, each group using
some or all of the factors listed above.
The price standard for direct labor, or the standard wage rate, is provided by the personnel department
and is a function of the competitive labor market and any labor contracts that may exist. The standard
wage rate varies according to the type of employees needed and the skill level required.
The cost standard for labor, whether direct or indirect, includes not only the hourly wage or salary paid but
also the employee benefits provided and the payroll taxes that must be paid. Employee benefits may include
medical insurance, life insurance, pension plan contributions, and paid vacation. Payroll taxes include unemployment taxes and the employer portion of Social Security and Medicare taxes. Workers’ compensation
insurance is a requirement, as well. Estimates of these other costs should be made and included in the
direct labor standard cost.
Note: The company may choose to treat the costs of employee benefits as an overhead cost and allocate
them to the units produced (both actual costs and for the budget) instead of including them with the
hourly wages in the direct labor budget. The method in which these costs are treated may have a small
effect on cost of goods sold, income, and inventory. Only in cases where direct labor is a large portion
of the total expenses will the difference be material.
Establishing Manufacturing Overhead Standards
Overheads are indirect costs that cannot be traced to any particular unit produced. They include:
•
Indirect materials, such as cleaning chemicals, disposable tools, or protective devices.
•
Indirect labor, such as plant superintendents, plant janitors, and so forth.
•
Other indirect costs, such as depreciation on manufacturing equipment, utilities, and other nontraceable costs.
Overhead can be either variable overhead for which costs fluctuate with changes in production volume
(for example, disposable tools), or it can be fixed overhead that does not fluctuate with changes in production volume (for example, depreciation on plant equipment or the plant superintendent’s salary).
Because fixed costs do not vary with changes in activity whereas variable costs do, fixed and variable
overheads are planned separately.
108
A cost driver is anything (such as an activity, an event, or a volume of something) that causes costs to be incurred
each time it occurs.
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Overhead standards are generally based on costs under normal operating conditions, anticipated volume,
and desired efficiency. The total overhead costs used come from the budgeted factory overhead costs. The
standard overhead rate is calculated by dividing the budgeted factory overhead cost by a predetermined
level of activity (traditionally machine hours or direct labor hours), which is the standard amount allowed
for the budgeted production level.
Budgeted Factory Overhead Costs
Predetermined Activity Level
= Standard Overhead Rate Per Unit of the Activity
Determining the Level of Activity to Use
In relation to the fixed and variable overhead allocation rates, the company must decide what anticipated
activity level to use for its budgeted amounts to calculate the overhead allocation rates that will be used.
The activity level decision is important because it will affect the overhead application rate that will be used
going forward.
The traditional method uses either machine hours or direct labor hours to allocate overhead. As will be
discussed later in greater detail, variable and fixed overheads may be allocated using the same allocation
base or different bases of allocation. For example, variable overhead may be allocated based on labor hours
and fixed overhead may be allocated based on the machine hours.
The steps in calculating the predetermined overhead allocation rate are:
1)
The company budgets its costs for fixed or variable overhead for the coming year.
2)
Management determines the appropriate allocation base to use for fixed and for variable overhead.
The most frequently used allocation bases are direct labor hours and machine hours.
3)
The company decides how much output it will produce during the coming year and, as a function
of that output, how many machine hours or how many direct labor hours, whichever it is using as
an allocation base, it plans to use during the year.
4)
The budgeted monetary amount of fixed or variable overhead is divided by the planned activity
level of the allocation base (number of hours allowed per unit multiplied by the number of units
planned) to determine the amount of overhead to allocate to each hour allowed for production of
each unit.
5)
Alternatively, the budgeted monetary amount of fixed or variable overhead can be divided by the
number of units budgeted to determine the amount of overhead to allocate to each unit produced.
Note: Absorption costing is used for external financial reporting by manufacturers. Under absorption
costing, all manufacturing overhead costs are applied to the units produced and are included in the cost
of inventory after production is completed. The costs of production—including the applied overhead
costs—that have been assigned to each unit flow to the income statement as a part of cost of goods sold
only when the units they are attached to are sold. Since overhead costs are applied to units produced,
they are not expensed as incurred under absorption costing. See Section D, Cost Management, in Vol. 2
of this textbook for more information.
As the activity level is one of the two figures used in the determination of the predetermined manufacturing
overhead rates, it will greatly impact the allocation rate.
The allocation rate is established for the full year. Predetermined (standard) allocation rates for fixed manufacturing overhead and for variable manufacturing overhead are established separately.
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•
Variable manufacturing overhead is overhead that varies in total with the number of units
produced, but its cost per unit remains constant. It includes costs such as supplies used in manufacturing (the greater the number of units manufactured, the more supplies are required) or the
electricity required to operate the equipment. Variable manufacturing overhead may be initially
budgeted in total and a per-unit cost developed by dividing that total by the number of units
initially expected to be produced. However, if the number of expected units is changed during the
budgeting process, the budgeted variable manufacturing overhead will be changed in total. Thus,
variable manufacturing overhead is usually budgeted on a per-unit basis. That is, a budgeted
amount is developed per unit produced, and the total budgeted amount is the amount per unit
multiplied by the number of units that management expects will be produced during the period.
•
Fixed manufacturing overhead is indirect manufacturing costs that do not vary in response to
changes in activity as long as the activity remains within the relevant range. 109 The types of overhead that go into the calculation of budgeted total fixed overhead are salaries for plant supervisors
and depreciation on equipment, to mention just two examples.
Fixed manufacturing overhead costs are budgeted in total for the year, not on a per-unit basis.
The fixed overhead predetermined cost per unit is the total overhead budgeted amount divided by
the number of units that management expects to produce. Thus, the budgeted cost per unit is
affected by the number of units that management expects to produce during the period. For example, if total budgeted fixed manufacturing overhead is $100,000 and management expects to
produce 10,000 units, the budgeted fixed manufacturing overhead per unit is $10 ($100,000 ÷
10,000). But if management expects to produce only 8,000 units, the budgeted fixed manufacturing overhead per unit is $12.50 ($100,000 ÷ 8,000).
The anticipated activity level used in the denominator of the predetermined cost per unit calculation
is a very important decision to be made in accounting for fixed manufacturing overhead.
Thus, the expected activity level is used for both variable manufacturing overhead and fixed manufacturing
overhead, but it is used in different ways.
•
Planning for variable manufacturing overhead costs begins with the budgeted overhead rate per
output unit or per input unit, and that rate is multiplied by each month’s budgeted activity level
per output unit or per input unit to calculate the total monthly budgeted overhead (see the example
following this explanation).
•
Planning for fixed manufacturing overhead costs is done in the opposite way: it begins with the
total budgeted overhead, which is divided by the budgeted activity level in either output units
or input units to determine the fixed overhead cost per unit produced or the fixed overhead cost
per input unit.
Choices for the Budgeted Output or Activity Level
In general, a company has four choices to determine the budgeted output or activity level. Two choices
relate to what the plant can supply and two choices relate to the demand for the plant’s output. These
are called denominator-level capacity concepts because they describe the denominators (divisors) that
can be used in the calculation of standard per-unit fixed overhead costs.
Supply Denominator-Level Concepts
•
Theoretical or ideal capacity. The theoretical or ideal capacity is the level of activity that will
occur if the company produces at its absolute most efficient level at all times. No allowances are
109
The relevant range is the range of activity over which a certain cost behavior holds true. The term is used most
often to refer to fixed costs. Fixed costs do not vary in response to changes in activity as long as the activity level remains
within a certain range. If the activity level drops below or rises above that range of activity, the fixed cost can change in
total. An example of a fixed cost that can change is depreciation on factory equipment. As long as production does not
rise beyond a certain level, the company will be able to continue production with its existing equipment. But if production
requirements rise beyond the level that current equipment can meet, additional equipment will be required and depreciation will increase.
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made for idle time and downtime, and no adjustments are made for any expected decrease in
sales demand. A company will not be able to achieve this level in the long run.
•
Practical (or currently attainable) capacity. The practical capacity is the theoretical level reduced by allowances for idle time and downtime but not reduced for any expected decrease in
sales demand.
Demand Denominator-Level Concepts
•
Master budget capacity utilization (or expected capacity utilization). Master budget capacity utilization, also called expected capacity utilization, is the amount of output actually expected
during the next budget period based on expected demand. This level will result in a different
overhead rate for each budget period because of increases or decreases in planned production due
to expected increases or decreases in demand.
•
Normal capacity utilization. Normal capacity utilization is the level of activity that will be
achieved in the long run, taking into account seasonal changes in the business and cyclical
changes. Seasonal changes in business result from changes in demand during the seasons of the
year, and cyclical changes are connected to the larger business cycle. Normal capacity utilization
is the level of activity that will satisfy average customer demand over a long-term period (such
as 2 to 3 years).
The master budget capacity is the best activity level to use for the denominator in calculating
budgeted fixed cost per unit for developing standards. That is because the master budget capacity
is the activity level that is considered applicable to the period for which the standards are being developed.
Variance reporting is much simpler if the activity level used in developing the overhead standard is the
same activity level as is used in developing the budgeted overhead costs for the master budget. If different
activity levels are used, differences between budgeted costs and standard costs due to the different planned
activity levels used will appear in variance reports as additional variances.
U.S. GAAP, in ASC 330, specifically prescribes that normal capacity should be used for external financial
reporting. Other denominator-level concepts are better choices for other purposes, and those will be discussed later in this volume.
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Example: Total manufacturing overhead is budgeted to be $900,000 for the budget year: $600,000 for
fixed manufacturing overhead ($50,000 per month) and $300,000 for variable manufacturing overhead.
Output, based on master budget capacity utilization, is budgeted at 500,000 units for the year. The
standard for variable overhead is $0.60 per unit ($300,000 ÷ 500,000), and the standard for fixed
overhead is $1.20 per unit ($600,000 ÷ 500,000).
The standard costs calculated per unit will be used to apply overhead costs to actual units produced, and
that process is covered in Section D, Cost Management, in this text.
Production is not planned to take place evenly throughout the year. The initial production budget for the
first quarter calls for 40,000 units to be produced in January, 50,000 in February, and 45,000 in March.
Therefore, the budgeted variable overhead, budgeted fixed overhead, and budgeted total overhead for
each month of the first quarter will be:
Budgeted/Standard
VOH @ $0.60/unit
Budgeted
Fixed Overhead
Budgeted
Total Overhead
January
$24,000
($0.60 × 40,000)
$50,000
$74,000
February
$30,000
($0.60 × 50,000)
$50,000
$80,000
March
$27,000
($0.60 × 45,000)
$50,000
$77,000
Now, assume that was just the first draft of the budget. Following meetings between senior management
and the plant manager, it has been agreed that the planned activity (production) level for the year needs
to be increased from 500,000 units to 600,000 units because of expected increased demand. The budgeted production for the first three months of the year has been changed to 45,000 units in January,
50,000 in February, and 55,000 units in March. Those production levels are within the relevant range
for fixed costs.
The amount budgeted and the standard per unit for variable manufacturing overhead will not change,
but the total variable manufacturing overhead budgeted for the year will change. The budgeted
variable manufacturing overhead for the year will become 600,000 units × $0.60 per unit (no change in
the per-unit cost), or $360,000, an increase of $60,000 from the former total of $300,000.
However, the total budgeted fixed manufacturing overhead will not change because the planned
production increases are within the relevant range.
Because of the increase in budgeted production, total budgeted overhead cost (fixed and variable) has
increased from $900,000 to $960,000 ($600,000 fixed and $360,000 variable). Note that the total budgeted fixed manufacturing overhead stayed the same and only the budgeted variable and total
manufacturing overhead increased. The standard for variable manufacturing cost remains $0.60 per
unit, but the standard for fixed overhead cost per unit must be decreased from $1.20 to $1.00 per unit
($600,000 ÷ 600,000).
The budgeted variable overhead, budgeted fixed overhead, and budgeted total overhead for each month
of the first quarter now will be:
Budgeted/Standard
VOH @ $0.60/unit
Budgeted
Fixed Overhead
Budgeted
Total Overhead
January
$27,000
($0.60 × 45,000)
$50,000
$77,000
February
$30,000
($0.60 × 50,000)
$50,000
$80,000
March
$33,000
($0.60 × 55,000)
$50,000
$83,000
The purpose and use of standard costs will be explained in more depth in the Performance Management
(Section C) and the Cost Management (Section D) sections of this textbook.
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Section B
B.3. Forecasting Techniques
Question 47: Which one of the following is most important to a successful budgeting effort?
a)
Experienced analysts
b)
Integrated budget software
c)
Reliable forecasts and trend analysis
d)
Top management support
(ICMA 2010)
B.3. Forecasting Techniques
One of the most important parts of the planning and budgeting process is the identification of the assumptions that a company must make about the future. Since planning and budgeting involve looking into the
future, the company must make some assumptions about the outlook for the environment in which its
business operates. These assumptions are called premises. When identifying premises, it is essential for
management to focus only on those premises that will actually impact the potential success of the business.
Focusing on premises that are not a critical part of the organization’s success wastes valuable time and
resources.
Some premises will affect the whole company, whereas some premises will not. Different departments will
have different premises because of the unique tasks and circumstances they face. The finance department
may be concerned about the expected interest rate, but the interest rate will not impact the production
department in the fulfillment of its objectives. However, the rate of growth (or rate of contraction) in the
economy and the rate of inflation (or deflation) expected during the budget period will probably impact
planning and budgeting for nearly every area of the organization.
This section covers forecasting techniques that can be used to develop budgeted amounts that are based
on premises. Once the premises have been identified and quantified, the forecasting can be done.
Mathematical models are commonly used in forecasting. A mathematical model is an equation that attempts to represent an actual situation. For example, if a company has a product that it sells for $1,000
each and R represents total revenue, then the total revenue the company will earn by selling x units can
be represented by the following equation or mathematical model:
R = 1,000x
For a model to be useful, it must be a good representation of the real situation. Therefore, it is important
to carefully construct the equations used in forecasting.
Using Linear Regression Analysis in Forecasting
Linear regression analysis using historical data can be used to make forecasts for budgeting purposes.
Collecting the Data for a Forecast
In forecasting, historical information is used in various ways. The past may be used to discover a pattern
for use in predicting the future, or the past relationship between two factors may be used to determine
whether or not a past cause-and-effect relationship can be used to predict future results. Collecting the
data is usually the most difficult step in analysis. One of the primary challenges in forecasting costs is
finding the cost driver that best fits the data—in other words, the causal factor in the cause-and-effect
relationship.
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Two basic forecasting methods are used:
1)
Time series methods, which look only at the historical pattern of one variable and generate a
forecast by extrapolating the pattern using one or more of the components (or patterns) of the
time series, and
2)
Causal forecasting methods, which look for a cause-and-effect relationship between the variable being forecasted (the dependent variable) and one or more other variables (the
independent variables).
Time Series Analysis
In a time series, the causal factor is the passage of time. Time series data reflect historical activity for one
variable over a sequence of past time periods. The variable may be sales revenue for a segment of the
organization, production volume for a plant, expenses in one expense classification, or anything being
forecasted. A time series method of forecasting uses only these historical values in an attempt to find
a pattern that can be used in forecasting the future. Only one set of historical time series data is used in
time series analysis and this set of historical data is not compared to any other set of data.
Time series analysis looks at patterns of the desired variable over time. The most frequent pattern and the
one most amenable to using for forecasting is a trend pattern, in which the historical data exhibit a gradual
shifting to a higher or lower level. If a long-term trend exists, short-term fluctuations may take place within
that trend; however, the long-term trend will be apparent. For example, sales from year to year may
fluctuate but in general may be trending upward, as is the case in the graph below.
Sales Year 1-Year 10 with Year 11 Forecast
$4,000,000.00
Sales
$3,000,000.00
$2,000,000.00
Sales
Regression Line with Forecast
$1,000,000.00
1
2
3
4
5
6
7
8
9
10
11
Years
The long-term sales trend has been upward from Year 1 to Year 10 despite the dips in Years 3 and 7.
According to this trend, a reasonable sales forecast for Year 11 would be $3,200,000.
Trends in a time series analysis are not always upward and linear110 like the above graph. Time series data
can exhibit an upward linear trend, a downward linear trend, a nonlinear (curved) trend, or no trend at all.
A scattering of points that have no relationship to one another would represent no trend at all.
110
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Linear means arranged in or extending along a straight or nearly straight line.
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Section B
B.3. Forecasting Techniques
A trend pattern is analyzed for forecasting purposes using simple regression analysis.
Note: Simple regression analysis is called “simple” to differentiate it from multiple regression analysis. The difference between simple linear regression and multiple linear regression is in the number of
independent variables. A simple linear regression has only one independent variable. In a time series,
that independent variable is the passage of time. A multiple linear regression has more than one independent variable. Multiple linear regression analysis is used in causal forecasting, which is covered later
in this section of the text.
Trend Projection and Linear Regression Analysis
A time series that has a long-term upward or downward trend can be forecasted by means of trend projection. A trend projection is performed with simple linear regression analysis, which forecasts values
using historical information from all available past observations of the value.
Simple linear regression analysis relies on two assumptions:
•
Variations in the dependent variable (the value being forecast) are explained by variations in
one single independent variable (the passage of time, if a time series is being used to develop
the forecast).
•
The relationship between the independent variable (time or a specific value) and the dependent
variable (sales or whatever is being forecast based on the value of the independent variable) is
linear. A linear relationship is one in which the relationship between the independent variable and
the dependent variable can be approximated by a straight line on a graph. The regression equation,
which approximates the relationship, will graph as a straight line.
The equation of a simple linear regression line is:
ŷ = a + bx
Where:
ŷ=
the predicted value of ŷ on the regression line corresponding to each
value of x, the dependent variable.
a=
the y-intercept, or the value of ŷ on the regression line when x is
zero, also called the constant coefficient.
b=
the slope of the line and the amount by which the ŷ value of the
regression line changes (increases or decreases) when the value of x
changes by one unit, also called the variable coefficient.
x=
the independent variable, the value of x on the x-axis that corresponds to the predicted value of ŷ on the regression line.
Note: If an equation contains any exponents, the graphed result will be a curved line. The equation of
a linear regression line graphs as a straight line because none of the variables in the equation are squared
or cubed or have any other exponents.
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The line of best fit as determined by simple linear regression is a formalization of the way one would fit a
line through the graphed data just by looking at it. To fit a line by looking at it, one would use a ruler or
some other straight edge and move it up and down, changing the angle, until it appears the differences
between the points and a line drawn with the straight edge have been minimized. The line that results will
be a straight line located at the position where approximately the same number of points are above the
line as are below it and the distance between each point and the line is as small as possible.
Linear regression is used to calculate the location of the regression line mathematically. On a graph, the
difference between each point and its corresponding point on the regression line is called a deviation.
When the position of the regression line is calculated mathematically, the line will be in the position where
the deviations between each graphed value and the regression line have been minimized. The resulting
regression line is the line of best fit. That line can then be used for forecasting by means of extrapolation
that extends the line into the future period or periods.
Simple linear regression was used to calculate the regression line and the forecast on the graph presented
earlier as an example of a trend pattern.
The regression line is called a trend line when the regression is being performed on a time series. When
the regression is being performed on data other than a time series, as is done in causal forecasting (discussed next), the regression line is simply called a regression line. However, the regression line is calculated
the same way in both types of data.
Note: The x-axis on the graph is almost always the horizontal axis and the y-axis is always the vertical
axis. The x-axis represents the independent variable and the y-axis represents the dependent variable.
In a time series regression analysis, the passage of time is on the x-axis as the independent variable.
Note: Candidates should know the linear regression formula, understand the function of each variable
in the formula, and be able to use the formula to solve for the value of ŷ at any given value of x.
However, the regression formula may not be given explicitly in an exam question. Instead, an exam
question may give a set of data points and give the slope and the y-intercept of the regression line that
describes that set of data points and ask for the predicted value of y, the dependent variable, at a given
value of x, the independent variable.
Especially, candidates should know that the slope is the variable coefficient (generally the letter next
to the “x” in the regression formula) and that the y-intercept is the constant coefficient (generally
the letter that stands by itself in the formula).
Time series analysis is covered in more detail in Section F.4, Data Analytics. The coverage in Data Analytics
includes calculation of the result of a simple regression equation.
Causal Forecasting
Causal forecasting methods are used when the value being forecast is affected by some other value. If a
cause-and-effect relationship can be identified between the two values and if that relationship is a linear
one, a projection of the other value can be used as the independent variable to forecast the dependent
variable, that is, the value being forecast.
For example, if it can be demonstrated that the level of sales is directly related to the level of advertising,
sales can be forecast once the future level of advertising is known. Therefore, once the advertising budget
has been set, the planned advertising expenditures can be used to forecast sales.
A cause-and-effect relationship between the two variables must first be determined. Simple regression
analysis and correlation analysis can help to determine whether a linear relationship exists between the
two variables and if so, whether the relationship is strong enough to make causal forecasting a valid method
of developing a forecast.
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Section B
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Regression analysis for causal forecasting is performed the same way as it is performed in time series trend
projection, but instead of using time as the independent variable, some other type of historical data such
as advertising expenditures serve as the independent variables used to forecast the dependent variable.
Note: Unlike a time series regression analysis in which time, the independent variable, can only increase,
the independent variable used in causal forecasting can either increase or decrease.
Note: Always remember that correlation does not necessarily mean causation. Two variables may be
highly correlated historically, but if no actual cause-and-effect relationship exists between them, the
independent variable will not be a good predictor of the dependent variable.
For example, a homeowner’s electric utility bill may be highly correlated with the household’s level of ice
cream consumption. But logically, there is no cause-and-effect relationship between the two. Increased
ice cream consumption does not cause high electric bills, and high electric bills do not cause increased
ice cream consumption. However, a third factor such as outside temperature might easily be affecting
both. Always consider whether it is reasonable to assume that a cause-and-effect relationship exists
between the two variables when doing causal forecasting.
Advertising expenditures usually do have a logical cause-and-effect relationship to sales. If historical
advertising expenditures and historical sales are reasonably well correlated, advertising expenditures
should be a good independent variable to use to forecast sales.
Multiple Regression Analysis in Causal Forecasting
If only one independent variable (such as advertising expenditures) is affecting the dependent variable
(such as sales) and if the relationship between them is linear, the regression analysis is simple linear
regression. However, it is also possible for the dependent variable such as sales to be affected by more
than one independent variable. For example, advertising expenditures, the size of the sales staff, competition, the economy, or any number of other circumstances can impact sales. When more than one
independent variable is known to impact the dependent variable and each one can be expressed numerically, regression analysis using all of the independent variables to forecast the dependent variable is called
multiple regression analysis. Multiple regression analysis is another type of causal forecasting.
For example, demographic information may be used to forecast sales for a new retail store that is being
planned. If the company has previously opened new outlets in other areas, management can use demographic information from those areas to relate to sales results in those stores. The size of the population,
the population’s socio-economic level, age breakdown, and many other factors can be used as independent
variables in relating actual sales levels experienced in other areas to demographic information for those
areas. If a linear relationship or relationships that are causal are found, similar demographic information
for the new area can be used to forecast its sales levels.
If several demographic factors are accurate predictors, they can be used in a multiple regression analysis.
Note: Remember that a reasonable basis must exist to assume a cause-and-effect relationship between
the independent variable(s) and the dependent variable. If there is no reason for the two variables to be
related, any correlation found through the use of regression analysis is accidental. A linear relationship
does not prove a cause-and-effect relationship, and correlation does not prove causation.
A simple regression analysis is in a single geometric plane. The graph of a multiple regression analysis will
have three or even more dimensions because it will have a dimension, or x-axis, for each independent
variable. Following is an illustration of a multiple regression analysis with two independent variables and
thus two x-axes, x1 and x2.
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y
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•
•
•
•
•
•
•
•
x2
•
x1
The equation of the three-dimensional multiple regression function displayed graphically above is:
ŷ = a0 + a1x1 + a2x2
Where:
ŷ
=
the predicted value of ŷ on the regression line corresponding
to each value of x1 and x2
a0
=
the constant coefficient, the y-intercept, and the value of ŷ
when x1 and x2 are zero
a1, a2 =
variable coefficients, similar to the slope of the line
x1
=
one of the independent variables, the value of x on the x1-axis
that corresponds to the value of ŷ on the regression line
x2
=
one of the independent variables, the value of x on the x2-axis
that corresponds to the value of ŷ on the regression line
The multiple regression equation above uses “a”s for the constant coefficient and both of the variable
coefficients, although “b”s could also be used. A multiple regression equation can have an infinite number
of independent variables. To indicate that infinite number of independent variables, the equation would be
written like the one following. The following formula uses “b”s for all of the coefficients, though “a”s could
also be used.
ŷ = b0 + b1x1 + b2x2 + ... + bkxk
To identify the constant coefficient and the variable coefficients, look for the x terms and for the term
without an x. The x terms will have the variable coefficients and the term without any x will be the constant
coefficient.
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Section B
B.3. Forecasting Techniques
Benefits of Using Regression Analysis in Forecasting
•
Regression analysis is a quantitative method and as such it is objective. A given data set generates
specific results. The results can be used to draw conclusions and make forecasts.
•
Regression analysis is an important tool for budgeting and cost accounting. In budgeting, it is virtually
the only way to compute fixed and variable portions of costs that contain both fixed and variable
components (mixed costs). The use of regression analysis for computing fixed and variable portions
of mixed costs will be covered later.
Limitations of Using Regression Analysis in Forecasting
•
To use regression analysis, historical data are required for the variable that is being forecast or for
the variables that are causal to the variable being forecast. If historical data are not available, regression analysis cannot be used.
•
Even when historical information is available, its use is questionable for predicting the future if a
significant change has taken place in the conditions surrounding that information.
•
In causal forecasting, the usefulness of the data generated by regression analysis depends on the
choice of independent variable(s). If the choice of independent variable(s) is inappropriate, the results
can be misleading.
•
The statistical relationships that can be developed using regression analysis are valid only for the
range of data in the sample.
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227
B.3. Forecasting Techniques
CMA Part 1
Using Learning Curves in Forecasting
The term “learning curve” refers to the concept that efficiency increases as the amount of experience a
person has with a given task increases. As a result, the time required for performing the task decreases as
increases occur in the number of times the task has been performed.
Higher costs per unit early in production are part of the start-up costs when a new activity is begun. It is
commonly accepted that new products and production processes experience a period of low productivity
followed by increasing productivity. However, the rate of productivity improvement declines over time until
the improvement stops. The required production time reaches a level where it remains until another change
in production occurs.
Learning curve analysis is used in planning, budgeting, and forecasting and also to determine estimated
labor costs when bidding on a contract. A company needs to be able to estimate what the long-term costs
of production will be.
Two learning-curve models are commonly used:
1)
The cumulative average-time learning model is based on the assumption that the cumulative
average time required per unit declines at a constant rate each time the cumulative quantity of
units produced doubles. The cumulative average-time learning model can be used to estimate the
average time per unit required to produce all of a given number of units produced.
2)
The incremental unit-time learning model is based on the assumption that the incremental
amount of time required to produce the last unit declines at a constant rate each time the cumulative quantity of units produced doubles. The incremental unit-time learning model can be used
to estimate the time needed to produce the last unit in a quantity of units.
Note: Only the cumulative average-time learning model is tested on the CMA exam. The incremental
unit-time learning model is introduced here only to show that other models may also be used. It will not
be explained in detail.
The amount of the learning curve is expressed as a percentage, such as 70%. The percentage refers to the
amount of time required as a percentage of the amount of time required at the previous level (before the
most recent doubling of production). The percentage of the learning curve indicates how much improvement
takes place every time production levels double. The lower the percentage is, the greater is the amount of
learning that is taking place.
Note: The learning curve percentage will be given in an exam problem, or information will be given that
enables calculation of the learning curve percentage.
The limits for learning curve percentages are as follows.
•
The learning curve will always be less than 100%, because if the learning curve is 100% then no
learning and no decrease in time required is taking place.
•
The learning curve percentage must be greater than 50%. If the learning curve percentage is
less than or equal to 50%, it would mean one of two impossible scenarios exists:
o
If the learning curve is less than 50%, the total time required to produce the additional units
when production doubles plus the time required to produce the initial units would be less than
the time required for production of the initial units.
o
If the learning curve is equal to 50%, the total time required to produce the additional units
when production doubles plus the time required to produce the initial units would be equal to
the time required for production of the initial units.
Neither of the two scenarios above is possible. The additional units must require some added
amount of time, so the total time for the additional units plus the time for the initial units must be
greater than the time required for the initial units.
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Section B
B.3. Forecasting Techniques
Cumulative Average-Time Learning Model
The cumulative average-time learning model assumes a constant rate of decline in the estimated cumulative
average time per unit each time the quantity of units produced doubles.
Note: “Cumulative” means “accumulating,” or “increasing by successive additions.” Therefore, the cumulative average time required per unit refers to the average time per unit calculated by dividing the
total time required for all batches or units produced to date by the number of all the batches or units
produced to date, each time the total number of batches or units produced doubles.
Each time the total number of batches or units produced doubles, the total time required for all batches
or units produced to date used in the numerator increases by the additional time required for the batches
or units produced in the doubling, and the number of batches or units used in the denominator of the
calculation increases by the additional number of batches or units produced in the doubling.
For example, if the learning curve is 70%, every time the total number of units produced doubles, the
estimated cumulative (total) production time for all units produced decreases to 70% of what it would
have been if no learning had taken place. (If no learning had taken place, the production time required
for twice the production amount would be twice the production time required at the previous production
level.)
The cumulative average-time learning model can be used to calculate three things:
1)
The estimated average time per unit for the entire quantity produced, from the very first unit to
the very last unit produced, or the “cumulative average.”
2)
The estimated total time required for the entire quantity produced, from the very first unit to the
very last unit produced.
3)
The estimated total production time required for a certain block of units can be calculated
by finding the total time required for all the units produced through the end of that block and
subtracting from that the total time required for the units up to that block. This calculation is
possible only if the block of units represents the units that are produced in a doubling of production.
For example, when 8 units are produced, production that began with 1 unit has doubled 3 times
(1 to 2 units is the first doubling; 2 to 4 units is the second doubling; and 4 to 8 units is the third
doubling). To calculate the total time required to produce units 5 through 8 (in the third doubling),
calculate the total time required to produce units 1 through 8 (3 doublings) and subtract from that
the time required to produce units 1 through 4 (2 doublings). Since the jump from 4 units to 8
units represents a doubling of production, the time requirement can be calculated for just the
additional 4 units numbered 5 through 8.
Mathematically, two methods can be used to calculate the estimated total time required for all units produced and the estimated average time required per unit for all units produced using the cumulative average
model:
1)
Calculate the estimated total time required for all units produced, then use the estimated total
time to calculate the estimated cumulative average time per unit;
2)
Calculate the estimated cumulative average time per unit, and then use the estimated cumulative
average time per unit to calculate the estimated total time required for all units produced.
Exam Tip: The proper method to use for a particular exam problem will depend upon what the question
asks and the information given, so candidates should learn both methods.
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229
B.3. Forecasting Techniques
CMA Part 1
Method 1: Calculate the estimated total time required for production, then use the estimated total time
to calculate the estimated cumulative average time per unit:
Estimated total time required
for all units produced
Where:
LC
N
=
n
Time required for the first unit × (2 × LC)
= Learning curve percentage (in decimal format)
= Number of doublings of units produced to date
Once the total time is known, the estimated cumulative average time per unit can be calculated by dividing
the estimated total time by the total number of units produced, as follows:
Estimated cumulative average time per
unit required for all units produced
=
Estimated total time required
for all units produced
Total number of units produced
Method 1 works better when the question requires the calculation of the estimated total time required
for all units produced.
Example: A plant that manufactures cars is subject to an 80% learning curve. Ten hours are required
to produce the first car of a new model. According to the cumulative average-time learning model, the
estimated total time required to manufacture the first two cars will be 80% of the total time it would
have taken to produce two cars if no learning had taken place.
If no learning had taken place, then estimated production time for the first two cars would be 20 hours.
With an 80% learning curve, the estimated total time required to produce two cars will be 80% of 20
hours, or 16 hours (10 × [2 × 0.8]), which equates to an estimated cumulative average of 8 hours
for each of the first two cars (16 ÷ 2). The mathematical process is shown for the first three doublings
of production.
The first doubling (to produce a total of 2 units):
[Note: Any number raised by the exponent 1 is the number itself.]
1) Estimated total time required for units 1 and 2 = 10 × (2 × 0.80)1 = 10 × 1.6 = 16 hours
2) Estimated cumulative average time per unit for units 1 and 2 = 16 ÷ 2 = 8 hours
The second doubling (to produce a total of 4 units):
1) Estimated total time required for units 1 through 4 = 10 × (2 × 0.80)2 = 10 × 2.56 = 25.6 hours
2) Estimated cumulative average time per unit for units 1 through 4 = 25.6 ÷ 4 = 6.4 hours
The third doubling (to produce a total of 8 units):
1) Estimated total time required for units 1 through 8 = 10 × (2 × 0.80)3 = 10 × 4.096 = 40.96 hours
2) Estimated cumulative average time per unit for units 1 through 8 = 40.96 ÷ 8 = 5.12 hours
And so on.
Notice that with each doubling, multiplying the previous estimated total time by 2 and then by 80%
results in the new estimated total time. For example, 25.6 estimated total hours required for the first 4
units multiplied by 2 and then multiplied by 80% equals 40.96 hours, the estimated total hours required
for the first 8 units.
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Section B
B.3. Forecasting Techniques
Method 2: Calculate the estimated cumulative average time per unit for all units produced, then
use the estimated cumulative average time per unit to calculate the estimated total time required for all units produced:
Estimated cumulative average time
per unit for all units produced
Where:
LC
n
=
=
=
Time required for the first unit ×
LCn
Learning curve percentage (in decimal format)
Number of doublings of all units produced
This method works because the time required to produce the first unit or lot is also the cumulative average
time required for that unit or lot. The total time required for the first unit or lot divided by the number
produced (1) equals the average time per unit or lot for the first unit or lot. This method begins with the
cumulative average time per unit or lot required to produce the first unit or lot.
Once the estimated cumulative average time per unit is known, the estimated total time can be calculated
by multiplying the estimated cumulative average time by the number of units produced, as follows:
Estimated total time required
for all units produced
=
Estimated cumulative average
×
time per unit for all units produced
Total number of
units produced
Method 2 works better when the question requires the calculation of the estimated cumulative average
time required per unit for all units produced.
Example: The following doublings refer to the same plant from the previous example. It manufactures
cars and is subject to an 80% learning curve. The time required to produce the first car is 10 hours.
The first doubling:
[Note: Any number raised by the exponent 1 is the number itself.]
1) Estimated cumulative average time per unit for units 1 and 2 = 10 × 0.801 = 10 × 0.80 = 8 hours
2) Estimated total time required for units 1 and 2 = 8 × 2 = 16 hours
The second doubling:
1) Estimated cumulative average time per unit for units 1 through 4 = 10 × 0.802 = 10 × 0.64 = 6.4
hours
2) Estimated total time required for units 1 through 4 = 6.4 × 4 = 25.6 hours
The third doubling:
1) Estimated cumulative average time per unit for units 1 through 8 = 10 × 0.80 3 = 10 × 0.512 =
5.12 hours
2) Estimated total time required for units 1 through 8 = 5.12 × 8 = 40.96 hours
And so on.
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B.3. Forecasting Techniques
CMA Part 1
Note that methods 1 and 2 produce identical answers. The above examples demonstrate the mathematical
operations of solving two questions using the same information but asking for different things.
•
If a question requires the calculation of the cumulative total time required to produce all the
units, when the total number of units produced is a doubled level, then Method 1 will more quickly
find the estimated total time, which equals time required for the first unit × (2 × LC)n.
•
If a question requires the calculation of the cumulative average time per unit for all the units
produced, when the total number of units produced is a doubled level, then Method 2 will more
quickly find the estimated cumulative average time per unit, which equals time required for the
first unit × LCn.
Time Required for a Specific Block of Units Using the Cumulative Average Time-Learning Model
To find the estimated total time required to produce only units 5, 6, 7, and 8 in the examples above,
subtract the estimated total time required for units 1 through 4 from the estimated total time required for
units 1 through 8, as follows:
Estimated total time required for units 5, 6, 7, and 8 only = 40.96 – 25.6 = 15.36 hours
The estimated average time per unit for units 5, 6, 7, and 8 is 15.36 hours divided by 4 units, or 3.84 hours
for those four units only.
To find the estimated total time required for units 3 and 4 only in the examples above, subtract the estimated total time required for units 1 and 2 from the estimated total time required for units 1 through 4, as
follows:
Estimated total time required for units 3 and 4 only = 25.6 – 16 = 9.6 hours
The estimated average time per unit for units 3 and 4 is 9.6 hours divided by 2 units, or 4.8 hours for those
two units only.
However, the estimated time required for just one specific unit/lot other than for unit/lot 2 cannot be
calculated using the cumulative average-time learning model. Presumably within the block of units 5
through 8, unit 6 will require less time than unit 5, unit 7 will require less time than unit 6, and unit 8 will
require the least time of all. The estimated average time per unit for a group of units can be calculated,
but it is not possible to calculate the estimated time for just one of the units in the group.
Either of the two methods illustrated above can be used to find either the estimated total time required for
all units/lots produced or the estimated cumulative average time per unit/lot for all units/lots produced, or
both, because:
•
The estimated cumulative average time per unit or lot for all units/lots produced × the total number
of units or lots produced = the estimated total time for all units or lots produced; and
•
The estimated total time for all units or lots produced ÷ the total number of units or lots produced
= the estimated cumulative average time per unit or lot for all units/lots produced.
However, it is better to be familiar with both methods in order to choose the faster method for the calculation required to answer a given question.
In the above examples, if no learning had taken place (LC percentage = 100%), the time required to
produce 2 cars would have been 10 hours for each car, which is 20 hours (10 hours × 2).
10 × (2 × 1.00)1 = 10 × 2 = 20
A learning rate of 1.00 or 100% is equivalent to no learning taking place. However, because learning
did take place, and the learning curve was 80%, the time required to produce the first car was 10 hours,
and the time required to produce the second car was 6 hours, for a total of 16 hours for both (80% of 20
hours). The cumulative average time per unit for the first two cars was 8 hours for each car.
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Section B
B.3. Forecasting Techniques
The maximum learning rate possible using the cumulative average time-learning model is some percentage greater than 50%, for example 50.01%, or 0.5001.
The maximum learning rate must be greater than 50% because at a learning rate of exactly 50%, the total
time required for production of the first 2 cars would be exactly the same as the time required to produce
the first car, and that would be impossible:
10 × (2 × 0.50)1 = 10 × 1 = 10 hours
At a rate of 49%, the total time required for production of the first two cars would be less than the time
required to produce the first car, which would also be impossible:
10 × (2 × 0.49)1 = 10 × 0.98 = 9.8 hours
Even 50.01% is a highly improbable rate because it would mean that the second car is estimated to require
only 0.002 hours:
10 × (2 × 0.5001)1 = 10 × 1.0002 = 10.002 hours
Thus, 50% or lower is an impossible learning rate in the cumulative average model because it is impossible
to produce 2 cars in the same or less time than it took to produce the first car.
Therefore, when the cumulative average-time learning model is used, the learning rate will always be
greater than 50% and less than 100%.
Note: The learning rate using the cumulative average-time learning model will always be between 50%
and 100%.
Learning rates are developed by analyzing historical data. If overhead costs are applied on the basis of
direct labor hours, historical overhead costs may need to be segregated according to their fixed and variable
components. If so, the method used to segregate the costs may be the high-low points method or a regression analysis. The high-low points method can be used to segregate fixed overhead costs from variable
overhead costs, and that is covered and illustrated in Section D, Cost Management, in Volume 2 of this
book under the topic Estimating Fixed and Variable Costs.
Example: Given a 90% learning curve, the following data about productivity apply:
Number of units
100
200
400
Cumulative average time per unit, in minutes
5
4.5, calculated as 5 × 0.90
4.05, calculated as 4.5 × 0.90
Note that the cumulative average times per unit are each given for lots of 100; therefore, the total time
for each line will be the cumulative average time per unit multiplied by the number of units produced.
Question: What is the average time per unit required for the second 100 units?
Solution: The first 100 units required 100 × 5 = 500 minutes to produce. The first 200 units (units 1
through 200, the first doubling) required 200 × 4.5 = 900 minutes to produce.
Therefore, the average time per unit required for the second 100 units (units 101 through 200) is (900
minutes − 500 minutes) ÷ 100 units = 4 minutes.
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233
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CMA Part 1
Example: The cost accountant for Ray Lighting Manufacturing Company is planning production costs for
a new lamp. Production of the new lamp will be subject to a 60% learning curve since it involves only
minimal adjustments to established processes. The initial lot of 500 lamps is expected to require 1,000
hours of labor. Costs are as follows:
Direct Labor
Direct Materials
Variable OH Applied
$20/hr.
$150/lot of 500
$25/DLH
(1) Question: What is the estimated cumulative average time per unit after 8 lots have been
manufactured, if the cumulative average-time learning model is used?
Answer: Note that the information is given in the form of 500-unit lots rather than individual units.
However, the question asks for average time per unit, so an additional calculation will be necessary.
The first doubling will occur when the second lot of 500 has been produced. The second doubling
will occur when the fourth lot of 500 has been produced. The third doubling will occur when the
eighth lot of 500 has been produced. Therefore, production has doubled three times, which means that
in the formula n = 3, while LC = 0.60.
The estimated total number of labor hours required for 8 lots of 500 lamps is:
1,000 × (2 × 0.60)3 =
1,000 × 1.23 = 1,728 estimated total labor hours required for 8 lots of 500 lamps.
The estimated cumulative average number of labor hours required per lamp for 8 lots of 500 lamps
each is found by dividing the total of 1,728 labor hours required for 8 lots by the total number of lamps
produced in 8 lots, which is 500 × 8, or 4,000:
1,728 hours ÷ 4,000 = 0.432 estimated cumulative average number of labor hours required per lamp
for 8 lots of 500 lamps each.
Alternatively, the estimated cumulative average number of labor hours required per lot for 8 lots can
be calculated, and that can be used to determine the average number of labor hours per unit for 8 lots.
1,000 × 0.603 = 216 estimated cumulative average number of labor hours per lot for 8 lots.
216 estimated cumulative average labor hours per lot ÷ 500 lamps per lot = 0.432 estimated cumulative
average number of labor hours required per lamp for 8 lots of 500 lamps each.
(2) Question: What is the estimated incremental variable cost for the eighth lot using the
cumulative average-time learning model?
Answer:
Estimated total number of hours required to produce 8 lots = 1,000 × (2 × 0.60)3 = 1,728 hours
Estimated total number of hours required to produce 4 lots = 1,000 × (2 × 0.60)2 = 1,440 hours
Estimated total number of hours required to produce lots 5-8: 1,728 hours – 1,440 hours = 288 hours
Estimated average number of hours per lot for lots 5-8: 288 ÷ 4 = 72
The total direct labor and variable overhead cost per direct labor hour is $45 ($20 direct labor plus $25
variable overhead applied). Since an estimated 72 hours are required to produce the eighth lot, the
estimated direct labor and variable overhead cost of the eighth lot is $3,240 [72 × ($20 + $25)].
Direct materials cost for 1 lot of 500 units: $150
Estimated incremental variable cost for the eighth lot, including direct labor, variable overhead, and direct materials = $3,240 + $150 = $3,390
Note that this $3,390 is the incremental variable cost for each of lots 5, 6, and 7 as well. The incremental
variable cost per lot is the average incremental cost per lot for those four lots (5, 6, 7, and 8).
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Section B
B.3. Forecasting Techniques
Benefits of Using Learning Curves in Forecasting
•
Learning curves should be used in the development of production and labor budgets when changes
such as new products are planned.
•
Recognizing that higher costs will occur in the early phase of the product life cycle allows more effective evaluation of managers.
•
Labor costs should be adjusted regularly in recognition of the fact that learning causes standard costs
to decrease over time.
•
Life-cycle costing and bidding: In calculating the cost of a contract, learning curve analysis can ensure
that the cost estimates are accurate over the life of the contract, leading to better, more competitive
bidding on projects.
•
Cost-Volume-Profit analysis: If learning is not considered in determining a breakeven point, the result
may be an overstatement of the number of units required to break even. (Cost-Volume-Profit analysis
and breakeven point calculation are covered on the CMA Part 2 exam.)
•
Capital budgeting: Costs can be projected more accurately over the life of the capital investment
when expected improvements in labor productivity due to learning are included. (Capital Budgeting
is covered on the CMA Part 2 exam.)
•
Make or buy decisions: The analysis of the cost to make the product will be affected by the learning
curve in effect. (Make or buy decisions are covered on the CMA Part 2 exam.)
Limitations of Using Learning Curves in Forecasting
•
Learning curve analysis is appropriate only for labor-intensive operations involving repetitive
tasks where repeated trials improve performance. If the production process primarily relies on robotics and computer controls, little repetitive labor is involved and thus little opportunity exists for
learning to take place.
•
The learning rate is assumed to be constant. In real life, the decline in labor time might not be
constant. For example, the time required might decline at the rate of 70% for the first 75,000 units,
followed by 80% for the next 50,000 units, and 95% for the next 25,000 units.
•
The reliability of a learning curve calculation can be jeopardized because an observed change in
productivity might actually be associated with factors other than learning, such as a change
in the labor mix, the product mix, or other factors. If some factor or factors other than learning are
affecting productivity, a learning model developed using the affected historical data will produce inaccurate estimates of labor time and cost.
Question 48: Reeves Inc. has developed a new production process to manufacture its product. The new
process is complex and requires a high degree of technical skill. However, management believes there
is a good opportunity for the employees to improve as they become more familiar with the production
process. The production of the first unit requires 100 direct labor hours. If a 70% learning curve is used,
the cumulative direct labor hours required to produce a total of eight units would be
a)
196 hours
b)
274 hours
c)
392 hours
d)
560 hours
(ICMA 2010)
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235
B.3. Forecasting Techniques
CMA Part 1
Question 49: The average labor cost per unit for the first batch produced by a new process is $120. The
cumulative average labor cost after the second batch is $72 per product. Using a batch size of 100 and
assuming the learning curve continues, the total labor cost of four batches will be:
a)
$4,320
b)
$10,368
c)
$2,592
d)
$17,280
(CMA Adapted)
Using Probability Concepts in Forecasting
Note: The term “random variable” is often used in discussions of probability. A random variable is “a
numerical description of the outcome of an experiment.” A random variable is a variable that can have
any value within a range of values that occurs randomly and can be described using probabilities.
If the random variable can take on any one of a number of values that can be counted, and if those
values are always whole numbers (such as number of items sold), the random variable is called a discrete random variable. For example, the number of customers coming into a store between the hours
of 12 noon and 1 p.m. is a discrete random variable. The number of people can be counted.
In some cases, a random variable can take on any value whatsoever within an interval or a collection of
intervals. For example, if a random variable can take on any value whatsoever in the interval from 0 to
100 (such as 5.635 or 72.36092), the random variable is a continuous random variable. Since the
number of decimal places that the continuous random variable can have is unlimited, there can be no
limit to the number of different values the variable could assume.
Three Methods of Assigning Probable Values
Three methods are used to assign probable values to possible outcomes: the classical method, the relative
frequency method, and the subjective method.
1)
The classical method assumes that each possible outcome has an equal probability of occurring.
Thus, if ten possible outcomes exist, each outcome is assumed to have a 10% probability of occurring. The classical method is the method used to assign probabilities to coin tosses or dice rolls.
Business decisions don’t usually involve coin tosses or dice rolls, so the classical method is seldom
used in situations of business uncertainty.
2)
When factual information is available that can be used to determine the probability that something
will occur, the use of that information to assign probabilities is called the relative frequency
method. The information may come from a sample, analytical data, or any other reliable source.
3)
The subjective method is used when neither the classical nor the relative frequency methods
can be used because the possible outcomes are not equally likely and relative frequency data are
not available. The subjective method of assigning probabilities consists of using whatever data are
available plus the experience and intuition of the decision maker to assign a probable value that
expresses his or her degree of belief that the outcome will occur. Subjective probability is personally determined, and different people will assign different probabilities to the same event.
Despite this relative freedom in assigning probabilities, the two necessary requirements for all
probabilities must nevertheless be met:
236
a.
The probable value for each possible outcome must be between 0 and 1; and
b.
All the probabilities for all the possible outcomes must total 1.
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Section B
B.3. Forecasting Techniques
Sometimes the various methods are used in combination, such as when probabilities are determined by
combining estimates from the classical or relative frequency methods with subjective probability estimates.
Example: The management of Digital Age, a computer store, needs to know how many computers are
sold each day in order to forecast sales for the coming year. The budget analyst groups together the
number of computers sold each day to show how many days in a year the store made no sales at all,
how many days it made one sale, and so on. The maximum number of computers Digital Age has sold
in any one day is 10. The store is open 6 days per week, or 312 days per year. The budget analyst sets
up a table with historical data for one year. The following table is called a frequency distribution.
Number of Sales
0
1
2
3
4
5
6
7
8
9
10
Total
Number of Days (Frequency)
17
23
29
35
41
47
41
29
23
17
10
312
Next, the analyst creates the following probability distribution based on the above frequency distribution (some of the probabilities have been adjusted to compensate for rounding differences so that
the probabilities will sum to 1.00):
Number
of Sales
0
1
2
3
4
5
6
7
8
9
10
Total
17/312
23/312
29/312
35/312
41/312
47/312
41/312
29/312
23/312
17/312
10/312
Probability
0.06
0.08
0.09
0.11
0.13
0.15
0.13
0.09
0.08
0.05
0.03
1.00
Based on the above probability distribution, the probability that Digital Age will sell no computers in a
given day is 6%. The probability that it will sell 10 computers in any one day is 3%. The probabilities
can be summed to calculate the probability of a range of sales. For example, the probability that the
store will sell 4, 5 or 6 computers in any one day is 13% + 15% + 13%, or 41%.
All of the probabilities sum to 100%. Therefore, the probability that the store will sell between 0 and 10
computers, inclusive, on any given day is 100%.
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237
B.3. Forecasting Techniques
CMA Part 1
efham CMA
The graph of the probability distribution for Digital Age’s sales looks like the following:
Probability Distribution
Number of Sales Per Day
18%
16%
14%
Probability
12%
10%
8%
6%
4%
2%
0%
0
1
2
3
4
5
6
7
8
9
10
Number of Sales
The highest probability, 15%, is 5 sales per day. The probability that no computers will be sold on any given
day is 6%. The probability that 10 computers will be sold is 3%. According to the historical data, 10 is the
maximum number of computers sold in one day’s time.
Expected Value
When a situation has several possible outcomes, expected value can be used to determine the outcome to
use in a decision model. “Expected value” has a very specific meaning. It does not mean “forecasted value”
or “anticipated value” or “budgeted value.”
The expected value is the mean value, also known as the average value. The symbol for the mean,
average, or expected value is 𝜇 (mu). The expected value is an average of all the possible outcomes
that could occur over a long period of time. An expected value will probably not be equal to the actual
outcome in any specific period; but over a long period of time, it should approximate the average of the
actual outcomes.
The expected value of a discrete random variable is calculated as the weighted average of all the possible values of the random variable using the probabilities of each of the outcomes as the weights.
A discrete probability distribution can be used to compute the expected value of the random variable. The
following steps are used:
1)
Identify the possible quantitative outcomes and assign a probability to each one. All of the probabilities must be between 0 and 1 and altogether they must add up to 1. In order to calculate a
weighted average, the possible outcomes must be whole numbers, as well.
2)
Multiply each possible quantitative outcome by its assigned probability.
3)
Sum the products of Step 2.
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Section B
B.3. Forecasting Techniques
The sum of the products of Step 2 is the expected value, which is a weighted average of the possible
outcomes, using each outcome’s probability as its weight. The expected value is then used as the assumption in the decision model. In forecasting, the expected value may be used as a forecasted amount.
Continuing with the Digital Age example, management calculates the expected value of sales to determine the number of computers the store can expect to sell on an “average” day. Each possible number
of computers that could be sold in a day is multiplied by the probability of making that number of sales.
The sum of the products is the expected value of computer sales on an average day.
Number
Number of Sales
of Sales
Probability
× Probability
0
×
0.06
=
0.00
1
×
0.08
=
0.08
2
×
0.09
=
0.18
3
×
0.11
=
0.33
4
×
0.13
=
0.52
5
×
0.15
=
0.75
6
×
0.13
=
0.78
7
×
0.09
=
0.63
8
×
0.07
=
0.56
9
×
0.05
=
0.45
10
×
0.03
=
0.30
Expected Value/Weighted Average (mean)
4.58
Obviously, the store will never sell exactly 4.58 computers in a given day since it cannot sell a portion
of a computer. But over the long term, the average number of computers the store can expect to sell
per day is 4.58.
This daily sales volume, the number of days the store is open in a given time period such as a month or
a year, and the average amount of each sale, can be used to develop budgeted sales revenue.
An expected value is a “long-run” average value for a random variable. As a result, an expected value is
more reliable as a long-run average forecast and less reliable as a forecast of, for example, sales for the
coming period. Despite not being a reliable forecast, expected value is often used to project future sales or
other budget components because it is the best method available for obtaining a forecast.
Variance and Standard Deviation
The expected value gives an average or expected result. The variance and standard deviation both give
an idea of the variability of the possible values about the mean (the weighted average, or expected value).
The variance and the standard deviation measure how far from the expected value the various possible
values lie. In the example of Digital Age computer store, these values refer to the number of computers
sold in a day. If on some days no computers are sold but on other days ten computers are sold, then the
range for the number of computers that could be sold on any given day is fairly large (that is, 0 to 10).
The variance is the weighted average of the squared differences of the values of a random variable from
the mean, with the probabilities of each serving as the weights. The difference from the mean of each result
is important because it indicates the distance that particular measurement is from its expected value.
The variance is used to summarize the variability in the values of a random variable (such as computers
sold), that is, how much they are spread out. Another word for this variability is dispersion. The amount
of variability in the values of the random variable about their mean (that is, their average) is the amount
by which they are dispersed, or the amount of their dispersion.
The amount of dispersion is important because it is a measurement of risk. If the values are highly
dispersed about their mean, then they vary widely from their expected value. The greater the dispersion of
the values is about their mean, the greater is the risk associated with the values because the probability
that the actual results will be different from the expected value is increased.
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239
B.3. Forecasting Techniques
CMA Part 1
For example, the lowest number of one-day computer sales in Digital Age’s probability distribution is 0, the
highest is 10, and the mean is 4.58. Consider instead another store owned by Digital Age where the lowest
one-day sales figure is 0, the highest 25, and the mean (expected value) is 9. The distance from the lowest
value to the mean and from the mean to the highest value is greater for the second store than it is for the
first store. Thus, the variability of the random variable values about their mean for the other store is greater.
As the observations vary more widely from their expected value, the probability becomes greater that the
actual results in the future will vary widely from forecasted results, and that wide variability creates risk.
The variance of a population is represented by σ2 (sigma squared).
The standard deviation is the positive square root of the variance. Since the variance is σ2, the standard
deviation, which is the square root of the variance, is represented by σ (sigma). Whereas variance is measured in squared units, standard deviation is measured in the same units as the variable, which in this
example is the number of computers sold. Both measures provide information on how much the various
values are dispersed around the mean. In the computer store example, the mean number of sales per day,
𝛍, is 4.58.
Continuing with the table of Digital Age’s computers sold per day, the variance and the standard
deviation are as follows.
Number
of Sales x
0
1
2
3
4
5
6
7
8
9
10
0
1
2
3
4
5
6
7
8
9
10
−
−
−
−
−
−
−
−
−
−
−
x−μ
4.58 =
4.58 =
4.58 =
4.58 =
4.58 =
4.58 =
4.58 =
4.58 =
4.58 =
4.58 =
4.58 =
(x − μ) 2
(x − μ)
Probability
× Probability
20.9764
0.06
1.2586
12.8164
0.08
1.0253
6.6564
0.09
0.5991
2.4964
0.11
0.2746
0.3364
0.13
0.0437
0.1764
0.15
0.0265
2.0164
0.13
0.2621
5.8564
0.09
0.5271
11.6964
0.07
0.8187
19.5364
0.05
0.9768
29.3764
0.03
0.8813
Total = Variance σ 2 =
6.6938
Standard deviation σ = 6.6938 =
2.59
2
−
−
−
−
−
4.58
3.58
2.58
1.58
0.58
0.42
1.42
2.42
3.42
4.42
5.42
Assuming Digital Age has two computer stores and the standard deviation of sales in Store A is 2.59 whereas
the standard deviation of sales in Store B—where the daily sales range from 0 to 25 and the mean is 9—is
7.41, the sales budget for Store A will probably be more accurate than the sales budget for Store B, because
the sales at Store B vary more than do the sales at Store A.
Question 50: The table below shows the estimated probabilities of the percent of defective units resulting from a production run.
Percent Defective
2%
3%
4%
Probability
30%
50%
20%
The expected percent defective for a production run would be
a)
1.50%
b)
2.30%
c)
2.90%
d)
3.00%
(ICMA 2010)
240
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Section B
B.4. Budget Methodologies
B.4. Budget Methodologies
The Annual/Master Budget
The master budget is the culmination and the goal of the budgeting process. The master budget is also
called the comprehensive budget. The master budget is a full set of budgeted financial statements for
the budget year, including monthly or at least quarterly interim budgeted financial statements. The budgeted financial statements include the budgeted balance sheet, budgeted income statement, and
budgeted statement of cash flows. The budgeted financial statements are prepared by responsibility
center, and the responsibility center budgeted statements are consolidated into the company-wide budgeted financial statements. The individual responsibility center budgets and the consolidated budget together
make up the master budget.
A projected financial statement can be called a pro forma financial statement; however, the master
budget is not a pro forma financial statement. The term pro forma is used to refer to a forecasted financial
statement prepared for a specific purpose (for example, to do “what if” analysis in the process of planning).
A company might prepare many different sets of pro forma financial statements for the same period in its
planning process. A pro forma financial statement is not used for formal variance reporting as the master
budget and the flexible budget111 are. However, if an action that was forecasted is implemented, the company would probably want to compare the actual results with the forecasted, pro forma ones. But pro forma
financial statements are not a part of the formal budgeting process. They are used for planning and decision-making purposes, and the amounts in them may be quite different from the amounts in the master
budget. (Planning and the use of pro forma financial statements are discussed more in the topic of TopLevel Planning and Analysis in this section.)
The master budget is a static budget. A static budget is one that is prepared for just one planned activity
level, and the activity level is whatever is projected before the period begins.
Note: The term activity level or level of activity is used in planning and budgeting to refer to various
activities. It is often used to mean the planned number of units the company expects to produce or the
planned number of direct labor or machine hours the company expects to use. It can also refer to a
planned sales volume or any other planned volume.
The master budget is created using both non-financial and financial assumptions, which come about as a
result of the planning process. For instance, companies develop budgets for the number of units of each
product that they expect to manufacture and sell, the number of employees they will need, and so forth.
The master budget is a result of both operating decisions and financing decisions. Operating decisions
are concerned with the best use of the company’s limited resources. Financing decisions are concerned with
obtaining the funds to acquire the resources the company needs.
A profit plan that is broken down according to responsibility center lines will provide more feedback and will
function as more of a control tool than one that is not prepared by responsibility center, because each
responsibility center manager will be responsible for meeting his or her responsibility center’s profit plan.
Ideally, each responsibility center manager will also be responsible for developing his or her responsibility
center’s profit plan. These underlying budgets are used in developing the master budget. The master budget
is the consolidation of all the responsibility center budgets. It comprises operating budgets and financial budgets.
Operating budgets are used to identify the resources that will be needed to carry out the planned activities
during the budget period, such as sales, services, production, purchasing, marketing, and R&D (research
and development). The operating budgets for individual units are compiled into the budgeted income statement.
111
A flexible budget is a budget that is prepared using budgeted variable revenues and costs per unit multiplied by
the actual level of activity. It is essentially what the budget would have been if the company had known what the actual
level of activity would be when it developed the budget.
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241
B.4. Budget Methodologies
CMA Part 1
Financial budgets identify the sources and uses of funds for the budgeted operations. Financial budgets
include the cash budget, budgeted statement of cash flows, budgeted balance sheet, and the capital expenditures budget.
Static Budgets and Flexible Budgets
When a company develops its budget for a future period, it does not know what its actual sales and production volumes will be during that period. Revenues and costs in the master budget are based on
forecasted volumes. The master budget is a static budget because each item in it is developed for one
specific activity level.112 When variance reports are prepared that compare the actual results to the master
budget, one of the causes for each variance will usually be that the actual volume achieved was different
from the planned volume. Variances between actual results and master budget amounts are not very useful
for the company because they do not let the company know how the actual results compared to what the
results should have been, based on the actual level of sales.
Since variances due simply to volume variations are expected, it is more important to focus on variances
caused by other factors. For example, a variance caused by an increase in the cost per unit of direct labor,
leading to a total cost above what is expected for the actual production level could signal a problem in
production and should be investigated. But an increase in the cost of direct labor that is caused by increased
production only−not by an increase in cost per unit leading to a total cost above the expected amount for
the actual production level−is not a production problem.
A flexible budget is a budget that is prepared after the actual level of activity is known. A flexible
budget for a production department will consist of the budgeted variable amounts per unit adjusted to the
actual volume of units produced. A flexible budget for an income statement will be adjusted to the actual
volume of units sold.
The flexible budget is prepared for the actual level of activity using all of the standard variable costs per
unit along with the standard total fixed cost as determined at the beginning of the year. Essentially, what
the flexible budget does is answer the question, “If we had known what the actual level of activity was
going to be when we prepared the budget, what would the budget have looked like?” In other words, the
flexible budget is the budget that would have been prepared for the actual level of activity for the period.
Since the flexible budget is based on the actual level of activity for a period, the flexible budget amounts
cannot be finalized for a reporting period (usually a month at a time) until the period is past and the actual
achieved activity level for that period is known.
Note: Here is another way of looking at the preparation of the flexible budget: After the budget process
is complete and the master budget has been created (but before the actual sales results are known),
the budgeting team creates a number of other budgets for different levels of sales. If, for example, the
master budget projected 100,000 units of sales, the flexible budget process will create budgets for
85,000 units, 90,000 units, 95,000 units, 105,000 units, 110,000 units, and 115,000 units. At the end
of the year, the actual results are compared to the flexible budget that matches the actual level of sales.
Theoretically, such alternate budgets can easily be created for a company that produces one product.
Simply divide the master budget total variable costs by the master budget total volume to be sold and
multiply the result by the revised budgeted total volume to be sold. Budgeted fixed costs are the same
in the flexible budget as they are in the master budget, as long as the changes in volume do not move
outside the relevant range and thus cause the total fixed costs to change.
In reality, of course, it is impossible to prepare thousands and thousands of flexible budgets, one for
every possible activity level and−for a multiple product company−every possible combination of sales.
For that reason, the flexible budget is not prepared until the actual level of activity is known.
112
The term “activity level” is used to refer to the volume of whatever activity is relevant to the situation. The relevant
activity levels are usually sales volume and production volume. Thus, “activity level” could refer to either sales volume
or production volume.
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Section B
B.4. Budget Methodologies
If a variance is caused by a decline in sales volume below the planned level, of course, the decline in sales
does need to be addressed, and a comparison of actual results to the flexible budget will not be useful for
recognizing a decline in sales. For that reason, a comparison between actual results and the master budget
for sales, variable costs and contribution margin113 also needs to be done. Thus, a flexible budget cannot
replace a static budget. Most companies that use flexible budgeting also have their managers report on the
variances between the master (static) budget and the flexible budget because those variances are the
variances that are due to volume variations.
In determining what variances should be investigated, the following factors should be considered:
•
The magnitude of the variance. What constitutes a material variance will vary depending on
the size of the budget line item. If the budgeted amount is $1,250, a $1,000 variance would
represent 80% of the budgeted amount and would be important to investigate. But if the budgeted
amount is $1,000,000, a $1,000 variance would be only 0.10% of the budgeted amount and would
not be material.
•
The trend of the variance over time. If an unfavorable variance has been ongoing for several
months and is getting larger, then it needs to be investigated, even if its magnitude is not large.
•
The likelihood that an investigation will eliminate future occurrences of the variance.
This factor is a cost-benefit determination. If an investigation would not result in any changes that
could eliminate future occurrences of the variance, then the benefit to be gained from investigating
the variance would not be worth the cost of the investigation.
A flexible budget takes the variable revenues and costs as they are planned in the master budget (the static
budget) and adjusts the master budget amounts to what the budgeted amounts would have been if the
actual sales volume had been used in preparing the budget.
A flexible budget is prepared and used in addition to the master budget. The flexible budget is different
from the master budget because the flexible budget focuses on variances that are caused by things other
than differences in volume from the volume that was assumed when the master budget was prepared. The
flexible budget takes out the portion of the total variance from the master budget that was caused by
variances in volume. The flexible budget variances thus report only the variances that were caused by other
factors, so the flexible budget allows management to focus on the variances that may be caused by production or administrative problems that need attention.
Note that in a flexible budget only the variable budgeted revenues and costs are adjusted. Only
variable revenues and costs change with changes in volume. Fixed costs are just that: fixed. They do not
change with changes in sales volume, as long as the activity remains within the relevant range. Therefore,
fixed costs in the flexible budget are exactly the same as the fixed costs in the static budget.
Note: Flexible budgeting and a standard costing system go together. One is meaningless without the
other.
113
The contribution margin is sales revenue minus variable expenses. A contribution margin per unit can be calculated
by subtracting the per-unit variable expenses (including direct materials, direct labor, variable manufacturing overhead,
and variable selling and variable administrative costs) from the per-unit sales price. The total contribution margin is total
sales minus total variable expenses, or the per-unit contribution margin multiplied by the number of units sold.
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B.4. Budget Methodologies
CMA Part 1
Example: Here is an income statement showing actual results alongside the static budget (the master
budget) and the flexible budget prepared for the actual sales volume:
Actual
Results
Units sold
Revenues
Variable costs:
Direct materials
Direct manufacturing labor
Variable manufacturing overhead
Total variable costs
Contribution margin
Fixed costs
Operating income
Static
Budget
Flexible
Budget
20,000
24,000
20,000
$ 2,500,000
$ 2,880,000
$ 2,400,000
1,243,200
396,000
261,000
$ 1,900,200
$ 599,800
570,000
$
29,800
1,440,000
384,000
288,000
$ 2,112,000
$ 768,000
552,000
$ 216,000
1,200,000
320,000
240,000
$ 1,760,000
$ 640,000
552,000
$
88,000
The flexible budget will be used along with the static budget for the period’s variance reporting. The only
difference between the static budget and the flexible budget is the volume used to calculate variable revenues and expenses. The static budget is prepared for a planned sales volume of 24,000 units, whereas the
flexible budget is prepared as if the company had a planned sales volume of 20,000 units, which is the
actual number of units sold. The variable revenue and cost items in the flexible budget have been adjusted
downward for the sales that were lower than planned. Note that the budgeted fixed cost amount is the
same in the flexible budget as it is in the static budget.
For each variable revenue and cost, the static budget amount has been divided by the static budget volume
of 24,000 to find the budgeted per unit revenue/cost, and that per unit revenue/cost has been multiplied
by the actual number of units sold (20,000) to calculate the flexible budget amount. The fixed cost static
budget amount of $552,000 has been carried over to the flexible budget column unchanged.
The flexible budget can be prepared only after the end of a period, when the actual volume for the period
is known. Therefore, a flexible budget would be prepared for each month or each quarter as well as for the
year-end, but only when the actual volume for that period is known.
Benefits of Flexible Budgeting
•
Flexible budgeting enables management to focus its attention on variances caused by factors other
than differences between actual and budgeted volumes.
Limitations of Flexible Budgeting
•
If sales decline below the planned level, the decline does need to be addressed and a flexible budget
will not be useful for pinpointing a decline in sales below what was planned.
•
Flexible budgeting needs to be used with a standard costing system. The two go together, and one is
meaningless without the other.
The section on Performance Management covers the use of flexible budgets in variance reporting.
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Section B
B.4. Budget Methodologies
Project Budgeting
As the name suggests, a project budget is a budget for a specific project. As such, the time frame of the
budget may be very short or more long-term, depending on the length of the project.
Project budgets are fundamentally different from the master budget and the flexible budget. The master
budget or the flexible budget covers a distinct time span, such as the month of January. In contrast, a
project budget covers an identifiable project that has its own time span. That time span may be as little as
a week or it may be as long as several years. The focus in project budgeting is on one separate project.
Examples of projects that might be budgeted for separately are capital budgeting projects such as the
purchase of a new machine or the construction of a new plant. A project may be the development and
testing of a new product, the acquisition of another company, a new software installation, a marketing plan
for entering a new geographical area, or a budget for a long-term contract.
Projects must be planned over their entire life spans and should be viewed as special commitments. Their
budgeted amounts must be integrated into the master budget of the company for the relevant period or
periods.
A project budget must include all of the costs that will be required for the project. Though this requirement
seems very obvious, indirect costs and overheads that will be allocated to the project can easily be missed.
All indirect costs and overheads to be allocated to the project must be identified and included.
A long-term project budget for the introduction of a new product can also be called a life-cycle budget. A
life-cycle budget plans incomes and expenses for one specific product throughout its entire life cycle, from
its development through its decline, enabling the company to see the cash flows that will result from the
product over its entire life. When all the lifetime development and production costs are set forth in the lifecycle budget, management can set a price that will cover not only the company’s costs but also its required
return on investment.
Benefits of Project Budgeting
•
Management can determine in advance whether or not the project is one that should be undertaken.
•
The project budget enables management to plan for the amount of resources (personnel, effort,
supervisors, and finances) that will be needed.
•
The project budget focuses management’s attention on anticipated cash inflows and outflows from
the project and the decisions that will affect the cash flows.
•
Project budgeting fosters cooperation and coordination among the various responsibility centers that
will be affected by the project.
•
A project budget covers an identifiable project that has its own time span.
Limitations of Project Budgeting
•
Projects must be planned over their entire life spans and thus they should be viewed as special
commitments.
•
Budgeted amounts for projects must be integrated into the master budget of the company for the
relevant period or periods. Unless that is done, the project budget cannot be fully utilized.
Capital budgeting is covered in depth on the CMA Part 2 exam.
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245
B.4. Budget Methodologies
CMA Part 1
Activity-Based Budgeting (ABB)
Activity-based budgeting (ABB) is similar in concept to activity-based costing (ABC), which is covered in
detail in this book in the section on Cost Management (Section D). Activity-based costing is an alternate
method of allocating overhead costs to products.
Note: Before proceeding with the following explanation of activity-based based budgeting, please read
the topic Activity-Based Costing in Section D in Vol. 2 of this textbook.
When activity-based costing is used to allocate overhead costs, the overhead allocations are not based on
usage of resources such as direct labor hours or machine hours as in traditional costing.114 Instead, they
are based on activities performed and the cost of those activities. ABC is much more detailed than traditional costing, because it uses many more cost pools and each cost pool has its own cost driver. When
activity-based costing is being used for overhead allocations, the overhead allocation rates under ABC are
calculated according to the activity-based costing cost pools. Activity-based budgeting is integral to developing the overhead allocation rates used in activity-based costing.
Activity-based budgets are prepared based on the budgeted overhead costs to perform the budgeted activities. Activities that drive the costs are identified and a budgeted level of activity for each of the drivers
is determined based on a budgeted level of production. A budgeted cost pool (budgeted overhead costs) is
developed for each activity. Budgeted overhead costs per unit of each activity are determined by dividing
the total budgeted overhead costs for the activity by the total budgeted units of the activity. Overhead
costs are allocated to products on the basis of the budgeted levels of each activity for each product. The
company may have several different overhead cost pools, each with a different cost driver and a different
cost allocation to the units produced. Thus, several different overhead allocations may be made to each
product.
An activity-based budget system makes clear the relationship between activities performed and output.
The advantage of this clear relationship is that when changes are made to products, product design, product
mix, manufacturing processes, and so forth, managers are able to examine the effects of the changes on
budgeted activities and on the costs of those activities.
If activity-based costing is used as the costing system, then the budget should also be activitybased to enable continuous improvement and also to make comparisons between actual results
and budgeted results meaningful. Activity-based budgeting is an extension of the company’s activitybased costing system and uses the same activity cost pools to group budgeted costs as the activity-based
costing system uses to group actual costs.
However, before using the current year’s activity cost pools to develop the next period’s budget, a firm
needs to review its activity pools and the costs going into each pool for their continued appropriateness and
accuracy. Some of the factors may change before the future budget period begins, and data from the
current ABC system may need to be updated. Updating of the current ABC system will be needed especially
if variances during the current or previous periods have been significant. For example, new equipment may
have been acquired that has decreased setup time per batch or has reduced supervisory time during setup
or production. Cost per setup will change as a result.
114
The traditional method of applying overhead costs to units produced uses either machine hours or direct labor hours
allowed per unit of output as the basis of the allocation. The budgeted total overhead fixed costs are determined and the
budgeted total overhead variable costs are determined. The budgeted overhead costs are divided by the number of hours
(machine or labor) budgeted to find the fixed and variable costs per hour allowed for the budgeted output, and the result
is the standard overhead cost per hour. The standard overhead cost per hour multiplied by the number of hours (direct
labor or machine) allowed per unit is the standard overhead cost per unit.
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Section B
B.4. Budget Methodologies
Benefits of Activity-Based Budgeting
•
The process of preparing an activity-based budget brings out information about opportunities for cost
reductions and the elimination of wasteful activities. Thus, activity-based budgeting makes it possible
to identify and enhance high value-added activities and to eliminate low value-added activities, which
promotes continuous improvement.
•
It helps managers to identify resources needed and changes that will be needed in resources if
changes are made in products offered, product design, product mix, manufacturing processes, and
so forth.
•
Budgeted costs are based on the costs for the resources required to perform the budgeted activities,
which defines a clear relationship between resource consumption, costs, and output.
•
Activity-based budgeting can help to identify budgetary slack.
•
An activity-based budget system makes clear the relationship between activities performed and output. When changes are made to products, product design, product mix, manufacturing processes,
and so forth, managers are able to examine the effects of the changes on budgeted activities and on
the costs of those activities.
Limitations of Activity-Based Budgeting
•
Activity-based budgeting must be used in conjunction with activity-based costing.
•
Both ABC and ABB require more work than a traditional costing and budgeting system and so are
costlier to implement. Costs include the research needed to do the cost allocations and the time
required to educate managers about the cost allocations. The more complex the cost allocations are,
the higher the costs to educate.
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B.4. Budget Methodologies
CMA Part 1
Zero-Based Budgeting versus Incremental Budgeting
Typically, budgets are developed by beginning with the current period’s actual or the current period’s budgeted figures and adjusting them for any changes anticipated in the coming period. This process assumes
that the budget period will be related to the current period. The focus is on things that are expected to
change during the coming year. This approach to budgeting is called an incremental approach.
Zero-based budgeting is different. Under zero-based budgeting, the budget is prepared without any reference to, or use of, the current period’s budget or the likely operating results for the current
period. Every planned activity must be justified with a cost-benefit analysis.
Benefits of Zero-Based Budgeting
• In zero-based budgeting, all of the activities a department plans are identified and then justified. Only
revenues and costs from activities that are justified are included in the budget. Because the budget is
built up from zero, each manager must justify all of the expenses in his or her department. The zerobased budgeting approach is preferable to the incremental approach because it enables the company
to identify expenses that are not value-adding or that should be reduced due to some development in
production methods or something similar.
• Having to justify every activity forces a prioritizing of activities because the activities are ranked on
the basis of their cost-benefit analyses in order to determine which ones are justified. This ranking
provides a systematic basis for resource allocation.
• Because a manager needs to examine every single expenditure and activity within the department,
he or she is more likely to develop better or less costly methods of accomplishing the same objectives,
or both. This development of alternative methods is the chief benefit of zero-based budgeting.
Limitations of Zero-Based Budgeting
• The major limitation of zero-based budgeting is that it can require a nearly impossible amount of work
to review all of a company’s activities every year.
As an alternative to reviewing all of the company’s activities every year, a company could schedule zerobased budgeting on a rotating basis, with only a few different departments or divisions being subject to an
in-depth review of their activities each year.
Note: With incremental budgeting, the actual results from the current period are assumed to be
acceptable for future periods (with some adjustments for changed circumstances). That assumption is
not made with zero-based budgeting.
Continuous (Rolling) Budgets
A continuous budget, also called a rolling budget, is one that is prepared for a certain period of time ahead
of the present. For example, a one-year continuous budget would be prepared at the end of every month
for the next twelve months.
Continuous budgets are discussed in more detail in Time Frames for Budgets in the Budgeting Concepts
topic in this section.
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Section B
B.5. Annual Profit Plan and Supporting Schedules
Question 51: The type of budget that is available on a continuous basis for a specified future period by
adding a month, quarter or year in the future as the present month, quarter or year ends is called a
a)
Rolling budget.
b)
Kaizen budget.
c)
Activity-based budget.
d)
Flexible budget.
(ICMA 2010)
Question 52: Which one of the following is not an advantage of activity-based budgeting?
a)
Better identification of resource needs
b)
Linking of costs to outputs
c)
Identification of budgetary slack
d)
Reduction of planning uncertainty
(ICMA 2010)
B.5. Annual Profit Plan and Supporting Schedules
The Budgeting Cycle
The budgeting cycle is a process that goes on throughout the year, even though the budget is probably
completed before the year begins. The budgeting cycle consists of more than just the development of the
annual profit plan, although that is a big part of the cycle. Throughout the budget year, actual results need
to be compared with planned results and variances investigated. Without this comparison and investigation,
the budgeting cycle loses much of its usefulness to the company. The process includes:
•
Using data from past performance as well as future expectations, managers at all levels in the
organization work together to plan the performance of the company as a whole for the next budget
period. Management accountants are involved in this planning, as well. The result is the annual
master budget or profit plan for the coming period.
•
Throughout the period, actual results are reported on and compared with budgeted results on a
monthly or quarterly basis.
•
Management accountants assist managers in investigating the variances from the plan. If necessary, operational changes are made. If the budget cannot be achieved because of some external
situation that has developed, the budget itself may need to be revised.
•
Throughout the period, managers and management accountants monitor market feedback, external conditions, and actual results as they plan for the next budget period. For example, if a sales
decline occurs, managers may plan changes to the product line for the next period.
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Question 53: Which one of the following best describes the role of top management in the budgeting
process? Top management:
a)
Should be involved only in the approval process.
b)
Lacks the detailed knowledge of the daily operations and should limit its involvement.
c)
Needs to be involved, including using the budget process to communicate goals.
d)
Needs to separate the budgeting process and the business planning process into two separate
processes.
(CMA Adapted)
Question 54: The budgeting process should be one that motivates managers and employees to work
toward organizational goals. Which one of the following is least likely to motivate managers?
a)
Participation by subordinates in the budgetary process.
b)
Having top management set budget levels.
c)
Use of management by exception.
d)
Holding subordinates accountable for the items they control.
(CMA Adapted)
Development of the Annual/Master Budget or Profit Plan
The end result of the annual profit planning process is a full set of budgeted financial statements for the
budget year, including monthly or at least quarterly interim budgeted financial statements. The budgeted
financial statements include the budgeted balance Sheet, budgeted income statement, and budgeted statement of cash flows. The budgeted financial statements are prepared by responsibility center, and the
responsibility center budgeted statements are consolidated into the company-wide budgeted financial statements. The individual responsibility center budgets and the consolidated budget together make up the
master budget.
The development of an annual profit plan for a large corporation may take many months to complete
because the annual profit plan is made up of several different budgets, and some budgets cannot be developed until other budgets have already been completed. For example, the Sales Budget will be the driving
factor in determining how many units must be produced, and therefore the Sales Budget must be completed
before the production budget can be completed.
One of the most important things that can be done in the process of developing the profit plan is involving
all of the correct people. Profit planning is not a process to be undertaken exclusively by upper management
or during board meetings. Lower-level managers need to be involved because they know what is possible,
what is not possible, and what resources are required to meet a specific level of activity. Including lowerlevel managers in the budgeting process is called participative budgeting.
Participative budgeting has a number of benefits for the organization. When the people responsible for
fulfilling the budget are involved in the process of developing it, they will be more likely to support and
accept the budget and be more motivated to meet it. In addition, the accuracy of the budget will be increased because of the input from the people who are actually involved in the process being planned.
Bottom-up budgeting is similar in concept to participative budgeting. In bottom-up budgeting, the budget
is developed by starting at the lowest levels in the operations systems and building revenues and costs
from there.
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Even when participative or bottom-up budgeting are being used, upper management still needs to be involved in the planning and budgeting process. Management needs to set the goals, establish the
priorities, and provide the necessary support to make sure the process is completed correctly.
Development of the Master Budget
The Master Budget consists of two classifications: the Operating Budget and the Financial Budget.
The Operating Budget
The Operating Budget includes the Budgeted Income Statement and all the budgets that support it,
which will be detailed in the following pages, including:
•
Sales Budget
•
Production Budget
•
Direct Materials Usage Budget
•
Direct Materials Purchases Budget
•
Direct Labor Budget
•
Manufacturing Overhead Costs Budget
•
Ending Inventories Budgets (Finished Goods and Direct Materials)
•
Cost of Goods Sold Budget
•
Nonmanufacturing Budgets
The Financial Budget
The Financial Budget includes:
•
Capital Expenditures Budget
•
Cash Budget
•
Budgeted Balance Sheet
•
Budgeted Statement of Cash Flows
The Capital Expenditures Budget
The Capital Expenditures Budget is not a part of the annual budget development process, but it is
very important to the development of the annual budget.
The Capital Expenditures Budget is the budget for long-term capital expenditures such as property,
plant, and equipment. Because capital expenditures are large and expensive, they require advance planning
in order to have the financing in place and the necessary time to purchase or construct the assets so they
will be available when they are needed. Therefore, the capital expenditures budget is usually prepared for
years in advance and reviewed on an annual basis.
Any capital expenditures to be made during the budget year will need to be included in the budgeting
process for the year. Capital expenditures budgeted for the coming year will affect the Budgeted Balance
Sheet as increases in fixed assets and in accounts receivable, inventory, and accounts payable. They will
affect the Budgeted Income Statement as income expected from the new projects along with related expenses, including depreciation on the new equipment. Those effects on the income statement and the
balance sheet will affect cash as well, so they will flow to the Cash Budget and the Budgeted Statement of
Cash Flows.
The Capital Expenditures Budget consists of a list of each major project that has been approved and the
amount to be funded for the coming year. The annual amount for each project is then broken down according to the quarter(s) or possibly month(s) when the expenditures for each project are expected to occur
and when the cash inflows from each project are expected to occur. The quarterly or monthly totals of cash
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CMA Part 1
inflows and cash funding requirements for all projects will be used in preparing the Cash Budget as well as
the Budgeted Balance Sheet. Any anticipated financing must also be included in the Cash Budget and the
Budgeted Balance Sheet. The Budgeted Balance Sheet must reflect the investments and the financing, and
the Budgeted Income Statement and Statement of Cash Flows must reflect any net income and cash flows
planned to be generated by the capital projects for the coming period.
Senior management must communicate information about planned capital projects for the year to the department heads who will be developing the Operating Budgets so they can incorporate the effects of the
planned capital projects into their budgets for the year.
The Operating Budget
The Operating Budget is the Budgeted Income Statement and all the individual budgets that feed into
it. The individual budgets and the purpose of each will be discussed, as well as the order in which they are
prepared.
Note: For the exam, candidates may need to know the order in which the different operating budgets
are prepared because some of the questions may be based on the order of preparation. It is critical to
produce the Sales Budget first so that the company knows how many units will need to be produced
or purchased.
As the various Operating Budgets are explained, examples will be given. For each budget example, annual
amounts will be used for simplicity’s sake. However, in a real situation, these budgets would be developed
using monthly figures or at least quarterly figures, so that actual results for each month or quarter and the
year-to-date can be compared with planned results for the same period and year-to-date as the coming
year progresses. The monthly or quarterly amounts are needed in order to develop the Cash Budget, as
well. These monthly or quarterly figures should not be the same for every month or quarter; that is, they
should not be annual amounts simply divided by twelve or by four. Seasonal changes and other expected
variations in activity should be taken into consideration.
1. Sales Budget
The Sales Budget shows the expected sales in units of each product and each product’s expected selling
price. The Sales Budget is based on the firm’s forecasted sales level, its short- and long-term objectives,
and its production capacity.
The first Operating Budget to be prepared is always the Sales Budget, because the Production
Budget and all the other budgets for the company are derived from the Sales Budget. If sales are expected
to be low, the company does not need as much inventory or as many sales people, and so on. On the other
hand, if sales are expected to be high, more of each of these resources will be required.
The Sales Budgets should be developed for each responsibility center individually or possibly for each sales
person, depending on the nature of the business. The Sales Budget needs to be based on realistic estimates of sales, since the Sales Budget will be the driver behind all of the remaining budgets.
•
If the Sales Budget is too optimistic, production will be too high, inventory will be too high, and
problems such as cash shortfall may result.
•
If the Sales Budget is too low, production and inventory will be too low, and sales may be lost
because of a lack of product to sell.
The Sales Budget is probably the most difficult budget to produce because it relies entirely on information and estimations that are outside of the direct control of the company. The company has no direct
control over the economy as a whole or over competitors and technological advances that may affect sales
of the company’s product.
If demand is greater than the company’s production capacity, however, the Sales Budget should not reflect
the amount the company could sell if it were able to increase production to meet the demand. Unless the
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company has specific plans in its Capital Expenditures Budget to increase production facilities due to the
expected increased demand, the Sales Budget will need to be adjusted to the quantity that will be available to be sold.
Thus, it follows that the Sales Budget will need to incorporate information about sales revenues expected
from any capital projects that are expected to begin generating sales during the coming year.
Note: One more item that needs to be considered in the Sales Budget is the level of credit sales and
when those credit sales will be collected. Though the timing of collections is not critical for the Sales
Budget itself, the amount of collections is critical for the development of the Cash Budget (covered later).
Example: Sales Budget for the year ending December 31, 20X3 for Wood Creations, a manufacturer
of three products: wood birdhouses, wood garden benches, and wood bowls.
Product
Budgeted Sales
In Units
Selling
Price
Total Sales
Revenues
$
Wood birdhouses
4,000
$ 50
Wood garden benches
2,500
275
687,500
Wood bowls
3,500
60
210,000
Total Budgeted Sales Revenue
200,000
$1,097,500
The budgeted sales revenue in the Master Budget will be $1,097,500. The production department will
use the information about how many units of each product the sales department plans to sell in its
budget.
2. Production Budget
After determining the Sales Budget, the Production Budget is developed so that it incorporates the company’s Sales Budget along with its capacity and inventory objectives. The Production Budget incorporates
the final determination of how many units to produce during the period.
If the company would like to increase its inventory level by year-end, it will need to include the expected
inventory increase in its production plans. Similarly, if the company wants to decrease year-end inventory,
it will need to produce fewer units than it plans to sell in order to sell down the units in inventory. In
addition, the Production Budget will of course need to include production from any new capital projects
planned to begin production during the year.
The Production Budget also includes when the units will be produced. The units must be produced prior to
the time when they will be needed for sale but not too far in advance. If increased sales are expected in
the early part of the year, production should be planned to be higher early in the year. If higher sales are
expected later in the year, increased production needs to take place later in the year or the company will
need to pay significant storage costs.
Note: If the prices of the inputs to the production process (primarily direct materials) are expected to
change significantly in the future, the expected changes must also be considered in determining when
and how many units to produce. As much as possible, the company will want to purchase inputs to
produce its products when the prices of the inputs are lower rather than higher.
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Example: Production Budget for the year ending December 31, 20X3 for Wood Creations.
The company expects to end 20X2 (the current year) with 300 birdhouses, 200 benches, and 300 bowls
on hand in finished goods inventory. The company wants to increase its finished goods inventory levels
to 350 birdhouses, 250 benches, and 350 bowls at year-end 20X3.
Budgeted sales in units
Plus: Ending finished goods inventory required
Total units required
Minus: Beginning finished goods inventory
Finished goods units to be produced
Birdhouses
4,000
350
4,350
300
4,050
Benches
2,500
250
2,750
200
2,550
Bowls
3,500
350
3,850
300
3,550
The Production Budget in number of units to be produced provides the foundation for the development of
the following four budgets:
1)
Direct Materials Usage Budget.
2)
Direct Materials Purchases Budget is created in much the same way as the Production Budget,
taking into account the desired change in inventory of raw materials.
3)
Direct Labor Costs Budget.
4)
Factory Overhead Costs Budget includes both variable costs (such as equipment maintenance
because it increases as production increases and vice versa) and fixed costs (such as supervisory
salaries). Fixed factory overhead costs do not change as production levels change as long as the
change in activity remains within the relevant range, but if the budgeted production is outside the
relevant range, appropriate adjustments need to be made to fixed manufacturing costs.
The Direct Materials Usage and Purchases Budgets, Direct Labor Costs Budget, and Factory Overhead Costs
Budget feed into the Ending Inventories Budget, and all of these individual budgets feed into the Cost of
Goods Sold Budget.
Because all of these budgets are interrelated, a change in one budget will require a change in another
budget or budgets. As the level of production changes, the amount of labor and material required will
change. As the amount of labor changes, there may need to be a change as well in indirect materials and
indirect labor, both of which are overhead costs.
•
Indirect materials are materials used in the manufacturing process, but their costs are not directly
traceable to any particular product. They may represent a very minor part of the finished product
or they may not be an integral part of the finished product at all. Examples are screws, glue,
cleaning chemicals, and disposable tools.
•
Indirect labor is likewise not directly traceable to any particular product. The wages of a janitor
who cleans up the plant are indirect labor costs, since the janitor’s wages cannot be traced to any
one product.
As these items change, changes will be required in the Factory Overhead Costs Budget.
Note: Because of the way the individual budgets are connected to each other, a change in one budget
will almost always affect at least one other budget.
2A. Direct Materials Usage Budget
The number of units to be produced (from the Production Budget) is used to calculate the amount of direct
materials required and their costs. The quantities of direct materials to be used depend upon how efficient
the production employees are in assembling them into finished products as well as the quality of the direct
materials purchased.
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For each product, the company has a bill of materials that specifies which materials and how much of
each are to be used in manufacturing the product, the sequence in which the materials are to be used, and
in what department each process is to be completed. Those bills of materials are used to develop the Direct
Materials Usage Budget.
The Direct Materials Usage Budget will be affected by production needs created by any new capital projects
scheduled to begin production during the year.
An example of a Direct Materials Usage Budget follows.
Example: Direct Materials Usage Budget for the year ending December 31, 20X3 for Wood Creations.
Direct materials required to produce one birdhouse: 1.5 board feet of ⅜” oak, cost $10 per ft.
Direct materials required to produce one garden bench: 9 board feet of ½” oak, cost $12 per ft.
Direct materials required to produce one bowl: 0.5 board feet of 3” oak, cost $20 per ft.
All direct material costs are expected to be the same for 20X3 as they have been for 20X2.
The company’s beginning direct materials inventory is planned to be 170 board feet of ⅜” oak, 1,000
board feet of ½” oak, and 75 board feet of 3” oak. The company wants to end the year with 200 board
feet of 3/8”, 1,100 board feet of ½”, and 100 board feet of 3” oak.
Physical Units Budget:
DM for birdhouses: 4,050 units × 1.5 board feet
DM for benches: 2,550 units × 9 board feet
DM for bowls: 3,550 units × 0.5 board feet
Total quantity of direct materials to be used
⅜”
6,075
½”
3”
_____
22,950
______
1,775
6,075
22,950
1,775
Total
Cost Budget:
Available from beginning materials inventory:
⅜”: 170 board ft. × $10
½”: 1,000 board ft. × $12
3”: 75 board ft. × $20
$ 1,700
$ 12,000
$ 1,500
Plus - To be purchased this period:
⅜”: (6,075 – 170 on hand) × $10
½”: (22,950 – 1,000 on hand) × $12
3”: (1,775 – 75 on hand) × $20
_______
263,400
_______
34,000
Total cost of direct materials to be used1
$60,750
$275,400
$35,500
59,050
$371,650
1
Note that the total cost of direct materials used does not include any adjustment for desired ending
direct materials inventory. This budget is only the Direct Material Usage budget. The Direct Material
Purchases budget (shown next) will incorporate the desired ending balances of direct materials inventory.
2B. Direct Material Purchases Budget
After the Direct Materials Usage Budget is complete, the Purchasing Department can prepare the Direct
Material Purchases budget, because the Direct Material Purchases Budget is derived from the Direct Material
Usage Budget. Like the overall Production Budget, the amount of direct materials to be used in production
is adjusted by the amount of change from beginning to ending materials inventory to determine the quantity
of each material to be purchased, and then the costs for those quantities are determined, using the standard
costs developed.
The Direct Materials Purchases Budget will also be affected by production needs created by any new capital
projects planned to begin production during the year.
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B.5. Annual Profit Plan and Supporting Schedules
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Example: Direct Material Purchases Budget for the year ending December 31, 20X3 for Wood Creations.
⅜”
½”
3”
Physical units:
To be used in production
Plus: Desired ending direct materials inventory
Total required
Minus: Beginning direct materials inventory
6,075
200
6,275
170
22,950
1,100
24,050
1,000
1,775
100
1,875
75
Purchases
6,105
23,050
1,800
Total
Costs:
⅜” oak: 6,105 board ft. × $10
½” oak: 23,050 board ft. × $12
3” oak: 1,800 board ft. × $20
$61,050
_______
$276,600
_______
$36,000
Total cost of direct materials purchases
$61,050
$276,600
$36,000
$373,650
2C. Direct Labor Budget
The Direct Labor Budget is developed using direct labor standards—the time allowed per unit of output and
the standard cost allowed per hour of direct labor time—to calculate the budgeted cost for direct labor. The
company usually prepares a separate Direct Labor Budget for each type of labor used in production at its
standard cost.
The standard cost per hour of direct labor time will generally include wages and all other employee costs.
These other costs include employer contributions to Social Security (FICA) and Medicare, workers’ compensation insurance for workers who are hurt on the job, federal and state unemployment taxes paid by the
employer, health and life insurance premiums if they are provided, pension plan contributions paid by the
company, and any other employee benefits. These may all be presented in an Employee Benefit Statement.
Example: Direct Labor Budget for the year ending December 31, 20X3 for Wood Creations. Wood
Creations has only one standard direct labor hourly rate: $20 per hour. The direct labor time standards
are:
Direct labor hours allowed per unit
Birdhouses
Benches
Bowls
0.6
2.0
1.0
Thus, the Direct Labor Costs Budget is as follows:
Units
Produced1
4,050
2,550
3,550
Birdhouses
Garden benches
Bowls
Standard
Hrs./Unit
0.6
2.0
1.0
Totals
1
Total
Hours
2,430
5,100
3,550
11,080
Hourly
Rate
$20
20
20
Total
Cost
$ 48,600
102,000
71,000
$221,600
From Production Budget.
2D. Manufacturing Overhead Costs Budget
Under the traditional method of applying overhead costs to units produced, either the standard machine
hours or direct labor hours allowed per unit of output are used as the basis of the allocation. The budgeted
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total fixed overhead costs and the budgeted total variable overhead costs are determined. Those totals are
each divided by the standard number of hours of the allocation base (machine hours or direct labor hours)
allowed for the budgeted production volume to calculate the standard fixed and variable overhead application rates per hour allowed for the budgeted output.
Example: Manufacturing Overhead Costs Budget for the year ending December 31, 20X3 for Wood
Creations. The budgeted fixed and variable costs are divided by the 11,080 direct labor hours in the
Direct Labor Budget to determine the standard fixed and variable overhead rates per direct labor hour.
Wood Creations allocates manufacturing overhead on the basis of direct labor hours. Here are the total
fixed and variable costs budgeted:
Fixed costs for capacity of 11,080 direct labor hours:
Depreciation
Supervisory salaries and employee costs
Other indirect fixed costs
Variable costs:
Indirect manufacturing labor
Equipment maintenance
Supplies
Total budgeted manufacturing overhead costs
$ 2,240
30,000
1,000
$13,960
5,000
3,200
$ 33,240
22,160
$55,400
The standard overhead rates per direct labor hour are:
Fixed overhead: $33,240 budgeted ÷ 11,080 direct labor hours budgeted = $3/DLH
Variable overhead: $22,160 budgeted ÷ 11,080 direct labor hours budgeted = $2/DLH
Total overhead: $55,400 budgeted ÷ 11,080 direct labor hours budgeted = $5/DLH
3. Ending Inventories (FG and DM) Budget
The next budget to be prepared is the budget for Ending Inventories, both finished goods inventory and
direct materials inventory. The overhead costs are treated as inventoriable product costs, so total overhead
costs will be allocated to production at the rate of $5 per direct labor hour allowed for each unit planned
(as calculated in the Manufacturing Overhead Costs Budget).
Example: Ending Inventories Budgets for the year ending December 31, 20X3 for Wood Creations.
Finished Goods Inventory cost per unit:
Birdhouses
Direct materials:
⅜” oak: 1.5 board ft. per unit × $10
½” oak: 9 board ft. per unit × $12
3” oak: 0.5 board ft. per unit × $20
Direct labor:
Birdhouses: 0.6 hours × $20
Benches: 2 hours × $20
Bowls: 1 hours × $20
Manufacturing overhead:
Birdhouses: 0.6 hours × $5
Benches: 2 hours × $5
Bowls: 1 hour × $5
Total cost per unit
Benches
Bowls
$15
$108
$10
12
40
20
3
____
10
____
5
$30
$158
$35
(Continued)
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Wood Creations uses the first-in-first-out (FIFO) cost flow assumption. Therefore, the costs per
unit calculated above will be used to calculate the cost of the budgeted ending finished goods inventory.
Budgeted Ending Inventories (Direct Materials and Finished Goods):
Quantity
Standard
Cost per Unit
Extended Cost
Total
Cost
200
1,100
100
$ 10
12
20
$ 2,000
13,200
2,000
$17,200
350
250
350
$ 30
158
35
$10,500
39,500
12,250
62,250
Direct materials:
⅜” boards
½” boards
3” boards
Finished goods:
Birdhouses
Benches
Bowls
Total ending inventories
$79,450
4. Cost of Goods Sold Budget
After all of the production related budgets are completed, the company can produce the Cost of Goods
Sold Budget, which is based on the calculation of cost of goods sold, as follows:
Budgeted Beginning Inventory
+ Budgeted Purchases or Production
= Budgeted Goods Available for Sale
− Budgeted Ending Inventory
= Budgeted Cost of Goods Sold
Example: Cost of Goods Sold Budget for the year ending December 31, 20X3 for Wood Creations.
The cost of Wood Creations’ beginning inventory of finished goods is:
Birdhouses
Benches
Bowls
Quantity1
300
200
300
Cost per Unit2
$ 28
150
33
Extended Cost
$ 8,400
30,000
9,900
Total Cost
Cost per Unit3
$ 30
158
35
Extended Cost
$121,500
402,900
124,250
Total Cpst
$ 48,300
The expected budgeted production cost is
Birdhouses
Benches
Bowls
Quantity1
4,050
2,550
3,550
$648,650
The cost of Wood Creations’ desired ending inventory (from the Ending Inventories Budget) is
Birdhouses
Benches
Bowls
Quantity1
350
250
350
Cost per Unit3
$ 30
158
35
Extended Cost
$10,500
39,500
12,250
Total Cost
$ 62,250
(Continued)
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Section B
B.5. Annual Profit Plan and Supporting Schedules
The Cost of Goods Sold Budget is:
Budgeted beginning inventory
+ Budgeted production
= Budgeted goods available for sale
− Budgeted ending inventory
= Budgeted cost of goods sold
1
$
48,300
648,650
$ 696,950
62,250
$634,700
The quantity comes from the Production Budget.
2
Cost per unit for the 20X3 beginning inventory (the same as the current year’s ending inventory) is
different from the cost per unit for the 20X3 production and 20X3 ending inventory because the current
year’s direct labor and overhead costs were different from the budgeted amounts for the coming year.
Cost per unit for the beginning inventory is simply given here and cannot be calculated from any other
information given in this extended example.
3
Budgeted production cost per unit comes from the Ending Inventory Budget for Finished Goods.
5. Nonmanufacturing Budgets
Amounts for nonmanufacturing costs come from the various areas of the company that are not involved in
production. Those budgets include:
•
Research and Development (R&D) Budget.
•
Selling, Marketing and Distribution Budget, including sales supervisory salaries, sales commissions,
selling expenses (such as travel and entertainment), advertising and promotion expenses, shipping-out expenses, telephone and wireless, office supplies, and depreciation on office furniture and
equipment used by sales and marketing personnel, and so forth.
•
Administrative and General Expense Budget, including salaries and wages for management and
support staff in administrative and staff departments (for example, accounting, legal, IT, and human resources), travel and entertainment, insurance, audit fees, telephone and wireless, office
supplies, depreciation on office furniture and equipment used by administrative personnel, and so
forth.
•
Budgets for other expenses or sources of revenue such as interest income and interest expense.
Note: Each of the individual budgets prepared for expenses should be broken down into variable and
fixed costs. This breakdown is significant because at least in the short-term, fixed costs cannot be
changed. The breakdown is necessary in order to develop a flexible budget as well, since in a flexible
budget, variable items are adjusted to their equivalent values using actual activity while fixed items are
unchanged in total. Also, the budgeted variable costs are needed to determine the budgeted contribution
margin from each business unit. The contribution margin is total revenue minus all variable expenses.
The nonmanufacturing budgets need to be developed in enough detail to be useful. The assumptions underlying the amounts in them should be documented for reference. When the first drafts of the budgets are
revised, those documented assumptions will be needed in order to determine where changes can be made.
For example, the budgeted employees and their salaries underlying the budgeted salaries and wages
amount should be documented. If it is necessary to revise budgeted salaries and wages, it will be much
easier to make that revision if detail is available about the salaries and wages used to develop the first draft
of the budget.
After the Operating Budget is completed, the company can evaluate the expected profit for the upcoming
period. This evaluation may be done using earnings per share, an industry average, or a price-earnings
ratio.
In addition, the Budgeted Net Income becomes a part of the Budgeted Balance Sheet through its effect on
retained earnings in the equity section.
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259
B.5. Annual Profit Plan and Supporting Schedules
CMA Part 1
The Financial Budget
The Financial Budget is the other major classification within the Master Budget. It includes the
•
Capital Expenditures Budget,
•
Cash Budget,
•
Budgeted Balance Sheet, and
•
Budgeted Statement of Cash Flows.
The Capital Expenditures budget has already been covered, since it must be in place for the budget year
before any other budgets can be developed.
The Cash Budget
The Cash Budget (also called the Cash Management, Cash Flow or Working Capital Budget) draws upon
information from all other budgets. Because it uses information from the other budgets, it is the last
budget prepared before the budgeted financial statements are prepared. It is also one of the most important budgets developed. The Cash Budget tracks the inflows and outflows of cash on a month-by-month
(possibly even week-by-week or day-by-day) basis.
The Cash Budget is similar to but not exactly the same as a Budgeted Statement of Cash Flows. The Cash
Budget must be prepared before the Budgeted Balance Sheet can be prepared. On the other hand, the
Budgeted Statement of Cash Flows is prepared after the Budgeted Balance Sheet and Income Statement
are prepared. The cash flows in the Budgeted Statement of Cash Flows are segregated according to operating, investing, and financing cash flows. In contrast, the cash flows in the Cash Budget are segregated
according to receipts and disbursements.
The Cash Budget shows the planned sources and uses of cash for the budget period. The various budgets
prepared up to this point provide the information for the Cash Budget. For example, the Capital Expenditures Budget provides information on planned equipment purchases. The Sales Budget provides the
information needed to determine budgeted collection of accounts receivable. The Direct Material Purchases,
Direct Labor, and the Nonmanufacturing Costs Budgets provide the information needed for budgeted cash
disbursements. The ending cash balance appears on the Budgeted Balance Sheet for the period end.
If the Cash Budget is accurate, it will allow the company to plan for any cash shortfalls that may occur
during the year and also enable the company to plan for any excess cash that may accumulate during the
year. Any excess cash should be invested for the time period that it will not be needed.
One advantage of predicting cash shortfalls is that it will be easier (and less expensive) for the company to
obtain a short-term loan if management is aware of its need before the shortfall occurs and if it is able to
present cash inflow and outflow projections to the bank to support its loan request and show the source of
the repayment of the loan. The company also would have more time to obtain permanent capital from
equity sources by selling shares if that is the best alternative.
Note: Although all companies should prepare a Cash Budget, it is particularly important for those that
operate as seasonal businesses to do so, preferably on a monthly basis. For a seasonal business,
Production, Sales, and Ending Inventory by month are also critical budgets.
A numerical example of Wood Creations’ Cash Budget will not be given here. Much more detail than is
available regarding monthly or quarterly amounts budgeted for sales revenue, production costs, and nonmanufacturing items would be needed in order to develop appropriate cash receipts and cash disbursements
budget amounts. Several problems are available at the end of this topic and in ExamSuccess that can be
used for practice in developing budgeted cash receipts and cash disbursements for a month or a quarter.
A format for a Cash Budget is presented on the next page.
260
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Section B
B.5. Annual Profit Plan and Supporting Schedules
The following is the format of a cash budget. This format assumes the budgeting is done by quarter, but a
monthly budget would be even better, with columns for each month.
Cash Budget for the Year Ending December 31, 20X3
Quarters
Q1
Q2
Q3
Q4
Cash balance, beginning
$
$
$
$
Plus receipts:
Collections from customers
Sale of capital equipment
_________ _________ _________ _________
Total cash available
Minus disbursements:
Direct materials
Payroll
Manufacturing overhead costs
Nonmanufacturing costs
Capital equipment purchases
Income taxes
Total disbursements
Minimum cash balance desired
Total cash needed
Cash excess (deficit)
Financing:
Beginning borrowings
Repayment(s) during period
Interest expense
Total effects of financing
Cash balance, ending
Year as
a Whole
$
_________
_________
_________
_________
_________
_________
_________
_________
$
_________
_________
$
_________
_________
$
_________
_________
$
_________
_________
$
$
$
$
$
$
_________
$
$
_________
$
$
_________
$
$
_________
$
$
_________
$
$
Question 55: Holland Company is in the process of projecting its cash position at the end of the second
quarter. Shown below is pertinent information from Holland’s records.
Cash balance at end of 1st quarter
Cash collections from customers for 2nd quarter
Accounts payable at end of 1st quarter
Accounts payable at end of 2nd quarter
All 2nd quarter costs and expenses (accrual basis)
Depreciation (accrued expense included above)
Purchases of equipment (for cash)
Gain on sale of asset (for cash)
Net book value of asset sold
Repayment of notes payable
$
36,000
1,300,000
100,000
75,000
1,200,000
60,000
50,000
5,000
35,000
66,000
From the data above, determine Holland’s projected cash balance at the end of the second quarter.
a)
Zero
b)
$25,000
c)
$60,000
d)
$95,000
(ICMA 2010)
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261
B.5. Annual Profit Plan and Supporting Schedules
CMA Part 1
The Master Budget Financial Statements
Once the Operating Budgets and the Cash Budget have been prepared, the company can prepare its Master
Budget financial statements. The individual budgets that make up the Operating and Financial Budgets are
compiled into a Budgeted Income Statement, Balance Sheet,115 and Statement of Cash Flows. All of the
budgeted financial statements are interconnected in the same manner as the actual financial statements.
The Master Budget is the document the company relies on as its operating plan as it carries out management’s plans in order to achieve its goals and objectives. It is a summary of management’s operating and
financial plans for the period, expressed as a set of budgeted financial statements for the period that reflects
the impact of the operating decisions and financing decisions to be made during the coming period.
Master Budget financial statements will probably be prepared for each month of the budget period, or at
least for each quarter. The monthly budgeted financial statements can be developed and presented in a
spreadsheet format with the months as the column headings. Monthly budgeted financial statements are
very important because looking at the budgeted financial statements, particularly the cash flows for each
month during the period, will enable the company to identify any potential problems before they develop.
Potential problems identified may relate to the company’s existing loan agreements or restrictive covenants.116 For example, if the organization can determine, based on preliminary planned financial
statements, that it will probably be in violation of a loan covenant during the second quarter of the year, it
will have time to take corrective actions to prevent the violation and to adjust the budget accordingly.
Also, if management sees that it will not meet the expected (or desired) profits or other financial measures
after the preparation of the Master Budget financial statements, it needs to go back and look at the plans
for the year. This process of revision will probably take place several times until the resulting budgeted
financial statements are the way senior management wants them to look. However, as this reconsideration
takes place the company needs to be very careful to not perform unrealistic budgeting by making unattainable changes to the budgeted amounts.
Question 56: Which one of the following statements regarding selling and administrative budgets is
most accurate?
a)
Selling and administrative budgets are usually optional.
b)
Selling and administrative budgets are fixed in nature.
c)
Selling and administrative budgets are difficult to allocate by month and are best presented as
one number for the entire year.
d)
Selling and administrative budgets need to be detailed so that the key assumptions can be better
understood.
(CMA Adapted)
115
Ending work-in-process inventory is not included in the individual budgets because it would be difficult, if not impossible, to forecast. However, a monetary amount representing ending work-in-process inventory can be estimated for the
budgeted balance sheet based on historical levels.
116
Long-term debt usually involves requirements for the company to maintain certain ratios in its financial statements,
and these requirements are called covenants. Covenants are part of most loan agreements. One example of a covenant
is a requirement that the company maintain a certain minimum current ratio, such as at least 2:1. If the company’s
current ratio falls below the required level, the company is technically in default on its debt even though it may be
making every scheduled payment. Under such circumstances, the lender can legally demand payment of the entire loan
balance immediately, which could force the company into bankruptcy. Therefore, it is very important that the company
maintain compliance with its debt covenants.
262
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Section B
B.5. Annual Profit Plan and Supporting Schedules
efham CMA
Question 57: Which one of the following items should be done first when developing a comprehensive
budget for a manufacturing company?
a)
Determination of the advertising budget.
b)
Development of the sales budget.
c)
Development of the cash budget.
d)
Preparation of a pro forma income statement.
(CMA Adapted)
Question 58: A large manufacturer’s forecast of total sales revenue for a year is least likely to be
influenced by
a)
the seasonal pattern of sales revenues throughout the year.
b)
anticipated interest rates and unemployment rates.
c)
expected shortages of key raw materials.
d)
input from sales personnel.
(ICMA 2010)
Question 59: In the budgeting and planning process for a firm, which one of the following should be
completed first?
a)
Sales budget
b)
Financial budget
c)
Cost management plan
d)
Strategic plan
(ICMA 2010)
Question 60: In preparing a corporate master budget, which one of the following is most likely to be
prepared last?
a)
Sales budget
b)
Cash budget
c)
Production budget
d)
Cost of Goods Sold budget
(ICMA 2010)
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263
B.5. Annual Profit Plan and Supporting Schedules
CMA Part 1
Question 61: In an organization that plans by using comprehensive budgeting, the master budget refers
to:
a)
a compilation of all the separate operational and financial budget schedules of the organization.
b)
the booklet containing budget guidelines, policies, and forms to use in the budgeting process.
c)
the current budget updated for operations for part of the current year.
d)
a budget of a not-for-profit organization after it is approved by the appropriate authoritative body.
(ICMA 2010)
Ongoing Budget Reports
After the budgets are determined and approved, they will be used throughout the year to measure how the
actual period-specific and year-to-date results compare to the budgeted results. Variance reports comparing year-to-date actual amounts to year-to-date budgeted amounts and comparing the current period’s
actual amounts to the current period’s budgeted amounts should be reviewed regularly throughout the
year. Variance reporting is a very important part of budgeting.
A budget variance report compares the actual items (revenues, expenses, or units) with the budgeted
amounts for the same time period. If the company is doing better than the budget (meaning that actual
revenues are higher than budgeted or actual expenses are lower than budgeted), the company has a favorable variance. If the opposite is true, the company has an unfavorable variance. Variance analysis
is covered in detail in the Performance Management section of this textbook.
If the variances are significant or unexpected, management must investigate and determine the cause or
causes of each variance. Some variances are expected. For instance, if sales are higher than budgeted,
then it is only logical that there will appear to be an unfavorable variance in direct materials and direct
labor if the company uses a fixed (or static) budget for the variance reporting. However, an unfavorable
variance in manufacturing inputs is a matter for concern only if the flexible budget variances for direct
materials and direct labor are also unfavorable. If the variances are caused only by the higher than expected
sales having resulted in increased cost of sales, the variances are not a cause for concern as long as the
costs are in line with the expected costs for the actual level of output and sales.
Investigating the causes of unexpected variances is one of the most important steps in the budgeting
process. Investigation of variances is part of the control loop, which is the process by which the activities
of the company are controlled.
The major steps in the control loop are:
1)
Establish the budget or standards of performance.
2)
Measure the actual performance.
3)
Analyze and compare actual results with the budgeted results (variance reporting).
4)
Investigate unexpected variances.
5)
Devise and implement any necessary corrective actions.
6)
Review and revise the budget or standards if necessary.
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Section B
Answering Budgeting Exam Questions
Answering Budgeting Exam Questions
One of the most critical things candidates will need to do on the exam is make budgeting calculations.
Though at first these questions are very intimidating, they will become easier with practice. Four main types
of calculation questions could be asked on the exam.
1)
One set of potential calculations addresses the question: “What would the flexible budget have
been?” An exam problem will give a set of circumstances and the question will be related to what
the flexible budget amount would be given an actual volume. For a single-product firm, the flexible
budget amount is the standard rate by the actual quantity produced, sold, or whatever is required
given the situation.
2)
Some exam questions will ask for the number of units a company needs to produce or purchase within a given time period (usually a month) in order to meet the demand for that period
and the opening beginning inventory required for the next month. The answers to such questions
are based on the following formula:
Units needed for use in the current period
+
Units needed for the next month’s beginning inventory (ending inventory)
=
Total units needed this period
−
Units on hand at the start of this period (beginning inventory)
=
Units needed to be produced or purchased this period
The formula above analyzes inventory in two steps.
o
The first step of the formula determines how many
period. Units will be needed either for use/sale in the
ending inventory. Total units needed in the current
inventory (units on hand at the start of the period) or
period.
units will be needed during the current
current period or to have on hand in the
period can come either from beginning
from purchases or production during the
o
The second step of the formula is used to calculate how many units will need to be produced
or purchased during the period in order to have the required number of units available during
the period.
Note: The preceding formula is the formula used when calculating the Production Budget to
determine how many units the company needs to produce.
3)
Another type of question may relate to the amount of cash collected or spent during a period
(usually a month). Though these questions are difficult to read, the actual math is not too difficult.
The key is to make sure to identify how much of the credit sales are collected in the month of the
sale and how much are collected after the month of the sale. The same is true for payables: identify
when the cash is actually paid.
4)
The last type of question requires the use of the basic inventory formula. The formula may be
restated for use in different circumstances, depending on which one of the items in the formula is
the unknown. But one commonsense, basic, inventory formula can be used to find any unknown.
It can be restated as needed or it can be used just as it is without restating it by simply solving
for the unknown.
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265
Answering Budgeting Exam Questions
CMA Part 1
The formula is:
Beginning Inventory + Inventory Added – Inventory Removed = Ending Inventory
When any three of the four amounts are known, the fourth amount can be calculated algebraically
by solving the equation for the unknown.
Note: Sometimes, a problem will not specifically state all of the three known amounts needed
in order to find the fourth amount. However, it will always give the information necessary to
calculate the three known amounts.
•
When applied to Finished Goods Inventory costs, the formula is as follows:
Cost of Beginning Inventory
5)
+
Net Cost of Purchases (for a reseller) or
+
Cost of Goods Manufactured (for a manufacturer)
−
Cost of Goods Sold
=
Cost of Ending Inventory
Net Cost of Purchases means purchases minus returns plus landing costs (shipping-in costs). If
those costs are given in a problem, they should be used to calculate the net cost of purchases if
that amount is not given in the problem.
•
For Finished Goods Inventory in units, the formula is as follows:
Units in Beginning Inventory
+
Net Units Purchased or Manufactured
−
Units Sold
=
Units in Ending Inventory
If units purchased and units returned are given, those should be used if it is necessary to
calculate Net Units Purchased.
•
When applied to Direct Materials Inventory costs, the formula is as follows:
Cost of Beginning Inventory
266
+
Net Cost of Purchases
−
Cost of Materials Used in Production
=
Cost of Ending Inventory
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Section B
•
Answering Budgeting Exam Questions
For Direct Materials Inventory in units, the formula is as follows:
Units in Beginning Inventory
+
Net Units Purchased
−
Units Used in Production
=
Units in Ending Inventory
Flexible Budgeting Questions
Question 62: RedRock East Company uses flexible budgeting for cost control. RedRock produced 10,800
units of product during March, incurring cost of $13,000 for indirect materials. Its master budget for
the year reflected an indirect materials cost of $180,000 at a production volume of 144,000 units. A
flexible budget for March should reflect indirect material costs of:
a)
$13,975
b)
$13,500
c)
$13,000
d)
$11,700
(CMA Adapted)
Question 63: Butteco has the following costs for 100,000 units of product:
Raw materials
Direct labor
Manufacturing overhead
Selling/administrative expense
$200,000
100,000
200,000
150,000
All costs are variable except for $100,000 of manufacturing overhead and $100,000 of selling/administrative expenses. The total costs to produce and sell 110,000 units are:
a)
$650,000
b)
$715,000
c)
$695,000
d)
$540,000
(CMA Adapted)
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267
Answering Budgeting Exam Questions
CMA Part 1
Question 64: Based on past experience, a company has developed the following budget formula for
estimating its shipping expenses. The company’s shipments average 12 lbs. per shipment:
Shipping costs = $16,000 + ($0.50 x lbs. shipped)
The planned activity and actual activity regarding orders and shipments for the current month are given
in the following schedule:
Sales orders
Shipments
Units shipped
Sales
Total pounds shipped
Plan
800
800
8,000
$120,000
9,600
Actual
780
820
9,000
$144,000
12,300
The actual shipping costs for the month amounted to $21,000. The appropriate monthly flexible budget
allowance for shipping costs for the purpose of performance evaluation would be:
a)
$20,680
b)
$20,800
c)
$22,150
d)
$20,920
(CMA Adapted)
Question 65: Barnes Corporation expected to sell 150,000 board games during the month of November,
and the company’s master budget contained the following data related to the sale and production of
these games:
Revenue
Cost of goods sold
Direct materials
Direct labor
Variable factory overhead
Contribution
Fixed overhead
Fixed selling/administration
Operating income
$2,400,000
675,000
300,000
450,000
$ 975,000
250,000
500,000
$ 225,000
Actual sales during November were 180,000 games. Using a flexible budget, the company expects the
operating income for the month of November to be:
a)
$225,000
b)
$420,000
c)
$510,000
d)
$270,000
(CMA Adapted)
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Section B
Answering Budgeting Exam Questions
Units to Produce / Purchase Questions
Question 66: The Jung Corporation’s budget calls for the following production, in number of units:
Qtr. 1 – 45,000 units
Qtr. 2 – 38,000 units
Qtr. 3 – 34,000 units
Qtr. 4 – 48,000 units
Each unit of product requires 3 pounds of direct material. The company's policy is to begin each quarter
with an inventory of direct materials equal to 30% of that quarter's direct material requirements. Budgeted direct materials purchases for the third quarter are:
a)
38,200 pounds.
b)
89,400 pounds.
c)
114,600 pounds.
d)
29,800 pounds.
(CMA Adapted)
The following information is for the next two questions: Berol Company, which plans to sell
200,000 units of finished product in July, anticipates a growth rate in sales of 5% per month. The
desired monthly ending inventory in units of finished product is 80% of the next month's estimated
sales. Berol Company has 150,000 finished units in inventory on June 30.
Each unit of finished product requires 4 pounds of direct materials at a cost of $1.20 per pound. There
are 800,000 pounds of direct materials in inventory on June 30.
Question 67: Berol Company’s production requirement in units of finished product for the 3-month
period ending September 30 is:
a)
712,025 units.
b)
638,000 units.
c)
665,720 units.
d)
630,500 units.
Question 68: Assume Berol Company plans to produce 600,000 units of finished product in the 3-month
period ending September 30, and to have direct materials inventory on hand at the end of the 3-month
period equal to 25% of the use in that period. The estimated cost of direct materials purchases for the
3-month period ending September 30 is:
a)
$2,200,000
b)
$2,880,000
c)
$2,640,000
d)
$2,400,000
(CMA Adapted)
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269
Answering Budgeting Exam Questions
CMA Part 1
The following information is for the next two questions: Daffy Tunes manufactures a toy rabbit
with moving parts and a built-in voice box. Projected sales in units for the next 5 months are as follows:
Month
January
February
March
April
May
Projected
Sales in Units
30,000
36,000
33,000
40,000
29,000
Each rabbit requires basic materials that Daffy purchases from a single supplier at $3.50 per rabbit.
Voice boxes are purchased from another supplier at $1.00 each. Assembly labor cost is $2.00 per rabbit,
and variable overhead cost is $0.50 per rabbit. Fixed manufacturing overhead applicable to rabbit production is $12,000 per month. Daffy's policy is to manufacture 1.5 times the coming month’s projected
sales every other month, starting with January (in other words, odd-numbered months) for February
sales, and to manufacture 0.5 times the coming month’s projected sales in alternate months (in other
words, even-numbered months). This allows Daffy to allocate limited manufacturing resources to other
products as needed during the even-numbered months.
Question 69: The unit production budget for toy rabbits for January is:
a)
45,000 units.
b)
54,000 units.
c)
16,500 units.
d)
14,500 units.
Question 70: The dollar production budget for toy rabbits for February is:
a)
$327,000
b)
$127,500
c)
$113,500
d)
$390,000
(CMA Adapted)
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Section B
Answering Budgeting Exam Questions
The following information is for the next three questions: Rokat Corporation is a manufacturer
of tables sold to schools, restaurants, hotels and other institutions. Rokat manufactures the table tops,
but an outside supplier sells the table legs to Rokat. The Assembly Department takes a manufactured
table top and attaches the 4 purchased table legs. It takes 20 minutes of labor to assemble a table. The
company follows a policy of producing enough tables to ensure that 40% of next month's sales are in
the finished goods inventory. Rokat also purchases sufficient raw materials to ensure that raw materials
inventory is 60% of the following month’s scheduled production. Rokat’s sales budget in units for the
next quarter is as follows:
July
August
September
2,300
2,500
2,100
Rokat’s ending inventories in units for June 30 are:
Finished goods
Raw materials (legs)
1,900
4,000
Question 71: The number of tables to be produced during August is:
a)
1,900 tables.
b)
1,440 tables.
c)
2,340 tables.
d)
1,400 tables.
Question 72: Assume the required production for August and September is 1,600 and 1,800 units respectively, and the number of table legs in the July 31 raw materials inventory is 4,200 units. The
number of table legs to be purchased in August is:
a)
2,200 legs
b)
6,520 legs.
c)
6,400 legs.
d)
9,400 legs.
Question 73: Assume that Rokat Corporation will produce 1,800 units in the month of September. How
many employees will be required for the Assembly Department? (Fractional employees are acceptable
since employees can be hired on a part-time basis. Assume a 40-hour week and a 4-week month.)
a)
3.75 employees.
b)
60 employees.
c)
15 employees.
d)
600 employees.
(CMA Adapted)
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271
Answering Budgeting Exam Questions
CMA Part 1
The following information is for the next two questions: Wellfleet Company manufactures recreational equipment and prepares annual operational budgets for each department. The Purchasing
Department is finalizing plans for the fiscal year ending June 30, 20X9, and has gathered the following
information regarding 2 of the components used in both tricycles and bicycles. Wellfleet uses the firstin, first-out inventory method.
Beginning inventory, July 1, 20X8
Ending inventory, June 30, 20X9
Unit cost
Projected fiscal year unit sales
Component usage:
Tricycles
Bicycles
A19
3,500
2,000
$1.20
--
B12
1,200
1,800
$4.50
--
Tricycles
800
1,000
$54.50
96,000
Bicycles
2,150
900
$89.60
130,000
2/unit
2/unit
1/unit
4/unit
---
---
Question 74: The budgeted dollar value of Wellfleet Company’s purchases of component A19 for the
fiscal year ending June 30, 20X9 is:
a)
$309,000
b)
$540,600
c)
$2,017,800
d)
$538,080
Question 75: If the economic order quantity of component B12 is 70,000 units, the number of times
that Wellfleet Company should purchase this component during the fiscal year ended June 30, 20X9 is:
a)
Eight times.
b)
Nine times.
c)
Four times.
d)
Five times.
(CMA Adapted)
272
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Section B
Answering Budgeting Exam Questions
Cash Budget Questions
Question 76: DeBerg Co. has developed the following sales projections for the year:
May
June
July
$100,000
$120,000
$140,000
August
September
October
$160,000
$150,000
$130,000
Normal cash collection experience has been that 50% of sales are collected during the month of sale
and 45% are collected the following month. The remaining 5% of sales is never collected. DeBerg’s
budgeted cash collections for the third calendar quarter are:
a)
$450,000
b)
$440,000
c)
$414,000
d)
$360,000
(CMA Adapted)
The following information is for the next two questions: Information about Noskey Corporation’s
sales revenue is presented in the following table.
Cash sales
Credit sales
Total sales
November
(Actual)
$ 80,000
240,000
$320,000
December
(Budget)
$100,000
360,000
$460,000
January
(Budget)
$ 60,000
180,000
$240,000
Management estimates that 5% of credit sales will become credit losses. Of the credit sales that are
collectible, 60% are collected in the month of sale and the remainder in the month following the sale.
Purchases of inventory are equal to next month’s sales and gross profit margin is 30%. All purchases
of inventory are on account; 25% are paid during the month of purchase, and the remaining 75% are
paid during the month following the purchase.
Question 77: Noskey Corporation’s budgeted cash collections in December from November credit sales
are:
a)
$136,800
b)
$91,200
c)
$144,000
d)
$96,000
Question 78: Noskey Corporation’s budgeted total cash receipts in January are:
a)
$294,000
b)
$239,400
c)
$299,400
d)
$240,000
(CMA Adapted)
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273
Answering Budgeting Exam Questions
CMA Part 1
The following information is for the next two questions: The Raymar Company is preparing its
cash budget for the months of April and May. The firm has established a $200,000 line of credit with its
bank at a 12% annual rate of interest on which borrowings for cash deficits must be made in $10,000
increments. Interest is to be paid monthly. Principal repayments of the draws (loans) against the line
of credit are to be made in any month in which Raymar has a surplus of cash. Whenever the line of
credit has no outstanding balances, Raymar will invest any cash in excess of its desired end-of-month
cash balance in U.S. Treasury bills. The line of credit has no outstanding loan balance on April 1. Raymar
intends to maintain a minimum balance of $100,000 in cash at the end of each month by either borrowing for deficits below the minimum balance or investing any excess cash. Monthly collection and
disbursement patterns are expected to be:
•
Collections: 50% of the current month’s sales budget and 50% of the previous month’s sales budget.
•
Accounts Payable Disbursements: 75% of the current month’s accounts payable budget and 25%
of the previous month’s accounts payable budget.
•
All other disbursements occur in the month in which they are budgeted.
Sales
Accounts payable
Payroll
Other disbursements
March
$40,000
30,000
60,000
25,000
Budget Information
April
May
$50,000
$100,000
40,000
40,000
70,000
50,000
30,000
10,000
Question 79: In April, Raymar’s budget will result in:
a)
$45,000 in excess cash.
b)
A need to borrow $50,000 on its line of credit for the cash deficit.
c)
A need to borrow $100,000 on its line of credit for the cash deficit.
d)
A need to borrow $92,500 on its line of credit for the cash deficit.
Question 80: In May, Raymar will be required to:
a)
Borrow an additional $30,000 principal and pay $1,000 interest.
b)
Repay $90,000 principal and pay $100 interest.
c)
Pay $900 interest.
d)
Borrow an additional $20,000 and pay $1,000 interest.
(CMA Adapted)
274
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Section B
B.6. Top-Level Planning and Analysis
B.6. Top-Level Planning and Analysis
Pro Forma Financial Statements
In business, the term “pro forma” is used to describe some kind of information, usually financial statements,
where the financial statements are on an “as if” basis; that is, as if something in particular had happened.
Pro forma financial statements, prepared for internal use in the planning process, are financial statements
containing projected amounts that are expected if a particular course of action is followed. Pro forma financial statements are used in order to see what the financial statements of the firm will look like if something
under consideration or forecasted actually happens. Pro forma financial statements are often used to evaluate the effects on the company’s finances if a particular sales forecast is realized, although they can be
used for other “what if” scenarios as well.
By analyzing pro forma statements, managers can project what the company’s cash position will be,
whether it will need to borrow, whether it will be able to make its scheduled loan payments, whether it will
remain in compliance with debt covenants, and so forth.
Pro forma financial statements are not the same thing as the master budget financial statements, although
one or several versions of pro forma financial statements may be prepared as a part of the formal planning
process that will eventually result in the master budget. Pro forma statements may be prepared after the
formal budget for the year has been adopted, if the company is considering an activity that was not foreseen
before the formal budget was adopted. Pro forma financial statements are not prepared individually for
each department and then consolidated into budgeted statements for the whole company the way budgeted
financial statements are. They may be prepared for the company as a whole or for only one department or
division.
Pro forma financial statements include a pro forma income statement, a pro forma statement of financial
position (balance sheet), and a pro forma statement of cash flows. In other words, they are a complete set
of financial statements using projected amounts that tie together the same way the amounts in the actual
financial statements do.
Note: The term “pro forma” is sometimes used to refer to the master budget financial statements as
well, but use in that context is an inappropriate use of the term. This textbook uses the term “pro forma”
properly; however, be aware that “pro forma” might be used improperly elsewhere, possibly even on
the exam.
Pro forma financial statements are used internally for five general purposes:
1)
A pro forma financial statement is used to compare the company’s anticipated performance with
its target performance and with investor expectations.
2)
Pro forma statements are used for “what if” analysis in order to forecast the effect of a proposed
change. For example, if the company is contemplating a price increase that it anticipates will reduce the level of demand for its product, it will prepare a pro forma financial statement to
determine the result on the financial statements if the price increase is put into effect.
3)
They are used to determine in advance what the company’s future financing needs will be.
4)
Various cash flow projections and sets of pro forma statements may be prepared using different
assumptions for different operating plans. They are used to forecast the capital requirements of
the plans in order to select the plan that maximizes shareholder value.
5)
Pro forma financial statements are used to determine whether the company will be able to remain
in compliance with the required covenants on its long-term debt.
Pro forma financial statements may also be prepared by someone outside the company. For example, an
investor or security analyst might prepare pro forma financial statements in order to forecast a company’s
future earnings, cash flows, and stock price. However, in this text “pro forma” refers to top-level planning
that takes place within organizations.
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275
B.6. Top-Level Planning and Analysis
CMA Part 1
Sales Forecasting
In Forecasting Techniques in this volume, historical sales information for ten years was used to develop a
trend line for use in forecasting sales for Year 11. Although history is useful, future sales will be affected
by events occurring in the future, not events that happened in the past. Therefore, future sales will depend
upon the state of the domestic and global economies, the growth prospects for the market (or markets) in
which the company operates, the company’s future share of those markets, the company’s product line,
new products that the company may be planning to introduce, and the company’s marketing efforts. The
historical sales growth rate needs to be adjusted for any known factors that will affect future sales.
An accurate sales forecast is critical. For example, if the market the company operates in expands more
than the company expects it to, the company will be unprepared to meet the added demand and it will lose
customers to its competitors. But if the company’s forecasted sales are too high, then the company could
end up with excess capacity and excess inventory, which in turn hurts cash flow. If the company has
borrowed to expand in the expectation of higher sales and those higher sales do not materialize, then the
company will be stuck with high interest charges on its debt in addition to unsold inventory and unused
capacity. Therefore, management needs to use its best judgment about the future along with historical
information and not simply rely on a forecast made using regression analysis or any of the other forecasting
techniques.
Forecasting Future Financing Needs
When a company’s sales increase, the company will need additional funds. More inventory will be needed
to support the increased sales. Accounts receivable will increase in proportion to the increase in sales. The
company may need to purchase new equipment. The expected increases in assets can be funded in three
ways.
1)
When inventory increases, accounts payable will increase because more inventory is being purchased or manufactured. Accrued liabilities (such as accrued salaries and wages and accrued taxes)
will also increase because of the increased activity. These increases in liabilities, called spontaneous liability increases, will fund a portion of the increase in assets. These increases in liabilities
are called spontaneous liability increases because they occur naturally.
Note: Borrowed funds, such as bank loans or bonds issued, are not liabilities that increase
spontaneously. “Spontaneous” means produced without planning or without effort. The company needs to do something intentional to cause its borrowings to increase. For example, it
might request a bank loan or issue bonds. Therefore, borrowed funds do not increase spontaneously.
2)
Profits from additional sales will provide some of the funding. Any profits not paid out in dividends
increase retained earnings. The additional retained earnings increase equity and provide a source
of funds to finance future growth.
3)
The remainder of the funding beyond what can be supplied by items 1 and 2 will need to be
provided through external financing such as bank loans (short-term, long-term, or both) or issuance of new securities (stock or bonds).
The amount of external financing that will be required depends upon several factors:
276
•
The company’s rate of sales growth. Rapid sales growth generates increases in assets, and
increases in assets generate the need for external financing. The higher the growth rate in sales,
the greater will be the need for additional financing.
•
The company’s capital intensity ratio, or the amount of assets required per monetary
unit of sales. The capital intensity ratio is assets that increase when sales increase divided
by sales revenue, and it affects capital requirements. The higher the company’s capital intensity
ratio, the more assets it will require for a given increase in sales and thus it will have a greater
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Section B
B.6. Top-Level Planning and Analysis
need for external financing than a company with a lower capital intensity ratio. The capital intensity
ratio is not total assets divided by sales revenue, because it may be that not all assets increase
with increases in sales. Assets that increase with increases in sales are specific to each business.
For forecasting purposes, assets that do not increase with sales increases would be carried over
to the forecast year with no increase, whereas the capital intensity ratio would be used along with
forecasted sales to forecast the level of assets that do increase with sales.
•
The company’s spontaneous liabilities-to-sales ratio. A company that can finance more of its
working capital needs by using accounts payable and accrued liabilities will have less need for
external financing than will a company that does not have many spontaneous liabilities available
to use for financing. Therefore, a higher ratio means less external financing will be needed, while
a company with a lower ratio will have a greater need for external financing.
•
The company’s net profit margin. The higher a company’s net profit margin is, the more increased net income will be available to fund increases in assets and the less need the company
will have for external financing. The lower the net profit margin, the greater need the company
will have for external financing.
•
The company’s retention ratio. The retention ratio is the amount of net income not paid out in
dividends and retained in the company. A company that pays out less of its net income in dividends
will have more retained earnings and less need for external financing than a company that pays
out more of its net income in dividends. Therefore, companies with lower retention ratios will have
a greater need for external financing.
Medium-term forecasting covers periods of up to one year in the future, while long-term forecasting covers
multiple years. The Forecasted Financial Statement method is a method of forecasting the additional
funds needed that is well suited to medium- and long-term use. It is not the only forecasting method, but
it is the most flexible method and the one covered on the CMA exam.
Short-term cash forecasting covers periods of about 30 days into the future and is based on actual data
(such as expected receipts from actual accounts receivable outstanding, expected payments of actual accounts payable, and so forth) rather than on projected data. Short-term cash forecasting is not the type of
cash forecasting discussed here.
The Forecasted Financial Statement (FFS) Method
The Forecasted Financial Statement approach to forecasting future financing needs involves preparation of
a complete set of pro forma financial statements, including income statement, balance sheet, and statement
of cash flows. It begins with a forecast of sales, then forecasts are made of the assets (such as accounts
receivable, inventory, and fixed assets) that will be needed to support those sales, the spontaneous liabilities (such as accounts payable and accruals) that will arise, and the increase in retained earnings from
profits. Then all of the sources of financing are forecasted, including existing debt and equity. The forecasted
increase in retained earnings is developed from the projected income statement net of dividend payments.
The difference between total assets and total liabilities plus equity is the “additional funds needed,” which
is a “plugged” figure on the balance sheet.
The FFS method produces a forecast of the entire balance sheet and income statement. The pro forma
balance sheet and income statement can then be used to create the pro forma statement of cash flows.
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277
B.6. Top-Level Planning and Analysis
CMA Part 1
Steps in Forecasting Using the Forecasted Financial Statement Method (4 Steps)
Step 1: Analyze historical ratios that will be used for the projections. The ratios to be used will relate
the various items to sales by dividing each one by sales. Look at the actual ratios for at least the past 5
years, the historical average over the same period, and the industry average (developed from financial
statements for all firms in the industry) for the following ratios:
•
Costs divided by sales (COGS divided by sales, SG&A divided by sales)
•
Depreciation divided by net property, plant, and equipment
•
Cash divided by sales
•
Accounts receivable divided by sales
•
Inventory divided by sales
•
Net property, plant, and equipment divided by sales
•
Accounts payable divided by sales
•
Accruals divided by sales
Look for trends in the ratios and look at how the current ratios compare with their historical averages and
determine the cause of differences. Any change from the historical trend that has occurred recently might
be caused by temporary factors, and in the future the ratio might move back toward its average. Compare
the ratios with the industry averages. Consider the effects of the economy on sales and look at what is
happening in the industry within which the company operates to determine whether external factors might
affect the ratios in the future. Consider any known operating plans of the company, such as a planned
expansion. For example, if the company has been preparing for an expansion, its projected costs might
need to be increased temporarily due to increased anticipated advertising costs.
Example: Below are historical ratios for ABC Industries. Only two years of history are used, although in
practice five years should be used. All of these ratios relate the item to be forecasted to sales by dividing
the historical level of the item by historical sales. These ratios are used specifically for forecasting balance
sheet and income statement items based on forecasted sales, and therefore they are different from
ratios that are used for financial statement analysis.
COGS to sales
SG&A costs (excluding depreciation) to sales
Depreciation to net property, plant, & equip
Cash to sales
Accounts receivable to sales
Inventory to sales
Net property, plant, & equipment to sales
Accounts payable to sales
Accruals to sales
Actual
20X0
Actual
20X1
74.3%
17.3%
9.7%
0.6%
10.9%
10.5%
31.6%
1.5%
5.3%
75.5%
17.9%
9.1%
0.4%
11.2%
12.5%
32.3%
2.4%
5.9%
Historical
Average
74.9%
17.6%
9.4%
0.5%
11.1%
11.5%
32.0%
2.0%
5.6%
Industry
Average
72.5%
17.0%
9.4%
0.9%
10.8%
12.0%
33.5%
1.5%
4.5%
Step 2: Forecast the income statement. The income statement and the balance sheet need to be integrated, of course. The income statement is forecast first. Since net income net of dividends flows to retained
earnings on the balance sheet, forecasting the balance sheet will follow the income statement forecast.
These steps will be demonstrated in the example that follows for ABC Industries. The steps should be
performed in the following order.
1)
278
Forecast sales. ABC Industries’ sales during the previous year were $150,000 (000 omitted). The
company forecasts a 10% increase in sales during the current year. Therefore, forecasted sales
will be the previous year’s sales multiplied by 1.10. In the ABC Industries example, sales are
forecasted to be $150,000 × 1.10, or $165,000.
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Section B
2)
B.6. Top-Level Planning and Analysis
Forecast Earnings Before Interest and Taxes (EBIT). Forecast COGS and SG&A expense by
applying to the forecasted sales amount ($165,000) the most recent actual ratios of COGS and
SG&A expense to sales. ABC Industries’ most recent actual ratios are its ratios for 20X1 (above).
ABC’s actual, historical income statement amounts for 20X1 follow. The COGS and SG&A lines
below include notes about which 20X1 historical ratios will be used to calculate that item’s 20X2
forecast. The calculation of the 20X2 forecasted depreciation expense for SG&A is more complicated, and that is explained in a note below the 20X2 forecast example that follows.
Net sales (all on credit)
COGS (including depreciation)
Gross profit
SG&A exp. excluding depreciation
Depreciation exp.-SG&A only
EBIT
3)
20X1
Historical
$150,000
113,210
$ 36,790
26,880
409
$ 9,501
20X2 Forecast Based On
As explained in 1) above
20X1 COGS to Sales Ratio (75.5%)
20X1 SG&A Costs to Sales (17.9%)
See Note 1 in forecast example following
Forecast net interest expense or net interest income. Interest income and interest expense
are combined into a net interest figure that is either added to or deducted from forecasted EBIT to
calculate forecasted EBT. If interest expense is higher than interest income, the company will have
net interest expense and the net interest expense will be deducted from EBIT in calculating EBT.
Net interest expense is the sum of the company’s interest charges on all of its loans (short-term
and long-term) minus its interest income from short-term and long-term investments. If interest
income is higher than interest expense, the company will have net interest income and the net
interest income will be added to EBIT to calculate EBT. Net interest income is interest income
minus interest expense. (For most companies, interest will be a net expense, not a net income.)
The amount of interest expense used in this calculation depends on the outstanding loan balances
and the interest rate on those loan balances. However, these loan balances will not be the same
all year long. The outstanding loan balances could change daily. What outstanding loan balance to
use in calculating the interest expense on debt creates a problem. Several approaches can be used
to determine the outstanding loan balances, as follows.
a.
Use the loan balances expected at the end of the forecasted year. However, this approach
would create a full year’s interest charge on any new debt added during the year. A full year’s
interest charge would mean the new debt was expected to be in place at the very beginning
of the year, which is unlikely and could overstate interest expense.
Another problem with this approach is called financing feedback. Increasing the amount of
financing needed on the pro forma balance sheet causes interest expense on the pro forma
income statement to increase. Increasing interest expense in turn decreases pro forma net
income, which requires another increase in the amount of financing required, which causes
even higher interest expense, and so on in a never-ending cycle. Financing feedback can be
dealt with in a spreadsheet, but doing so increases the complexity of the projections beyond
what the benefits may justify.
b.
Use the average of the forecasted debt at the beginning and the end of the year. If the debt
were added evenly throughout the year, averaging the beginning and ending balances would
produce the correct interest expense. However, usually debt is not added evenly throughout
the year but rather the level of outstanding debt, particularly short-term debt, fluctuates up
and down. Furthermore, because the year-end debt level is used to calculate the average debt,
the problem of financing feedback exists with this approach as well.
c.
A third method, which is used in the example that follows, works well in most situations and
avoids the problem of financing feedback. The interest expense is based on the level of debt
at the beginning of the year to be forecasted. The problem with this third approach, of course,
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279
B.6. Top-Level Planning and Analysis
CMA Part 1
is that if the debt level increases during the year the interest expense will be underestimated.
The problem of underestimated interest expense can be dealt with by calculating interest expense using a forecasted interest rate that is approximately 0.5% higher than the interest rate
actually expected.
Exam Tip: If using the third approach on an essay exam question, make sure to note in the
answer that to avoid the problem of financing feedback, forecasted interest expense is based
on the outstanding loan balances as of the beginning of the year and the anticipated interest
rate plus 0.5%.
Different loans have different interest rates. For the following example forecast, just two rates will
be used: one rate for short-term borrowings and one rate for long-term borrowings. The rate to
use for short-term borrowings should be the present rate (or expected rate, if different from the
present rate) increased by 0.5%. For fixed rate long-term debt, use an average of the rates on the
current outstanding fixed rate long-term borrowings and the rate that is expected on any new
fixed rate long-term debt plus 0.5%. For current or new variable rate borrowings, use the expected variable rate plus 0.5%. The forecasted interest expense will be the net forecasted interest
expense on short-term financing plus the forecasted interest expense on long-term bonds.
For ABC Industries, the short-term loan balance at the end of 20X1/beginning of 20X2 is $10,000,
and the expected average interest rate on short-term borrowings is 5%. The fixed rate long-term
loan balance at the end of 20X1/beginning of 20X2 is $15,410, and the expected average interest
rate on fixed rate long-term borrowings is 7%. Interest rates in the 20X2 forecast have been
increased by 0.5% to reflect increased borrowing levels expected throughout the year.
Therefore, the forecasted interest expense is 5.5% on short-term borrowings of $10,000 plus 7.5%
on long-term borrowings of $15,410. ($10,000 × 0.055) + ($15,410 × 0.075) = $1,706 forecasted
interest expense for 20X2.
ABC Industries does not expect to have a material amount of interest income during 20X2, so none
is forecasted.
4)
Complete the income statement. Net interest expense (interest expense minus interest income)
is subtracted from EBIT to calculate EBT. If interest income is greater than interest expense, net
interest income (interest income minus interest expense) is added to EBIT to calculate EBT. Income
tax is then subtracted at a given rate to calculate net income
ABC Industries’ income tax rate is 40%.
280
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Section B
B.6. Top-Level Planning and Analysis
Example: Below are ABC Industries’ 20X1 actual and 20X2 forecasted income statements (000 omitted)
The 20X2 forecasts make use of the historical ratios for ABC calculated a few pages previously.
Actual 20X1
Net Sales (all on credit)
COGS (including depreciation)
Gross profit
SG&A exp. excluding deprec.
Depreciation exp.-SG&A only
EBIT
Less: Net interest
Earnings before taxes (EBT)
Taxes at 40%
Net income
$150,000
113,210 1
$ 36,790
26,880
409 1
$ 9,501
1,579
$ 7,922
3,169
$ 4,753
Forecast Based On
20X1 net sales × 1.10
20X2 forecasted net sales × 0.755
20X2 forecasted net sales × 0.179
See Footnote 1
See Footnote 2
Forecast 20X2
$165,000
124,575 1
$ 40,425
29,535
446 1
$ 10,444
1,706 2
$ 8,738
3,495
$ 5,243
1
Net property, plant, and equipment equaled 32.3% of net sales in 20X1, and total depreciation equaled 9.1% of net
plant and equipment in 20X1, or $4,409 in total. A portion of the depreciation on manufacturing facilities is included
in cost of goods sold expense and another portion is capitalized in inventory. Under absorption costing, fixed manufacturing costs (including depreciation on manufacturing facilities) are inventoried as part of the cost of each product
and become a part of COGS when the units they are attached to are sold. Thus, 20X1 COGS includes $3,160 in
depreciation expense and $840 in depreciation is capitalized in unsold inventory. SG&A depreciation is the only portion
of the total depreciation that is segregated on the income statement ($409). These three items sum to total 20X1
depreciation of $4,409. The preceding information in this footnote about total 20X1 depreciation and its
breakdown comes from the Notes to the Financial Statements for 20X1 and is not something that can be
calculated from other information given in this example. The forecast for net property, plant, and equipment
for 20X2 is forecasted 20X2 net sales of $165,000 × 0.323, or $53,295; the forecast for total depreciation for 20X2
is $53,295 × 0.091, or $4,850. The 20X2 forecasted depreciation is prorated among COGS, inventory, and SG&A
based on the allocation of the 20X1 actual depreciation. In 20X1, depreciation expensed in COGS represented 71.7%
of the $4,409 in total depreciation, depreciation capitalized in inventory represented 19.1%, and depreciation expensed in SG&A represented 9.2% of total depreciation. Therefore, $3,478 (71.7%) of the forecasted 20X2
depreciation is included in COGS expense, $926 or 19.1% is capitalized in inventory, and $446 or 9.2% is expensed
in SG&A.
2
The short-term loan balance at the end of 20X1/beginning of 20X2 is $10,000 and the expected average interest
rate on short-term borrowings is 5%. The long-term loan balance at the end of 20X1/beginning of 20X2 is $15,410
and the expected average interest rate on long-term borrowings is 7%. Interest rates have been increased by 0.5%
to reflect increased borrowing levels expected throughout the year. Therefore, the forecasted interest is 5.5% on
short-term borrowings of $10,000 plus 7.5% on long-term borrowings of $15,410. ($10,000 × 0.055) + ($15,410 ×
0.075) = $1,706. No interest income is planned.
Step 3: Forecast the Balance Sheet. The 20X1 balance sheet for ABC Industries appears in the example
that follows. Here are the steps to follow in forecasting the 20X2 balance sheet:
1)
Forecast operating assets. The 20X1 actual ratios for current assets are used as the basis for
the forecast. The 20X1 ratio of cash to net sales was 0.4%, accounts receivable to net sales was
11.2%, and inventory to net sales was 12.5%. However, the amount of net property, plant, and
equipment may or may not be proportional to net sales. A manufacturer’s fixed assets will stay at
a given level as long as production and net sales remain within the relevant range, and then they
will increase all at once. On the other hand, a retail store chain grows by opening new stores, and
that business’s fixed assets will increase more than the manufacturer’s will in proportion to net
sales.
In the long term, all costs are variable costs. Thus, in the long run, there will be a strong relationship between net sales and fixed assets for all companies. For short-term forecasting, companies
usually use planned investment in plant and equipment. Since information on planned investment
may not be available for a medium or long-term forecast, it is reasonable to assume a constant
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ratio of net plant and equipment to sales. For ABC, the 20X1 ratio of net plant and equipment to
net sales of 32.3% is used.
2)
Forecast operating current liabilities. Increased net sales will require increased purchases of
raw materials, which will lead to higher accounts payable. The most recent ratio of accounts payable to net sales (2.4%) is used to forecast the level of accounts payable. In addition, higher net
sales will create a need for more direct manufacturing labor, so accrued wages will increase. Higher
sales will result in higher taxable income for the company, so accrued taxes will also increase. The
ratio of accruals to sales for the most recent year (5.9%) will be used to forecast the 20X2 level
of accrued liabilities.
3)
Forecast items determined by policy decisions. The remaining liability and equity items depend on the company’s financial policies. The following policies are assumed:
•
No additional common or preferred stock will be issued. The current preferred dividend of $200
will continue. Common dividends in 20X1 were $2,400 and common dividends will be increased
at a rate of 4% per year.
•
No new bonds will be issued.
•
Short-term notes payable will be used for new financing requirements, since the company has
a line of credit it can use. Assuming that long-term debt and equity will be the same during the
coming year as they were at the end of the previous year, the same balance for short-term
notes payable as was outstanding last year ($10,000) is used temporarily. Since short-term
notes payable will be used for new financing requirements, though, short-term notes payable
will be adjusted after everything else is complete, so it is subject to change.
The forecasted balance sheet follows.
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Section B
B.6. Top-Level Planning and Analysis
Example: Here are ABC Industries’ actual 20X1 balance sheet and forecasted 20X2 balance sheet (000
omitted). The Notes Payable line has been adjusted to make the balance sheet balance.
Actual 20X1
Assets
Cash & Cash Equivalents
$
600
Short-term investments
0
Accounts receivable
16,800
Inventories (incl. $840 of depr.)
18,800 1
Total current assets
$ 36,200
Net property, plant, and equip
48,450 2
Total assets
$ 84,650
Liabilities and Equity
Accounts payable
Accrued liabilities
Notes payable
Total current liabilities
Long-term debt
Total liabilities
$
Forecast Based On
20X2 forecasted net sales × 0.004
If extra funds, use as plug
20X2 forecasted net sales × 0.112
20X2 forecasted net sales × 0.125
20X2 forecasted net sales × 0.323
Forecast 20X2
$
660
0
18,480
20,625
$ 39,765
53,295
$ 93,060
3,600
8,850
10,000
$ 22,450
15,410
$ 37,860
20X2 forecasted net sales × 0.024
20X2 forecasted net sales × 0.059
20X1 bal. of $10,000 + adjustment
Preferred stock
$
20X1 bal. of $4,000 (no change)
Common stock
Additional paid-in capital
Retained earnings
Total common equity
Total equity
Total liabilities and equity
$
1,920,000 shs., par value $1, no change $ 1,920
No change
13,000
20X1 RE + $2,547 addition to RE
30,417 4
$ 45,337
$ 49,337
$ 93,060
Required assets
Specified sources of financing
Additional funds needed
Required additional notes payable
Additional short-term investments
$ 93,060 5
88,442 6
$ 4,618
$ 4,618
0
4,000
1,920
13,000
27,870
$ 42,790
$ 46,790
$ 84,650
20X1 bal. of $15,410 (no change)
$
3,960
9,735
14,618 3
$ 28,313
15,410
$ 43,723
$
4,000
If the specified sources of financing had been greater than the required assets instead of less than the
required assets, then ABC would not need any additional financing and would have excess funds available
to invest.
1
A portion of the depreciation on manufacturing facilities is capitalized in inventory and another portion is included
in cost of goods sold expense. Under absorption costing, fixed manufacturing costs (including depreciation on manufacturing facilities) are inventoried as part of the cost of each product and become a part of COGS when the units
they are attached to are sold.
2
“Net” property, plant, and equipment means net of accumulated depreciation.
3
Notes payable has been adjusted to increase its 20X1 ending balance of $10,000 by the $4,618 of additional funds
needed to $14,618.
4
The $2,547 addition to retained earnings in the forecast comes from the forecasted income statement. It is $5,243
net income minus $200 preferred dividends minus $2,496 common dividends ($2,400 × 1.04).
5
Required assets are all of the forecasted operating assets ($93,060) plus short-term investment balance (0) for the
previous year.
6
Specified sources of financing include the forecasted operating current liabilities (accounts payable and accruals
only, $13,695), forecasted long-term debt ($15,410), forecasted preferred stock ($4,000), forecasted common equity
($45,337), and notes payable for the previous year ($10,000 before adjustment).
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The additional funds needed by ABC Industries during 20X2 is forecast to be $4,618, and this $4,618 has
been added to the notes payable balance of $10,000 that was outstanding at the end of 20X1 to calculate
the forecasted balance of notes payable outstanding at the end of 20X2.
Identifying the amount of additional funds that will be needed is one of the most important uses
of pro forma financial statements. If financial managers know how much financing they expect to need,
they can arrange to obtain the financing before the need becomes critical. In the example above, the need
is not great and the company can obtain the funds by borrowing them on a short-term basis. If the amount
needed is large, though, the company may decide to issue new stock or a new bond.
Step 4: Construct a pro forma statement of cash flows. Once the pro forma income statement and
pro forma balance sheet are complete, a pro forma statement of cash flows can be constructed in the same
manner as a statement of cash flows is constructed for actual results, by using the pro forma income
statement and pro forma balance sheet. Following is a pro forma statement of cash flows using the indirect
method of presenting cash flows from operating activities. The 20X1 actual and 20X2 pro forma balance
sheets and the 20X2 pro forma income statement for ABC Industries have been used.
Be sure to understand where all of the amounts on the following statement of cash flows come
from. Preparation of an indirect statement of cash flows is covered in this book in Section A, Financial
Statements.
Note: The following Statements of Cash Flows should not be used to learn how to develop a cash flow
statement. They are not adequate for that purpose because they do not have enough explanation. For
more information, please see the explanation of how to prepare a Statement of Cash Flows in this book
in Section A, Financial Statements.
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Section B
B.6. Top-Level Planning and Analysis
Below is the pro forma indirect Statement of Cash Flows for 20X2 for ABC Industries:
Cash Flows from Operating Activities:
Net income
$ 5,243
Add/(deduct) items not affecting cash:
Increase in accounts receivable
(1,680)
Increase in inventories
( 899)
(Ending inventory excluding depr. $19,699 minus
beginning inventory including depr. $18,800)1
Depreciation expense
3,924 2
Increase in accounts payable
360
Increase in accrued liabilities
885
Net cash flows from operating activities
$7,833
Cash Flows from Investing Activities:
Purchase of equipment
( 9,695)
3
Net cash used in investing activities
( 9,695)
Cash Flows from Financing Activities:
Dividends paid
(Common dividends $2,496 plus
Preferred dividends $200)
Increase in notes payable
(
2,696)
4,618
Net cash flows provided by financing activities
Net increase in cash and cash equivalents
Cash and cash equivalents at beginning of year
Cash and cash equivalents at end of year
1,922
$
$
60
600
660
1
Candidates frequently ask why beginning inventory includes depreciation but ending inventory excludes it. The
Statement of Cash Flows measures changes in cash that have taken place from the end of one year to the end of
the following year. Any transactions that affected inventory or any other accounts during any year previous to the
year under consideration are not relevant. Depreciation on manufacturing equipment, a noncash expense, is not
expensed when it is recorded. Instead, under absorption costing it is applied to products manufactured as part of
fixed overhead cost applied and thus it becomes part of the inventory cost of the manufactured goods. It is expensed
as part of cost of goods sold when the goods are sold. Since the depreciation included in beginning inventory was
a noncash transaction that occurred during the prior year, it is not relevant to calculating pro forma net cash flow
from operating activities for 20X2. However, any transactions that are projected to affect inventory during 20X2
are relevant. Thus, projected depreciation for 20X2 is deducted from 20X2’s pro forma ending inventory, but the
depreciation included in the beginning inventory (20X1’s ending inventory) is not deducted from the beginning
inventory.
2
Depreciation expense of $3,924 includes $3,478 of the forecasted 20X2 depreciation that is included in COGS expense plus $446 of SG&A depreciation that is expensed. Depreciation still capitalized in inventory has not yet been
expensed and therefore is not added back to net income here. See Note 1 on the pro forma income statement for
details.
3
Beginning Net PP&E + Purchases – Current Depreciation = Ending Net PP&E.
48,450 + Purchases – 4,850 = 53,295
Purchases = 9,695
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Summary of Forecasting Using the Forecasted Financial Statement Method
1)
Analyze historical ratios
2)
Forecast the pro forma Income Statement
3)
Forecast the pro forma Balance Sheet
4)
Construct a pro forma Statement of Cash Flows using the pro forma Income Statement and pro
forma Balance Sheet
Analysis of Pro Forma Financial Statements
Developing the forecasted financial statements is only the beginning of the top-level planning process. The
pro forma financial statements need to be analyzed to determine whether the firm’s forecasted financial
situation meets the firm’s targets. If it does not, then changes will be needed, not just to the forecast but
also to the operating plans that resulted in the forecast, and the pro forma statements will need to be
revised.
Ratio analysis is used to compare the firm’s actual ratios and projected ratios with target ratios as well as
the latest industry average ratios. Ratio analysis is covered in detail on the CMA Part 2 exam, but candidates
will need to be somewhat familiar with it for this exam in order to analyze the ratios in the pro forma
financial statements.
The following ratios will be used in analyzing ABC’s pro forma financial statements. Although average balances for balance sheet items are preferable for financial statement analysis when relating an income item
to a balance sheet item, if averages are not available then it is acceptable to use ending balances. For this
purpose, ratios for year-end 20X1 are being compared with ratios for forecasted year-end 20X2 and 20X1
year-end industry averages. Since average balances of balance sheet items are not available for the industry, year-end balances will be used for ABC’s ratios to be consistent with the industry ratios.
Ratios
Current ratio:
Total current assets / Total current liabilities
Inventory turnover:
Annual cost of sales / Inventory
Days sales in inventory:
365 / Inventory turnover or
Inventory / (Cost of goods sold / 365)
Accounts receivable turnover:
Annual net credit sales / Accounts receivable
Days sales in receivables:
365 / Accounts receivable turnover or
Accounts receivable/(Annual net credit sales/365)
Interest coverage ratio:
EBIT / Interest expense
Asset turnover:
Net sales / Total assets
Debt to equity ratio:
Total liabilities / Total equity
Gross profit margin:
Gross profit / Net sales
Net profit margin:
Net income1 / Net sales
Return on assets:
Net income1 / Total assets
Return on equity:
Net income1 / Total equity
1
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Net income = Net income before preferred dividends are subtracted to calculate income available to common shareholders.
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Section B
B.6. Top-Level Planning and Analysis
Below are the key ratios for ABC. Candidates are advised to recalculate these ratios using the preceding
formulas in order to understand how they are calculated.
Actual
20X1
Forecast
20X2
Industry
Average
20X1
Current ratio
1.6 to 1
1.4 to 1
2.0 to 1
Inventory turnover
6.0 times
6.0 times
5.5 times
Days sales in inventory
60.8 days
60.8 days
66.4 days
Accounts receivable turnover
8.9 times
8.9 times
8.0 times
Days sales in receivables
41.0 days
41.0 days
45.6 days
Interest coverage ratio
6.0 to 1
6.1 to 1
7.2 to 1
Asset turnover
1.9 times
1.8 times
1.8 times
Debt to equity ratio
80.9%
88.6%
75.0%
Gross profit margin
24.5%
24.5%
30.7%
3.2%
3.2%
4.5%
Net profit margin
Return on assets
5.6%
5.6%
8.5%
Return on equity
10.2%
10.6%
12.0%
With the exception of the debt to equity ratio, the ratios for forecasted 20X2 are very similar to the ratios
for actual 20X1 because the 20X1 ratios were used to develop the 20X2 forecast. The debt to equity
ratio is higher in the 20X2 forecasted financial statements than in the 20X1 actual statements because
the 20X2 forecast reflects the anticipated borrowing need.
The first step in the analysis is to compare the 20X2 forecasted ratios to the industry averages. ABC’s
ratios are a little better than the industry averages for inventory and receivables turnover but worse
than the industry averages for everything else.
After comparing the company’s forecasted ratios to the industry averages, the next step is to analyze
the actual and pro forma financial statements to determine the causes of the negative variances from
the industry averages. ABC’s debt to equity ratio is higher than the industry average, which means its
interest expense is also higher than that of its peers. Furthermore, a considerable amount of the debt is
short-term, which is causing its current ratio to be lower than the industry average.
ABC’s gross profit margin, net profit margin, return on assets, and return on equity are all much lower
than industry averages. The lower return on assets and return on equity indicate that ABC is earning
less net income for each dollar invested in assets and for each dollar of its equity than other companies
in the same industry. The lower gross profit margin indicates the amount of gross profit it is earning on
each dollar of sales is also lower than that of its peers in the industry, which in turn means ABC’s cost
of goods sold is higher than that of its peers.
As a result of this analysis, ABC is looking at its cost of sales to determine if it is experiencing waste in
the production process. It is also studying the profitability analyses by product line to determine whether
some of the less profitable product lines should be discontinued or changed. If the company can improve
its profitability, it should be able to pay down some of its debt and lower its interest expense.
After the company makes its decisions about operational changes to be made, it will revise the pro forma
statements for 20X2 and recalculate the ratios to see whether the changes will create enough improvement in the ratios to enable the company to reach its targets. If the revised ratios are satisfactory, ABC
will pursue those operational changes. If the revised ratios are still not satisfactory, the company will
reconsider what else needs to be changed in its operations in order to achieve its objectives.
After the pro forma financial statements have been revised and the operational changes have been
made, the company’s management will need to evaluate its actual results against the pro forma statement to determine whether its objectives have been met. The primary method of making this
determination will be a comparison of the actual ratios and the pro forma ratios.
The revised pro forma financial statements and the revised ratios are not shown here.
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efham CMA
Other Uses of Pro Forma Financial Statements
Pro forma financial statements can also be used to evaluate the company’s dividend policy. ABC Industries
has had a policy of increasing its dividend on its common stock every year, and it has projected a 4%
increase in its dividend for 20X2. However, if the company were to reduce the growth rate of the dividend,
additional funds would be available to invest in plant, equipment, or inventories; to use to reduce borrowings; or possibly to use to repurchase its stock.
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Section C
Section C – Performance Management
Section C – Performance Management
Performance Management represents 20% of the CMA Part 1 exam. Part 1 is a four-hour exam containing
100 multiple-choice questions and two essay questions. Topics within an examination part and the subject
areas within topics may be combined in individual questions. Therefore, it is difficult to predict the number
of multiple-choice questions from this section that will be on any given exam, nor is it easy to predict
whether or not there will be any essay questions from this section. The best approach to preparing for this
exam is to know and understand the concepts well and be ready for anything.
The majority of the mathematical questions on performance management will be on variance analysis and
performance measures. A number of variances are covered, and candidates will need to know how to
calculate them, what they mean, and who can affect them. While the variance topic may seem large and
overwhelming at first, when it is broken down into its individual elements it will become easier.
The performance measurement portions focus on Return on Investment (ROI) and Residual Income (RI).
Candidates need to know what these measurements are, how they are calculated, how they are used, and
be able to identify the weaknesses that are inherent in each measurement.
In addition to variance analysis and performance measurement, the Performance Management section covers responsibility accounting, transfer pricing, and the balanced scorecard.
Responsibility accounting is the process of breaking down revenues and expenses according to those that
can be controlled by the manager and those that cannot be controlled by the manager.
Transfer pricing is a topic that candidates need to know from both a theoretical standpoint and a numerical
standpoint. Exam questions may require an understanding of the issues a company faces in establishing a
transfer price as well as the ability to calculate an acceptable transfer price under certain conditions.
The final topic covered in this section is the balanced scorecard, which focuses on both financial and nonfinancial measures. Candidates need to understand how the balanced scorecard works and its application.
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C.1. Cost and Variance Measures
CMA Part 1
C.1. Cost and Variance Measures
Variance analysis is the process of comparing the actual expenses and revenues during a certain period to
the budgeted amounts for that same period. Variance analysis shows management where the differences
are between actual and budgeted amounts, enabling management to investigate to determine the reasons
for the variances. Knowing the reasons can help management to focus its efforts on the areas that have
been operating less efficiently than planned.
Variances and Management by Exception
The comparison of actual costs to standard costs and the calculation of variances enable a company to
analyze its actual costs and undertake some cost controls. A large variance between the actual cost and
the standard cost alerts management that something may be wrong and may need attention.
In a system where variances are identified and reported to the appropriate level of the company, management can manage by exception once the standards have been set. Management by exception refers
to a system whereby only significant variances between actual results and the budget or plan are brought
to the attention of management. Management by exception focuses management’s attention on the things
that have the highest priority, defined as the greatest variances.
Benefits of Management by Exception
•
Management can focus its time in areas where it has identified problems by means of unfavorable
variances.
•
Management can look into the departments and divisions that have favorable variances, too. It is
possible that one of the departments has adopted a new policy or procedure that might be beneficial
if used in other departments.
Limitations of Management by Exception
•
Negative trends may be overlooked at earlier stages because the variances may not be great enough
to come to management’s attention.
•
If too many deviations from the budget occur, management by exception can become a very confusing
and complex process of trying to fix all the problems at once. Management would need to decide
which variances are the most important.
•
If favorable variances are overlooked because they are favorable, management might miss the opportunity to implement positive changes throughout the company.
Standard Costs
Standard costs were introduced in the Budgeting section. Before getting into the process of variance analysis, a review of standard costs and the role they play in the accounting and costing system is appropriate.
A standard cost is an estimate of the cost the company expects to incur in the production process. Without
a standard cost, the analysis of actual activities and results is very difficult because the company has no
target (or standard) against which to measure its performance.
Standard costs are calculated prior to the beginning of each period and they are based on the estimated costs and the expected level of activity or production. As discussed in Section B in this volume,
Planning, Budgeting, and Forecasting, standard costs are determined through the use of accounting and
production estimates. They are not simply created by management.
A standard cost is not the same as a standard cost system. A standard cost prescribes expected performance in terms of the expected cost of a specific item. A standard cost system is an accounting system
that uses standard costs and standard cost variances in the formal accounting system. In other words,
the costs recorded in the accounting system are the standard costs, and the chart of accounts includes
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Section C
C.1. Cost and Variance Measures
specific general ledger accounts that are used for recording the variances as they occur. Other types of
accounting systems are used, and standard costs can be used with those systems as well. In those other
types of accounting systems, the standard costs are used for control purposes outside the formal accounting system. The emphasis in this section, though, will be on standard cost systems that operate
within the formal accounting system.
Using a Standard Cost System
A standard cost system may be used with either a process costing system or a job-order costing system. A
process costing system is used to assign costs to individual products when the products are all relatively
similar and are mass-produced, as on an assembly line. Job-order costing is a method in which all of the
costs associated with a specific job or client are accumulated and charged to that job or client. Both process
costing and job order costing are covered in detail in Section D in Volume 2 of this textbook, Cost Management.
Below are three reasons for adopting a standard cost system:
1)
It is usually simpler to use standard costs rather than actual costs in a process costing system
because of the repetitive nature of the operation.
2)
Use of standard costs in a process cost system makes it much easier to determine cost per equivalent unit. The standard costs serve as the cost per equivalent unit for direct materials, direct
labor, and manufacturing overhead.
3)
Use of standard costs simplifies recordkeeping in either a process costing system or a job-order
costing system. Records need to be kept for quantities on hand and quantities used. The costs
associated with those quantities are simply the standard costs for the period.
Standard costs are best used with a flexible budgeting system. A flexible budgeting system provides the
most useful variance analysis. The flexible budget will enable the company to identify differences from the
budget that are not simply due to the actual quantity produced or sold having been different from the
budgeted quantity.
Note: A flexible budget is a budget that is prepared using the standard costs per unit produced and the
actual level of activity (sales or production, as appropriate). The flexible budget is essentially what the
budget would have been if the company had known what the actual level of sales or production would
be in advance and had used that information when it developed the budget. Flexible budgets are covered
in much more detail in Section B of this volume, Planning, Budgeting and Forecasting.
Determining the Level of Activity for Standard Costs
Costs are the result of activities, called cost drivers, that are undertaken to create products or render
services. Therefore, managers should focus on managing the activities, or cost drivers, rather than
the costs. Standards should be established for the use of the activities that are the cost drivers underlying
the costs. For example, a company needs to know how many direct labor hours will be needed for the
number of units planned for production during the period. In order to determine how many direct labor
hours will be needed, a standard number of direct labor hours needed to produce one unit is essential.
Standard costs are based on assumptions about the quantity of direct inputs needed to produce one unit
of product and the cost per unit used of those direct inputs. The assumptions used, such as the number of
direct labor hours allowed for each unit produced, should be challenging but attainable under normal conditions. If the standards are too rigorous, they will not be attained and the company will have large
variances in its reporting that may cause inventory and cost of goods sold to be reported improperly.
Standard costs also include assumptions about the cost for manufacturing overheads that should be allocated to each unit produced. Overhead standards are generally based on costs under normal operating
conditions, anticipated volume, and desired efficiency. The total overhead costs used are the budgeted
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factory overhead costs. The budgeted factory overhead costs are divided by a predetermined level of
activity to calculate a standard overhead rate.
Using the correct level of production or activity is important when setting standard costs. If the standard
level of activity is set too high, the workers will be unmotivated because they will know that no matter how
hard they work, they will fail to meet the budgeted level of output.
•
The ideal (also called perfect, or theoretical) level of output assumes that there will be no
breakdowns, no waste, no time lost to illness, and that the workers are working at maximum efficiency. While this ideal maximum output may be achieved for short periods of time, the ideal level
of output is not realistic in the long run.
•
An alternative to the theoretical level of output is the practical (also called currently attainable)
level of output. The practical level of output is the theoretical level reduced by a normal amount
of time lost due to downtime caused by maintenance issues, absences, and a normal learning curve
for employees but not reduced for any expected decrease in sales demand. The goal is to use a
level that is attainable but difficult to achieve. Such a level will motivate the workers while at the
same time requiring them to work diligently.
•
For controlling production costs, however, either the normal level of output or the master
budget level of output is used to set the standards used. The normal level is an average expected level of production that will satisfy average customer demand over a period of several years
(up to three) given the reasonable expectations of effective and efficient production. Master
budget capacity is the planned capacity utilization for the next budget period.
In addition to using the correct level of output to determine the standard cost per unit, standard costs also
need to be reviewed regularly. Just because the standard cost was $X per unit last year does not mean
that $X per unit is still a reasonable standard cost. Prices may change, the amount of material (or other
activity) required may change, or the production process may change. All of these fluctuations may require
the standard cost to be adjusted.
Sources of Standards
Several sources can be used to set appropriate standards for usage and prices. These sources can include
activity analysis, historical data, benchmarking, target costing, and strategic decisions.
Activity Analysis
Activity analysis involves identifying, delineating or outlining, and evaluating all the activities necessary to
complete a job, a project, or an operation. An activity analysis considers everything required to complete
a task efficiently and involves personnel from several areas, including engineers, management accountants,
and production workers. Product engineers specify product components. Industrial engineers analyze the
steps or procedures necessary to complete the task. Management accountants work with the engineers to
complete the analysis.
Benefits of Using Activity Analysis to Set Standards
•
If properly executed, activity analysis is the most precise way to determine standard costs.
Limitations of Using Activity Analysis to Set Standards
•
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Activity analysis can be time-consuming and expensive.
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Section C
C.1. Cost and Variance Measures
Historical Data
If reliable information is available, then historical data for a similar product can be a good source for determining the standard cost of an operation.
Although historical standards are more attainable than ideal standards, they are not consistent with a
philosophy of continuous improvement.
Benefits of Using Historical Data to Set Standards
•
Use of historical data is a less costly way to develop standard costs.
•
Using historical data is a method based on the way the particular firm has operated in the past.
Limitations of Using Historical Data to Set Standards
•
Basing a standard on the past can perpetuate past inefficiencies.
•
Although historical standards are more attainable than ideal standards, they are not consistent with
a philosophy of continuous improvement.
Benchmarking
Benchmarking to develop standard costs is based on using current practices of similar operations in other
firms. Associations of manufacturers often collect industry information and have data available. The firm
can use benchmarked data as guidelines for setting its standard costs.
Benefits of Using Benchmarking to Set Standards
•
A firm that uses benchmarking to set standard costs is making use of information about the best
performance anywhere. Achieving equivalent performance can help the firm sustain its competitive
edge.
Limitations of Using Benchmarking to Set Standards
•
Benchmarked data might not be completely applicable to the firm’s own situation.
Target Costing
Using target costing to set standard costs puts the focus on the market and on the price the product can
be sold for. A target price is the price the firm can sell its product for, and the target cost is the cost that
must be attained for the firm to realize its desired profit margin for the product. Once the target cost has
been determined, detailed standards are then set to attain the desired cost.
Target costing utilizes the concept of kaizen, the Japanese term for continuous improvement, to reduce
costs to what is necessary in order to earn the desired profit margin. This reduction of cost is accomplished
by developing new manufacturing methods and techniques. Development of new methods and techniques
entails an ongoing search for new ways to reduce costs, resulting in continuous improvement, which is the
heart of the kaizen concept.
Additionally, strategic decisions may affect a product’s standard cost. For example, a decision to replace
an obsolete machine with a new, computer-controlled machine would require an adjustment to the standard
cost and machine hours for the process. A commitment to strive for kaizen is another example, as that
commitment might require standards to be set at a level that would provide the maximum challenge.
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Question 81: Which one of the following is least likely to be involved in establishing standard costs for
evaluation purposes?
a)
Budgetary accountants.
b)
Industrial engineers.
c)
Top management.
d)
Quality control personnel.
(CMA Adapted)
Question 82: A firm most often uses a standard costing system in conjunction with:
a)
Management by objectives.
b)
Target (hurdle) rates of return.
c)
Participative management programs.
d)
Flexible budgets.
(CMA Adapted)
Variance Analysis Concepts
In general, variances are a comparison between the actual results of the company and the budgeted results
of the company. Variances are calculated for various levels, some containing more detail than others. The
greater the detail provided by the variance, the greater the information the variance provides about the
cause of the variance.
In manufacturing variances, which this topic focuses on, the detailed causes of the variances provide information about whether or not the actual quantity of inputs was different from the budgeted quantity and
whether or not the actual price per unit of inputs was different from the budgeted price.
Because of the nature of variances, all of the calculations made will be comparisons between an actual
amount and a budgeted amount. What is specifically compared will depend on the variance being calculated.
Note: The terms “budget” and “standard” usually mean the same thing: a planned amount.
“Levels” in Variance Analysis
Variances can be classified in terms of level. A level denotes the amount of detail provided by the variance.
A low-level variance provides the least detail, whereas more information is provided by a variance with a
higher-level number.
It is not important to memorize the various level numbers and which variances are included in each. It is
important, though, to recognize that these levels express relationships between and among variances. Each
successive level of variance analysis breaks the previous level’s variance down into more detail and thus
represents a deeper level of analysis that provides more insight into the causes of the lower level variance.
Static Budget Variances vs. Flexible Budget Variances
A static budget is a fixed budget. It is a budget prepared for one specific level of planned activity, and
that level of planned activity in the static budget does not change, no matter what the actual activity is. A
static budget is not very useful for control and evaluation purposes when the actual activity level such as
sales or production is different from the planned activity level (as almost always occurs). For instance, a
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cost may be higher in total than budgeted, but if sales were also higher than expected, the portion of the
variance that is due to the increased sales is to be expected and is not a cause for concern. Variances that
result from comparing total actual costs to the static budgeted costs are Level 1 variances. These low-level
variances are less useful than higher-level variances because low-level variances give no information about
the cause or causes of the variance.
A more useful and usable budget is a flexible budget. A flexible budget is one in which budgeted variable
revenues and costs have been adjusted to the total revenue or cost that would be anticipated for the actual
level of activity that has occurred, as opposed to the budgeted level of activity. Normally, fixed costs in the
flexible budget are the same as fixed costs in the static budget. Budgeted fixed costs in the flexible budget
are adjusted only if the actual activity level is outside the relevant range.
Flexible budget variances are a better indicator of operating performance than static budget variances
because they compare actual results to the budgeted results adjusted for the actual volume. If an
actual cost is higher than its flexible budget amount, then that variance may be cause for concern. Flexible
budget variances are Level 2 variances and are more useful for management decision-making.
The highest level of manufacturing variances, Level 3 variances, are variances calculated for a single manufacturing input (for example, direct material, direct labor, or variable overhead). These are the most
detailed and provide the most specific information for management to work with.
Level 1 Variances: Static Budget Variances
Level 1 variances are the most global variances. Static budget variances are Level 1 variances; therefore,
static budget variances are the most global. They are based on the income statement and merely compare
the actual results with the static (master) budget. Since they are based on the income statement, Level 1
variances report variances in revenue and cost of sales for sold units only. They do not report detailed cost
variances for all units produced.
While these variances indicate whether performance was better or worse than expected, they do not provide
any information as to why performance was better or worse than expected.
There are benefits and limitations to measuring performance by comparing actual results with the master
budget.
Benefits of Measuring Performance by Static Budget Variances
•
Static budget variances provide a means for management to recognize unexpected variances, thus
pointing out which operating variances need to be investigated, one of the most important steps in
the budgeting process.
•
Analysis of variances is part of the control loop, the process by which the activities of the company
are controlled.
Limitations of Measuring Performance by Static Budget Variances
•
Variances caused by more or fewer sales than planned are not segregated from variances caused by
other factors.
•
Comparison of actual results with the master budget focuses on short-term performance instead of
long-term success.
•
Managers should be evaluated on performance measures other than just whether or not they have
met short-term financial targets. Meeting financial targets is only part of the measurement of performance. Manager evaluation should include not only financial measures but also non-financial
measures.
Managers should be evaluated on their overall contributions to the achievement of the company’s goals. Managers’ financial contributions are part of their overall contributions, but they are not
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their full contributions. Evaluation of a manager’s overall contributions can be accomplished by means of
the balanced scorecard, which is discussed later in this section.
Example: Below is an example of a static budget variance report. This variance report is in income
statement format, meaning it is based on revenue and cost of units sold rather than cost of units
produced.
Note: Not all variances are based on units sold. Manufacturing input variance reporting is concerned
with production input costs instead of the income statement.
Level 1 Variance Report:
Static Budget Variances
Col. 1
Col. 2
Actual
Results
Static
Budget
Col. 3
(3) = (1) – (2)
Static Budget
Variance
Units sold
20,000
24,000
4,000 − U
Revenues
$2,500,000
$2,880,000
1,243,200
1,440,000
Direct manufacturing labor
396,000
384,000
12,000 + U
Variable manufacturing overhead
261,000
288,000
27,000 −
F
Total variable costs*
$1,900,200
$2,112,000
$
211,800 −
F
Contribution margin**
$ 599,800
$ 768,000
$
168,200 − U
570,000
552,000
18,000 + U
29,800
$ 216,000
$ 186,200 − U
$
380,000 − U
Variable costs
Direct materials
Fixed costs
Operating income
$
196,800 −
F
* In this example and others like it that follow in this text, lines for variable selling and variable administrative costs have not been included. However, if specific information is given about variable selling
and variable administrative costs, those costs are part of the variable costs that are included in the
calculation of the contribution margin.
** “Contribution margin” is sales revenue minus all variable costs of the sales.
When calculating variances, always subtract the budget amount from the actual amount (Actual –
Budget = Variance).
A favorable variance (designated by the letter “F”) is a variance that causes actual net operating income
to be higher than the budgeted amount. An unfavorable variance (designated by the letter “U”) is a
variance that causes actual net operating income to be lower than the budgeted amount.
Therefore, actual revenue that is below budgeted revenue, as is the case in the example, is a negative
variance because actual is lower than budget ($2,500,000 − $2,880,000 = $[380,000]). That negative
variance is unfavorable because it will cause actual net operating income to be lower than the budgeted
amount.
On the other hand, actual costs that are below budgeted costs are also negative variances because the
actual is lower than the budget, but they are favorable variances because they will cause actual net operating income to be higher than the budgeted amount.
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Actual revenues that are higher than budgeted revenues are positive and favorable, whereas actual
costs that are higher than budgeted costs are also positive but are unfavorable.
In the preceding example, actual direct material costs for the 20,000 units sold are $1,243,200, while
budgeted direct materials costs for the budgeted number of units to be sold are $1,440,000. Actual cost of
$1,243,200 minus budgeted cost of $1,440,000 equals $(196,800), which is a favorable variance because
the actual cost was lower than the budgeted cost.
If actual net operating income is to be higher than budgeted net operating income, revenues need to be
higher than budgeted (a positive variance amount) or expensed costs need to be lower than budgeted (a
negative variance amount), or a combination of both is needed. Revenues higher than budgeted and expenses lower than budgeted are both favorable variances.
Note: When calculating variances for revenues/incomes or costs/expenses, always subtract the
Budget amount from the Actual Amount (as in the example above).
Actual – Budget = Variance
When the budget amount is subtracted from the actual amount, the sign of the variance will always
follow these rules:
 A positive variance for a revenue or income item is a Favorable variance.
 A negative variance for a revenue or income item is an Unfavorable variance.
 A positive variance for a cost or expense item is an Unfavorable variance.
 A negative variance for a cost or expense item is a Favorable variance.
Note also in the preceding example that the operating income variance of $(186,200) cross foots, meaning
the amount is the same when calculated both horizontally and vertically.
•
Calculated horizontally: Actual operating income of $29,800 minus budgeted operating income of
$216,000 equals operating income variance of $(186,200) Unfavorable.
•
Calculated vertically: The revenue variance of $(380,000) minus the total variable cost variance
of $(211,800) equals the contribution margin variance of $(168,200); and the contribution margin
variance of $(168,200) minus the fixed costs variance of $18,000 equals the operating income
variance of $(186,200) Unfavorable, the same amount as was calculated horizontally.
Note: When entering negative numbers on a calculator, be sure to follow each negative number with
the “+/−“ key in order to input it as a negative number. To input $(380,000) minus $(211,800), input
it as follows:
<380000 +/−>
<−>
<211800 +/−>
<=>
The answer should be displayed as −168200.
Level 2 Variances: Flexible Budget Variances and Sales Volume Variances
Each of the static budget variances can be broken down into two sub-variances: the flexible budget
variance and the sales volume variance. The flexible budget and sales volume variances are Level 2
variances, and they provide more information about the static budget variances. These variances are also
in income statement format. Because they are based on the income statement and thus report on revenues
and costs for items sold, these variances are also called sales variances. The term “sales variances”
distinguishes them from manufacturing input variances, which are based on items produced.
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•
CMA Part 1
The flexible budget variance on a sales variance report is the difference between the actual
results and the flexible budget amount.
Flexible Budget Variance = Actual Results – Flexible Budget Amount
The flexible budget amount on a sales variance report is budgeted amounts that have been adjusted to the actual level of sales activity that has occurred. The flexible budget variance indicates
how much of the static budget variance was caused by factors other than the difference between
actual and budgeted sales volume. For example, the flexible budget variance on the revenue line
indicates how much of the static budget variance was due to a difference between the actual price
charged for each unit sold and the budgeted price per unit.
•
The sales volume variance on a sales variance report is the difference between the flexible
budget amount and the static budget amount.
Sales Volume Variance = Flexible Budget Amount – Static Budget Amount
The sales volume variance shows how much of the static budget variance was caused by actual
sales volume having been different from budgeted sales volume.
These variances may be calculated for operating income and for each line item on the income statement.
An example follows.
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Example: Here is the example income statement again, this time showing the static budget variances,
the flexible budget variances, and the sales volume variances for each line item and for net operating
income.
For each line, the flexible budget variance plus the sales volume variance equals the total static budget
variance. The calculation of the net operating income variances is shown at the bottom. It would be a
good idea to verify the variance calculations for the individual lines to be sure of understanding how they
are calculated.
Level 2 Variance Report:
Flexible Budget Variances
Col. 1
Col. 2
Col. 3
Col. 4
(2)=(1)–(3)
Flexible
Budget
Variances
Actual
Results
Units sold
20,000
Revenues
$2,500,000
Direct materials
Col. 5
(4)=(3)–(5)
Sales Volume
Variances
Flexible
Budget
0
Col. 6
(6)=(1)–(5)
also
(6)=(2)+(4)
Static
Budget
Static
Budget
Variances
20,000
4,000− U
24,000
4,000− U
$100,000+ F
$2,400,000
$480,000− U
$2,880,000
$380,000− U
1,243,200
43,200+ U
1,200,000
240,000− F
1,440,000
196,800− F
Direct manufacturing
labor
396,000
76,000+ U
320,000
64,000− F
384,000
12,000+ U
Variable manufacturing
overhead
261,000
21,000+ U
240,000
48,000− F
288,000
27,000− F
$1,900,200
$140,200+ U
$1,760,000
$352,000− F
$2,112,000
$211,800− F
$
768,000
$168,200− U
552,000
18,000+ U
216,000
$186,200− U
Variable costs
Total variable
costs
Contribution
margin
$
Fixed costs
Operating
come
599,800
$
570,000
in-
$
29,800
40,200− U
$
18,000+ U
$
58,200− U
$58,200− U
Total flexible
budget variance
640,000
128,000− U
552,000
$
0
88,000
$128,000− U
$
$128,000− U
Total sales
volume variance
$186,200− U
Total static budget variance
Notice that on the preceding report, the budgeted amounts for fixed costs are exactly the same in the
flexible budget as they are in the static budget. Even though actual sales were lower than budgeted sales,
sales remained within the relevant range. Therefore, budgeted fixed costs in the flexible budget are no
different from budgeted fixed costs in the static budget. Both are $552,000.
The detail variances covered in the following pages give more information than can be obtained from just
looking at a flexible budget variance report or a static budget variance report. The sales volume variance
for a single-product firm like those in the two variance report examples above can be explained by the fact
that the actual level of sales was different from the budgeted level of sales. The cause or causes of the
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sales volume variance do need to be investigated, but more variance detail is not needed for the investigation. A sales volume variance can be caused by the state of the economy, actions of competitors,
production problems at the plant that prevented the company from manufacturing enough product to meet
the demand, or any number of other things.
Flexible budget variances identify variances that are caused by something other than the different-fromexpected sales volume. Flexible budget variances can be caused by multiple factors, and it is important to
investigate the factors that caused the variances in order to determine what changes need to be made.
Additional variance detail can be calculated to assist in this determination.
Level 3 Variances: Manufacturing Input and Sales Quantity and Sales Mix Variances
Level 3 variances also include manufacturing input variances. Below are the different variances that will be
discussed in the following topic. Candidates need to know how to calculate each of these variances, need
to understand what the variances mean, and need to be able to identify possible causes of the variances.
Manufacturing input variances will be covered first, followed by sales variances, sales quantity, and sales
mix variances.
Manufacturing Input Variances:
Direct Materials Variances
1)
2)
Price variance
Quantity or efficiency variance
2a)
Mix variance*
2b)
Yield variance*
Direct Labor Variance
3)
4)
Rate (price) variance
Efficiency (quantity) variance
4a)
Mix variance*
4b)
Yield variance*
Factory Overhead Variances
5)
6)
Total Variable overhead variance
5a)
Variable overhead spending variance
5b)
Variable overhead efficiency variance
Total Fixed overhead variance
6a)
Fixed overhead spending or budget variance
6b)
Fixed overhead production-volume variance
Sales Variances
7)
8)
Flexible budget variance
Sales volume variance
8a)
Quantity variance**
8b)
Mix variance**
Level 2 variances
Level 3 variances
*
These specific manufacturing variances are calculated only when more than one input (either classes
of labor or types of material) is used in the production process.
** These specific sales variances are calculated only when the company sells more than one product.
Note: The preceding list contains a lot of variances. However, the number of variances should not be a
cause for discouragement. A number of these variances are simply variations on a theme. The formulas
are the same, so it is not necessary to memorize a separate formula for each variance.
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Manufacturing Input Variances
Manufacturing input variances are a special class of variances. Manufacturing inputs are the direct materials, direct labor, and manufacturing overhead used in production. Manufacturing input variances are
concerned with inputs to the manufacturing process, as follows:
•
Whether the amount of inputs used per unit manufactured was over or under the standard (a
quantity, or efficiency, variance),
•
Whether the inputs used cost more or less per unit of the input than the standard (a price variance), and
•
What the monetary impact was of each type of variance.
Manufacturing input variances are used in controlling production. Manufacturing input variances are also
called flexible budget variances, and the flexible budget amounts used are based on the price and quantity
of the input allowed for the actual production. Manufacturing input variances are reported on a production variance report, not on a report in the form of an income statement, because they report on units
produced, not on units sold.
In the accounting system, manufacturing input variances are closed out at the end of each period to cost
of sales or, if material, they are prorated among cost of sales, finished goods inventory, work in process
inventory and—for direct material variances only—direct materials inventory.
The Difference Between Sales Variances and Production Variances
The variance reports seen so far have been sales variance reports, and they present only the results of
units sold. Sales variances are Level 2 variances. In its variable manufacturing costs section, a Level 2 sales
variance report presents the total flexible budget variance for variable manufacturing costs for units sold.
This total flexible budget variance includes both the manufacturing input price and the manufacturing input
quantity variances for sold units. The price and quantity input variances for the sold units are presented on
the report as one combined variance.
A production variance report, which is a Level 3 report, is required to present the detail behind the total
flexible budget variance. However, a production variance report includes all units produced, whether they
were sold or remained in inventory as unsold units at the end of the period.
Because a Level 2 sales variance report presents information on units sold and a Level 3 production variance
report presents information on units produced, the two cannot be reconciled for a given reporting period
unless the units that were sold are the same units as the units that were produced during the period. Thus,
Level 2 variances based on revenue and costs of units sold should not be expected to reconcile with the
detail variances on a production variance report covering the same reporting period unless an exam question gives information that can be interpreted to mean that the same units that were produced were
the same units that were sold.
For example, an exam question might say that the company is a new manufacturing company that just
started in business (thus beginning inventories were all zero), and it sold all of its first period’s production
during its first period of operation. In that case, the company sold the same units as it produced. But if the
information given does not enable reconciliation, do not try to reconcile them, because it will not work.
Furthermore, the total flexible budget variances for variable manufacturing costs on the Level 2 report
cannot be broken down between manufacturing input price and quantity variances the way production
variances are because the information needed to do that is not available. Information given in the problem
might make it possible to reconcile the sum of the manufacturing input quantity and price variances on the
production variance report to the total flexible budget variance on a sales variance report (if the units
produced were the same units sold), but the breakdown between price and quantity variances cannot be
seen on the sales variance report.
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What Causes Manufacturing Input Variances?
Before getting into the specific manufacturing input variances, consider the possible reasons for an actual
input cost to be different from the standard, expected, or budgeted input cost. The standard cost is determined using an estimated cost and an estimated level of usage. Obviously, if a company either pays a
different price for an input than had been budgeted or uses a different amount of the input than was
budgeted for the actual level of output, or both, then the actual cost for the actual level of output will be
different from the budgeted cost for the actual level of output.
The simple fact that the actual cost was different from the budgeted amount is not, by itself, very useful
information to management. Management needs to know why the actual cost was different from the budgeted amount.
•
Was it because a different amount of raw materials or labor was used than should have been used
for the actual output?
•
Was it because a different price per unit was paid for the raw materials or labor?
•
Was it because of differences in both, the most likely scenario?
Variance analysis enables management to investigate the specific reason or reasons for the variance, and
then the company can focus its efforts on the areas that have a negative impact on the business.
Input cost variances are sub-divided into their two causes:
1)
A price variance that reflects the difference between actual and budgeted input prices.
2)
A quantity variance, also called an efficiency variance, that reflects the difference between
actual and budgeted input quantities used.
Mastering a conceptual understanding of these two basic causes of variances will make variance analysis
exam questions much easier.
Summary of Manufacturing Input Variances
The following table summarizes the formulas and the terms used in variance analysis, and it is presented
here as an overview of the material that will be covered in detail later. This table will appear again at the
end of the topic of variances.
Price Variance
Quantity Variance
(AP – SP) × AQ
(AQ – SQ) × SP
Materials
Price Variance
Quantity Variance
Labor
Rate Variance
Efficiency Variance
Mix Variance
Yield Variance
(waspAM – waspSM) × AQ
(AQ – SQ) × waspSM
Spending Variance
Efficiency Variance
(AP – SP) × AQ
(AQ – SQ) × SP
Spending (Flexible Budget) Variance
Production Volume Variance
Prime Costs
Multiple Inputs
(both Material and Labor)
Variable Overhead
Fixed Overhead
Budgeted OH – Applied OH
Actual OH − Budgeted OH
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Manufacturing Input Variances
Direct Materials Variances
The total direct materials variance is also the flexible budget variance for direct materials. The total
direct materials variance is the difference between the actual direct materials costs for the period and the
standard costs for the standard amount of materials allowed for the actual output at the standard price
per unit of direct materials (the flexible budget).
−
=
Actual total direct materials costs incurred (money spent)
(AP x AQ)
Standard amount of direct materials allowed for the actual
output at the standard price per unit of direct materials
Total direct materials variance
(SP x SQ)
Example: Medina Co. produces footballs. Each football requires a standard of 1 square meter of leather
that has a standard cost of $5.00. During the period, Medina produced 250 footballs and used 290 square
meters of leather. The actual cost of the leather was $4.50 per square meter.
The total actual cost of the leather used was $1,305 (290 × $4.50). However, given the actual output
of 250 footballs, Medina should have used only 250 square meters of leather. Since each square meter
should have cost $5, Medina should have spent $1,250 on leather in order to produce 250 footballs (250
× $5).
The total direct materials variance is:
Actual cost for 250 units – $4.50 × 290 sq. meters used
Standard cost allowed for 250 units – $5.00 × 250 sq. meters
Total variance
$ 1,305
$ 1,250
$
55 U
Medina spent $55 more than it should have spent for the leather to make 250 footballs. A manager
might conclude that this situation is acceptable and does not require any significant attention because
even though the variance is unfavorable, it is not large. However, a more in-depth examination will
reveal that the company used a greater quantity of materials than it should have, though the financial
impact of that variance was mitigated by the fact that it paid less than expected for each square meter
of leather used.
Because of the need for more useful analysis, the total materials variance is divided into two components:
price and quantity. The quantity variance (also called the efficiency or usage variance) measures how
much of the variance is due to having used either more or less direct material than budgeted, and the price
variance measures how much of the total variance was caused by having paid a different amount for the
material than had been budgeted.
The quantity variance plus the price variance equals the total variance, which is also the flexible
budget variance.
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The Quantity Variance
The quantity variance (also called the efficiency or usage variance) is calculated as:
(Actual Quantity − Standard Quantity for Actual Output) × Standard Price
or
(AQ – SQ) × SP = Quantity Variance
The above formula is actually a shorter way of expressing the following:
Actual Quantity × Standard Price
−
Standard Quantity × Standard Price
=
Quantity Variance
The quantity variance represents the difference in cost between the actual material used at the standard
price and the standard usage allowed for the level of actual output at the standard price.
The quantity variance formula is used to calculate the portion of the total variance that was caused by
either too much or too little direct materials having been used, without any reference to the amount of the
variance that was caused by a difference between the actual and the standard price per unit of the material
used. Both the actual quantity and the standard quantity for the actual output are multiplied by the standard
price in order to remove any effect of the price variance from the result.
Because the quantity variance measures a cost variance, a positive result is an unfavorable variance because costs were higher than expected, while a negative result is a favorable variance because costs were
lower than expected.
Example: In the example of Medina Co., where each football requires a standard quantity of 1 square
meter of leather that has a standard cost of $5 and Medina produced 250 footballs using 290 square
meters of leather, the amounts used in calculating the quantity variance are as follows:
Actual Quantity = 290 meters used
Standard Quantity = 1 meter allowed per football × 250 footballs produced, which equals 250 meters
Standard Price = $5 per meter
The quantity variance is (AQ – SQ) × SP and is calculated as:
(290 – 250) × $5 = $200 Unfavorable
The variance is unfavorable because it is a positive variance for a cost. The $200 variance means that
Medina had to pay $200 more than it should have paid for the materials used to produce 250 footballs
because it used too much material. Any variance caused by a difference between the actual price paid
per meter and the standard price per meter is not reflected in the unfavorable quantity variance.
Thus, if the actual price per meter of direct materials actually used had been the same as the standard
price per meter actually used (in other words, if there had been no price variance), the total direct
materials variance would have been $200 Unfavorable, all due to having used too much direct materials
in production.
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The Price Variance
Though it is commonly called the “price variance” for materials, the more complete name for this variance
is the “price usage variance.” The variance is called the “price usage variance” to distinguish it from the
“purchase price variance,” which will be covered next. For the sake of brevity, from this point onward
“price variance” will be used to mean the “price usage variance.”
The price variance is calculated as:
(Actual Price − Standard Price) × Actual Quantity
or
(AP – SP) × AQ = Price Variance
The above formula is actually a shorter way of expressing the following:
Actual Price × Actual Quantity
−
Standard Price × Actual Quantity
=
Price Variance
The price variance represents the difference between the actual material usage at the actual price and the
actual material usage at the standard price.
The price variance formula is used to calculate the portion of the total variance that was due to a difference
between what was actually paid (the actual price) per unit of direct materials used and the amount allowed
(the standard or budgeted price) per unit of direct materials actually used. Both the actual price and the
standard price are multiplied by the actual quantity used in order to remove any effect of the quantity
variance from the result.
Because the materials price variance measures a cost variance, a positive result is an unfavorable variance
because costs were higher than expected, while a negative result is a favorable variance because costs
were lower than expected.
Example: In the Medina Co. example, where the actual cost paid per meter of leather was $4.50, the
standard price was $5.00, and 290 meters were actually used in production, the amounts used in calculating the price variance are as follows:
Actual Price = $4.50 per meter
Standard Price = $5.00 per meter
Actual Quantity = 290 meters
The price variance is (AP – SP) × AQ and is calculated as:
($4.50 – $5.00) × 290 = $(145) Favorable
Medina saved $145 because the price per unit of the leather that was actually used in production was
lower than expected, a favorable variance. A negative variance for a cost is a favorable variance
because it means the actual cost per unit used was lower than the budgeted cost per unit. Even though
Medina used more leather than it should have for each football it manufactured, it saved $0.50 on each
square meter of leather actually used.
The variance of $(145) means that, because the price per square meter was $0.50 lower than expected,
the company’s cost for the 290 square meters of direct materials used was $145 lower than the standard
cost allowed for that quantity of materials.
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The Quantity Variance Plus the Price Variance Equals the Total Variance
Assuming the total, price, and quantity variances have been calculated accurately, the quantity variance
plus the price variance will equal the total variance.
Example: The total materials variance for Medina Co. is the sum of the quantity variance and the price
variance.
Quantity variance
Price variance
Total Variance
$ 200 U
(145) F
$ 55 U
In total, Medina had a positive variance of $55, which is unfavorable, because the cost for the extra
leather that was used was more than the savings on each square meter of leather used.
Even though Medina’s total actual cost came close to the total standard cost, the company has significant
production problems, revealed by the large unfavorable quantity variance and the almost equally large
price variance. Management will most certainly look at the production process to find out why so much
leather was required to make 250 footballs. The company may have a very inefficient process that wastes
too much leather, or perhaps it has new workers who are not as experienced as they will be in the future.
Perhaps the less expensive leather was more difficult to work with and therefore an excessive amount
was spoiled in the production process. In any case, despite the total cost variance being small, Medina
needs to investigate further the cause of the variance in its leather usage.
Investigation of a variance is an example of management by exception.117 All significant variances need
to be investigated, whether they are favorable or unfavorable.
•
Investigation of an unfavorable variance is needed to find out what went wrong so it can be corrected.
•
Investigation of a favorable variance may reveal a positive change in a process that can be duplicated throughout the organization.
Note: On the exam, candidates need to be able to identify possible reasons why a particular variance
is favorable or unfavorable. Most of these reasons can be identified by using common sense. For example, an unfavorable quantity variance may be caused by the purchasing department having bought an
inferior, defective product, or it may be caused by new, untrained employees or poor techniques.
In the Medina Co. example, the variances could be due to the purchasing department’s having gotten a
cheap price on inferior leather that was damaged in the production process or was not consistently of
an acceptable quality.
Materials Purchase Price Variance
The materials price variance may be calculated at the time of purchase instead of at the time of use. A
materials price variance computed at the time of purchase is a variation on the materials price usage
variance and is called a materials purchase price variance. The materials purchase price variance is
calculated in exactly the same way as the materials price usage variance, except the AP (Actual Price) in
the formula is the price paid for the materials during the period and the AQ (Actual Quantity) in the formula
is the quantity of direct materials purchased, not the quantity of direct materials used.
Determining materials price variances as soon as the materials are received instead of when the materials
are put into production leads to better control. If the variance is not computed until the materials are
117
“Management by Exception” refers to a system whereby only significant variances between actual results and the
budget or plan are brought to the attention of management. Management by exception focuses management on the
things that have the highest priority, defined as the greatest variances.
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requisitioned for production, corrective action will be more difficult because more time will have elapsed
from the date of purchase.
If an exam question is about the purchase price variance, the information given in the question will make
it clear that the question is asking for the purchase price variance. Be sure to notice the word “purchase”
if it is used since it changes the way the variance is calculated.
However, a question may not call the variance by its name of “purchase price variance.” Instead,
a question may describe the materials purchase price variance, to test whether candidates know what the
materials purchase price variance is. For example, the question may say that a company recognizes materials variances as early as possible. That is an indication the question is asking for the purchase price
variance.
If the purchase price variance is required, calculate it using all of the units purchased as the Actual
Quantity, not just the units that were put into production.
Exam Tip:

If a question asks for the materials price variance (or materials price usage variance), use the
units used as the Actual Quantity in the variance formula, not the units purchased.

If a question asks for the materials purchase price variance, or if the question says that the
company recognizes materials variances as early as possible (or some other description of
the materials purchase price variance), use the quantity purchased as the Actual Quantity in the
variance formula instead of the quantity used.
Most questions ask for the materials price usage variance, using the units placed into production. However, a question could be about the materials purchase price variance instead. Therefore, be aware of
this potential variation.
Note: The materials price variance (or materials price usage variance) is calculated at the time of
usage, while the materials purchase price variance is calculated at the time of purchase.
Exam Tip: For the exam, candidates need to be able to use the variance formulas to solve for the
variance itself and also to solve for any of the individual variables in the formulas.
For example, each variance uses three amounts to calculate the variance. In a straightforward question,
the variance is the unknown. The amounts for the formula (AP, SP, AQ, or SQ) are on the left side of the
equals sign and the calculated variance is on the right.
Instead, an exam question may give the variance and two of the amounts for the formula (or may give
enough information to determine what the two amounts are). The question may ask for the third amount
on the left side of the “equals” sign—the AP, SP, AQ, or SQ—so that amount will be the unknown. To do
the calculation, simply use the same formulas but use algebra to solve for a different unknown.
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Question 83: Price variances and efficiency variances can be key to the performance measurement
within a company. In evaluating performance, all of the following can cause a materials efficiency variance except the:
a)
Performance of the workers using the material.
b)
Actions of the purchasing department.
c)
Design of the product.
d)
Sales volume of the product.
(CMA Adapted)
The following information is for the next three questions: ChemKing uses a standard costing
system in the manufacture of its single product. The 35,000 units of raw material in inventory were
purchased for $105,000, and 2 units of raw materials are required to produce 1 unit of final product. In
November, the company produced 12,000 units of product. The standard cost for material allowed for
the output was $60,000, and there was an unfavorable quantity variance of $2,500.
Question 84: ChemKing’s standard price for one unit of material is:
a)
$2.00
b)
$2.50
c)
$3.00
d)
$5.00
Question 85: The units of material used to produce November output totaled:
a)
12,000 units.
b)
12,500 units.
c)
23,000 units.
d)
25,000 units.
Question 86: The materials price variance for the units used in November was:
a)
$2,500 unfavorable.
b)
$11,000 unfavorable.
c)
$12,500 unfavorable.
d)
$3,500 unfavorable.
(CMA Adapted)
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Question 87: Garland Company uses a standard cost system. The standard for each finished unit of
product allows for 3 pounds of plastic at $0.72 per pound. During December, Garland bought 4,500
pounds of plastic at $0.75 per pound, and used 4,100 pounds in the production of 1,300 finished units
of product. What is the materials price variance for the month of December?
a)
$117 unfavorable.
b)
$123 unfavorable.
c)
$135 unfavorable.
d)
$150 unfavorable.
(CMA Adapted)
Direct Labor Variances
As with the materials variance, the total labor variance (also called the flexible budget variance for
direct labor) is the difference between the actual labor costs incurred by the company for the period and
the standard labor costs for the standard amount of direct labor allowed for the actual level of output at
the standard wage rate per hour (the flexible budget). Similar to the total direct materials variance, the
total direct labor variance is attributable to variances in both labor rates and labor usage, meaning that the
company either paid a wage rate that was different from the standard rate, used a different number of
labor hours than the standard number of hours allowed for the actual level of output, or both.
−
=
Actual total direct labor costs incurred (money spent)
(AP x AQ)
Standard amount of direct labor allowed for the actual
output at the standard wage rate per hour
Total direct labor variance
(SP x SQ)
Because the direct labor variances are so similar to variance analysis for materials, direct labor variances
will not be covered in detail. Briefly, the total labor variance can be broken down into the labor rate variance
(a price variance) and the labor efficiency variance (a quantity variance). Direct labor price and quantity
variances are calculated in the same manner as the direct material price and quantity variances; but, when
direct labor is analyzed, different names are used for the price and quantity variances.
The Direct Labor Rate Variance
The direct labor rate variance is calculated in the same manner as the direct materials price variance:
(Actual Rate – Standard Rate) × Actual Hours
or
(AP – SP) × AQ = Labor Rate Variance
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The above formula is actually a shorter way of expressing:
Actual Rate × Actual Quantity
−
Standard Rate × Actual Quantity
=
Labor Rate Variance
The labor rate variance represents the difference between the cost of the actual labor used at the actual
rate and the cost of the actual labor used if it had been paid at the standard rate.
The labor rate variance formula results in the portion of the total direct labor variance that was due to a
difference between what was paid per hour (the actual rate) and the amount budgeted to be paid per hour
(the standard rate) for direct labor actually used. Both the actual rate and the standard rate are multiplied
by the actual quantity used in order to remove any effect of the quantity variance (called the efficiency
variance) from the result.
Because the labor rate variance measures a cost variance, a positive result is an unfavorable variance
because costs were higher than expected, while a negative result is a favorable variance because costs
were lower than expected.
The Direct Labor Efficiency Variance
The direct labor efficiency variance is calculated the same manner as the direct materials quantity variance:
(Actual Hours − Standard Hours for Actual Output) × Standard Rate
or
(AQ – SQ) × SP = Direct Labor Efficiency Variance
The above formula is actually a shorter way of expressing:
Actual Hours × Standard Rate
−
Standard Hours × Standard Rate
=
Direct Labor Efficiency Variance
The direct labor efficiency variance represents the difference in cost between the actual direct labor hours
used if those hours had been paid at the standard hourly rate and the standard direct labor hours allowed
for the level of actual output paid at the standard direct labor hourly rate.
The direct labor efficiency variance formula is used to calculate the portion of the total variance that was
caused by either too much or too little direct labor having been used, without any reference to the amount
of the variance that was caused by a difference between the actual rate and the standard rate per hour of
the direct labor used. Both the actual hours and the standard hours allowed for the actual output are
multiplied by the standard rate per hour in order to remove any effect of the labor rate variance from the
result.
Because the labor efficiency variance measures a cost variance, a positive result is an unfavorable variance
because costs were higher than expected, while a negative result is a favorable variance because costs
were lower than expected.
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Exam Tip: As with direct material variances, for the exam candidates need to be able to use the variance
formulas to solve for the variance itself and also to solve for any of the individual variables in the formulas.
Accounting for Direct Labor Variances in a Standard Cost System
The production payroll is recorded by debiting work-in-process inventory for the total number of standard
hours allowed for the units manufactured at the standard hourly rate. The credit is to accrued payroll
at the total number of hours actually used and at the actual hourly rate. The difference between the
two is recorded in the Direct Labor Rate Variance (the price variance) and the Direct Labor Efficiency Variance (the quantity variance) general ledger accounts. For both the rate variance and the efficiency variance,
unfavorable variances are recorded as debits and favorable variances are recorded as credits.
As with direct materials variances, direct labor variances are closed out at the end of the period, either to
cost of goods sold or, if they are material, they are prorated among work-in-process inventory, finished
goods inventory, and cost of goods sold.
However, note that direct materials inventory is not included in the proration of direct labor variances. In
addition, note that direct labor has no equivalent variance to the direct materials purchase price variance.
Labor rate variances are always rate variances for direct labor used. Both of these differences between the
handling of direct materials variances and direct labor variances are caused by the fact that labor cannot
be bought and stored until used the way direct materials can be.
Note: A company must decide how employee-related costs, such as employee benefits and payroll taxes,
will be treated. These costs may be included in the cost of direct labor or treated as an overhead cost
and allocated to the units produced as part of overhead. The method in which these costs are treated
may have a small effect on cost of goods sold, income, or inventory. Only in cases where direct labor is
a large portion of the total expenses will this difference be significant.
The following information is for the next three questions: Jackson Industries employs a standard
cost system that carries direct materials inventory at standard cost. Jackson has established the following standards for the prime costs of one unit of product:
Standard Quantity
Standard Price
Standard Cost
Direct Materials
5 pounds
$3.60 per pound
$18.00
Direct Labor
1.25 hours
$12.00 per hour
15.00
$33.00
During May, Jackson purchased 125,000 pounds of direct material at a total cost of $475,000. The total
factory wages for May were $364,000, 90% of which were direct labor. Jackson manufactured 22,000
units of product during May, using 108,000 pounds of direct materials and 28,000 direct labor hours.
Question 88: The direct materials usage (quantity) variance for May is:
a)
$7,200 unfavorable.
b)
$7,600 favorable.
c)
$5,850 unfavorable.
d)
$7,200 favorable.
(Continued)
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Question 89: The direct labor price (rate) variance for May is:
a)
$8,400 favorable.
b)
$7,200 unfavorable.
c)
$8,400 unfavorable.
d)
$6,000 unfavorable.
Question 90: The direct labor usage (efficiency) variance for May is:
a)
$5,850 favorable.
b)
$6,000 unfavorable.
c)
$5,850 unfavorable.
d)
$6,000 favorable.
(CMA Adapted)
Question 91: An unfavorable direct labor efficiency variance could be caused by a(n):
a)
Unfavorable variable overhead spending variance.
b)
Unfavorable materials usage variance.
c)
Unfavorable fixed overhead volume variance.
d)
Favorable variable overhead spending variance.
(CMA Adapted)
More Than One Material Input or One Labor Class
So far, the variances covered have involved only one material input into the product or only one class, or
wage rate, of labor.
A total variance, a price variance, and a quantity variance are also calculated in situations where more than
one direct material input or more than one class of labor is used in producing the product. However, when
multiple inputs are used—called a mix of inputs—the quantity variance is broken down into two sub-variances: the mix variance and the yield variance.
The mix variance shows the portion of the quantity variance that was caused by the actual mix used
having been different from the standard mix (that is, more of one ingredient was used and less of another
ingredient was used). The yield variance shows the portion of the quantity variance that was caused by
the total actual amount of all ingredients used having been different from the total standard amount.
In a situation with multiple inputs, the price variance is not broken down the way the quantity variance is.
Note: The mix of inputs (labor or materials) is called a weighted mix. To calculate the mix and yield
variances for a given amount of output, the weighted average standard price of the actual mix used
in the batch and the weighted average standard price of the standard mix for the batch need to be
calculated.
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efham CMA
Total Variance of a Weighted Mix
Variances of a weighted mix are calculated individually for materials and labor. The total variance of a
weighted mix for either materials or labor is the actual total cost minus the standard total cost allowed
for the actual output.
−
=
Actual total cost incurred for labor or materials
(AP x AQ)
Standard total quantity allowed of labor or materials for
the actual output at the standard rate or price
(SP x SQ)
Total direct labor or materials variance
Example: The Good Dog Food Company produces Beef Mix dog food consisting of three different ingredients: beef, spinach, and pumpkin. The standard prices and the standard quantities of the ingredients
allowed for the actual output during February are as follows.
Beef
Spinach
Pumpkin
Standard Price/Lb.
$2.00
$1.00
$0.20
Standard Lbs.
Allowed for Output
2,700
1,485
1,065
5,250
Standard Cost
$ 5,400.00
1,485.00
213.00
$ 7,098.00
Prices for all the ingredients increased during January due to inclement weather. The actual prices and
quantities used for the February production were as follows.
Beef
Spinach
Pumpkin
Actual Price/Lb.
$3.00
$1.20
$0.30
Actual Lbs. Used
2,547
1,725
1,200
5,472
The total variance of the weighted mix is $10,071.00 − $7,098.00, or
Actual Cost
$ 7,641.00
2,070.00
360.00
$10,071.00
$2,973.00
Unfavorable.
Materials Price Variance (or Labor Rate Variance) of a Weighted Mix
The price variance of a weighted mix is the sum of the price variances for each component of the mix, each
one calculated individually using the formula (AP – SP) × AQ.
Example: Below are the facts again for the Good Dog Food Company’s Beef Mix dog food for the month
of February.
Standard Lbs.
Standard Price/Lb.
Allowed for Output
Standard Cost
Beef
$2.00
2,700
$ 5,400.00
Spinach
$1.00
1,485
1,485.00
Pumpkin
$0.20
1,065
213.00
5,250
$ 7,098.00
The actual prices and quantities used during February were as follows:
Beef
Spinach
Pumpkin
Actual Price/Lb.
$3.00
$1.20
$0.30
Actual Lbs. Used
2,547
1,725
1,200
5,472
Actual Cost
$ 7,641.00
2,070.00
360.00
$10,071.00
(Continued)
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The materials price variance is the sum of the price variances for each of the three inputs. The formula
is (AP − SP) × AQ for each price variance. The three price variances and the total materials price variance
are:
Beef
Spinach
Pumpkin
($3.00 – $2.00)
($1.20 – $1.00)
($0.30 – $0.20)
×
×
×
2,547
1,725
1,200
=
=
=
Total materials price variance
$ 2,547.00
345.00
120.00
$3,012.00
Unfavorable
Total Materials Quantity or Labor Efficiency Variance of a Weighted Mix
The total materials quantity or labor efficiency variance of a weighted mix is the sum of the quantity
variances for each component of the mix. The formula (AQ – SQ) × SP is used to calculate the quantity
variance for each component of the mix separately. The individual quantity variances are then summed to
calculate the total quantity variance.
Example: Continuing the variances for Good Dog Food Company’s Beef Mix dog food for the month of
February, the total materials quantity variance is calculated for each of the inputs individually with the
usage formula (AQ − SQ) × SP and then the results are summed.
Beef
Spinach
Pumpkin
(2,547 – 2,700)
(1,725 – 1,485)
(1,200 – 1,065)
Total materials quantity variance
×
×
×
$2.00
$1.00
$0.20
=
=
=
$ (306.00)
240.00
27.00
$ ( 39.00) Favorable
Even though a greater quantity in total (5,472 lbs.) was used than the total standard quantity allowed
for the output (5,250 lbs.), the total materials quantity variance, or the total variance in cost because
of variances in the ingredients used, is favorable. The mix and yield variances will provide an explanation
for that.
Because more than one material is used in the production process, the total materials quantity variance
cannot be used to determine exactly why the total materials quantity variance occurred. The variance may
have occurred simply because a different total volume of materials was used in production even though the
individual materials were used in the correct ratio. Alternatively, it may have occurred because a different
mix of materials was used, even though the total volume of the materials used may have been equal to the
standard. Of course, the variance could have also been caused by differences from the standards for both
the total volume and the mix, which is the case with Good Dog Food Company.
“A different mix” means that the actual ratio of the inputs into the product was different from the standard
ratio of inputs for the product. In the example used here, instead of the input mix for dog food consisting
of the standard 51.4% beef, 28.3% spinach, and 20.3% pumpkin, it turned out to be 46.6% beef, 31.5%
spinach, and 21.9% pumpkin. The total volume of beef, spinach, and pumpkin used a little more than the
total standard volume of 5,250 lbs. allowed for February’s production. Because of that and because the
ratio of the inputs used was different from the standard ratio of inputs, a total materials quantity variance
arose.
Breaking down the total materials quantity or labor efficiency variance into two sub-variances (the mix and
the yield variances) reveals how much each of these factors contributed to the total quantity variance. The
same process for calculating the mix and yield variances is used for both labor and materials.
1) The Mix Variance (Materials or Labor)
Note: This is the first of the two sub-variances of the total quantity variance.
The mix variance is the portion of the quantity variance that was caused by the actual mix of materials
used or the actual mix of the labor used having been different from the standard mix. Returning to the dog
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food example, the cause of a mix variance would be including higher percentages of spinach and pumpkin
and a lower percentage of beef in the dog food than the standard.
Such a mix variance could occur if the company deliberately substitutes spinach and pumpkin for a portion
of the beef required. A mix variance could also occur accidentally if, for example, the wrong proportions
are used when the materials are added to the production process.
Note: Variances are calculated in order to determine the cause or causes of variances from the standard,
or planned, amounts. Once the variances have been calculated, the person who made the decisions that
resulted in each variance should be responsible for explaining why the variance occurred. Responsibility
for explaining a mix variance should usually be given to an individual only if that person actually had
control over the mix and over substitutions made in the mix during the reporting period when the variance arose.
In some cases, however, someone who does not have control over decisions may be in the best position
to explain the variances because he or she was closer to the situation and has knowledge that can be of
assistance in an investigation. That person may be made responsible for reporting on the causes of the
variance while the decision-maker remains responsible for the variance.
The formula used to calculate the mix variance is a variation of the price variance formula: (AP – SP) ×
AQ. Instead of using the actual and standard prices for the input, weighted average standard prices
are used. The weighted average standard price of the actual mix and the weighted average standard price
of the standard mix are calculated, as follows:
1)
The weighted average standard price of the actual mix: the actual quantity used for each
input is multiplied by the standard cost for that input, the products are summed, and the sum is
divided by the total volume of all inputs used. The result is the weighted average standard price
of one unit of the actual mix.
The weighted average standard price of the actual mix is how much one standard input should
have cost, based on the actual mix used. In the example of dog food, the actual mix used in the
production of dog food during February is determined. The next step is to calculate how much one
pound of the actual mix of ingredients (46.6% beef, 31.5% spinach, and 21.9% pumpkin) should
have cost, using the standard price for each input.
The weighted average standard price of the actual mix cannot be calculated until after the end of
the reporting period, because the actual inputs used during the period cannot be known until that
time.
2)
The weighted average standard price of the standard mix: The standard quantity of each
input allowed for the actual output is multiplied by the standard cost for each input, the results
are summed, and the sum is divided by the total volume of all inputs allowed for the actual output.
The weighted average standard price of the standard mix for the actual output that results from
this calculation is how much one standard unit of the mix should have cost, based on the standard
mix allowed for the actual output. In the example of dog food, the weighted average standard
price for the standard output is how much one pound of the standard mix allowed for the actual
output (51.4% beef, 28.3% spinach, and 20.2% pumpkin) should have cost.
The weighted average standard price of the standard mix can be calculated at the beginning of the
period even though the actual output is not known at that point. The weighted average standard
price of the standard mix will be the same regardless of the volumes actually used for each input
in the calculation, as long as the standard cost per pound of each input and the standard ratio of
the inputs to one another are used in the calculation.
Calculations of the weighted average standard price of the actual mix and the weighted average standard
price of the standard mix will be demonstrated in the examples that follow each part of the following
explanation. (It is not as bad as it sounds.)
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The mix variance is calculated as follows:
Weighted Average Standard Price of the Actual Mix −
Weighted Average Standard Price of the Standard Mix
(both calculated using the Standard Price)
x
Actual Quantity of all
material or labor inputs
or
(waspAM – waspSM) × AQ = Mix Variance
Note: “waspAM” and “waspSM” are abbreviations that were developed by HOCK, as is the method presented here for calculating the mix and yield variances. The method as it is explained here is simpler
than the way it is taught in most cost accounting textbooks, and it results in the correct variances.
Candidates who use these abbreviations in an answer to an exam essay question should explain what
they stand for so that the grader can understand what is being calculated.
Note: The way the mix variance is calculated is similar to the way a price variance is calculated, because
a price variance is calculated as (AP – SP) × AQ. However, the mix variance is not a price variance.
The mix variance formula uses the weighted average standard prices of both the actual mix and the
standard mix.
To calculate the amount of any variance caused by a difference between the actual and the standard
values of one variable, isolate the actual and the standard for that variable within the parentheses. In
the mix variance, the amount of variance caused by a difference between the actual mix and the standard
mix is being calculated, so the mix is the item that must vary within the parentheses.
To isolate the difference between the actual mix and the standard mix, the same price must be used for
both mixes. Therefore, the “weighted average standard price” is used for both mixes, and the variable
that differs is the mix: actual mix (AM) versus standard mix (SM).
An example of the calculation of the mix variance follows.
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Section C
Manufacturing Input Variances
Example: Below are the facts again for the Good Dog Food Company’s Meat Mix dog food production
for the month of February.
The standards were as follows:
Beef
Spinach
Pumpkin
Standard Price/Lb.
$2.00
$1.00
$0.20
Standard Lbs.
Allowed for Output
2,700
1,485
1,065
5,250
Standard Cost
$ 5,400.00
1,485.00
213.00
$ 7,098.00
The actual prices and quantities used during February were as follows:
Beef
Spinach
Pumpkin
Actual Price/Lb.
$3.00
$1.20
$0.30
Actual Lbs. Used
2,547
1,725
1,200
5,472
Actual Cost
$ 7,641.00
2,070.00
360.00
$10,071.00
The first step in calculating the mix variance is to calculate waspAM and waspSM.
The weighted average standard price of the actual mix (waspAM) is the sum of the individual
standard costs multiplied by the actual quantity of each input used, then the sum is divided by the total
actual quantity of all the inputs used.
The actual lbs. used totaled 5,472 and the total standard cost of the actual mix is calculated as follows:
Beef
Spinach
Pumpkin
$2.00 × 2,547 lb.
$1.00 × 1,725 lb.
$0.20 × 1,200 lb.
Totals, Actual Mix at Standard Price
=
=
=
5,472 lb.
The waspAM is $7,059.00 ÷ 5,472 =
$ 5,094.00
1,725.00
240.00
$7,059.00
$1.29 per lb.
The weighted average standard price of the standard mix (waspSM) is the sum of the individual
standard costs multiplied by the standard quantity of each input allowed for the actual output, then the
sum is divided by the total standard quantity of all the inputs allowed for the actual output.
Beef
Spinach
Pumpkin
$2.00 × 2,700 lb.
$1.00 × 1,485 lb.
$0.20 × 1,065 lb.
Totals, Standard Mix at Standard Price
The waspSM is $7,098.00 ÷ 5,250 =
5,250 lb.
=
=
=
$ 5,400.00
1,485.00
213.00
$7,098.00
$1.352 per lb.
The mix variance is the portion of the total material quantity variance that was caused by the actual mix
having been different from the standard mix. The mix variance is the difference between the weighted
average standard prices of the actual and the standard mix multiplied by the actual total quantity used
of all inputs. The formula is:
Mix Variance = (waspAM – waspSM) × AQ
The actual quantity is 5,472, waspAM is $1.29, and waspSM is $1.352. The materials mix variance is:
Mix Variance = ($1.29 – $1.352) × 5,472 = $(339.00) Favorable
Therefore, the $(39.00) favorable materials quantity variance, which is made up of the mix and the yield
variances, included $(339.00) of a favorable mix variance, caused by a different mix of ingredients than
had been planned.
Since the quantity variance is the mix variance plus the yield variance and the favorable mix variance is
greater than the favorable quantity variance, the yield variance must be unfavorable.
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2) The Yield Variance (Material or Labor)
Note: This is the second of the two sub-variances of the total quantity variance.
The yield variance results from a difference between the total actual quantity of the inputs that were
used to produce the actual output and the total standard quantity of inputs that should have been used
to produce the actual output.
The formula to calculate the yield variance is a variation of the quantity variance of the mix: (AQ – SQ)
× SP. Instead of using the standard price of a single input, however, the weighted average standard
price of the standard mix, or waspSM, is used. (This is the same waspSM as was used in the calculation
of the mix variance above.)
The yield variance is calculated as follows:
Actual Total Quantity of All Inputs –
Standard Total Quantity of All Inputs
×
Weighted Average Standard Price
of Standard Mix of All Inputs
Or
(AQ – SQ) × waspSM = Yield Variance
Note: In the formula above, the actual quantity of input to the product (AQ) is equal to the total pounds,
kilograms or hours (or whatever else) that was actually used to produce the actual level of output.
The standard quantity of input to the product (SQ) is equal to the total pounds, kilograms or hours (or
whatever else) that should have been used or that was allowed to produce the actual level of output.
Note: Remember, if a product has only one direct materials or direct labor input class, the mix and yield
variances are not calculated.
An example of the calculation of the yield variance follows.
Example: Below are the facts again for the Good Dog Food Company’s Meat Mix dog food production
for the month of February.
The standards were as follows:
Beef
Spinach
Pumpkin
Standard Price/Lb.
$2.00
$1.00
$0.20
Standard Lbs.
Allowed for Output
2,700
1,485
1,065
5,250
Standard Cost
$ 5,400.00
1,485.00
213.00
$ 7,098.00
The actual prices and quantities used during February were as follows:
Beef
Spinach
Pumpkin
Actual Price/Lb.
$3.00
$1.20
$0.30
Actual Lbs. Used
2,547
1,725
1,200
5,472
Actual Cost
$ 7,641.00
2,070.00
360.00
$10,071.00
(Continued)
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Section C
Manufacturing Input Variances
The yield variance is the portion of the quantity variance that occurred as a result of having used more
or fewer total inputs than the standard total inputs. Good Dog used a greater quantity of inputs than the
standard, so the yield variance must be unfavorable. The formula is:
Yield Variance = (AQ – SQ) × waspSM
The actual quantity is 5,472 lbs., and the standard quantity is 5,250 lbs.
The weighted average standard price of the standard mix (waspSM) was calculated as $1.352 in the
previous example.
Therefore, the materials yield variance is:
Yield Variance = (5,472 – 5,250) × $1.352 = $300.00 Unfavorable
Therefore, an unfavorable quantity variance of $300.00 occurred because in total the company used
more material input than it should have for the amount of output.
Example: Reconciliation and interpretation
Good Dog’s quantity variance is $(39.00) favorable. The quantity variance is broken down into the mix
variance and the yield variance. The mix variance is $339.00 favorable. The yield variance is $300.00
unfavorable. The mix and yield variances should sum to the quantity variance, and they do:
Mix variance
Yield variance
Quantity variance
$ (339.00) Favorable
300.00 Unfavorable
$ ( 39.00) Favorable
Furthermore, the price variance and the quantity variance should sum to the total variance, and they
do. The total variance is $2,973.00 unfavorable, the price variance is $3,012.00 unfavorable, and the
quantity variance is $(39.00) favorable.
Price variance
Quantity variance
Total variance
$ 3,012.00 Unfavorable
( 39.00) Favorable
$ 2,973.00 Unfavorable
Clearly, the largest component of the $2,973.00 unfavorable total materials variance was the price variance. The price variance was caused by price increases. If the price increases persist, the standard
prices in the system should be adjusted to reflect reality.
However, the price increase was mitigated somewhat by the $(339.00) favorable mix variance. Although
prices of all the ingredients increased, the effect of the beef increase was more significant because beef
accounts for 51.4% of the standard mix. During February, the proportion of beef used was reduced so
that beef accounted for 46.6% of the actual mix instead, so the mix variance was slightly favorable.
Another comprehensive example appears on the following pages.
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Comprehensive example: The Sunny Grains Cereal Company produces cereal made up of different
grains. The material prices in effect for the fiscal year ending June 30 and the standard kilograms (kg)
allowed for each input for the April output of Sunny Morning cereal are:
Corn
Wheat
Rice
Standard Price/Kg
$ 10.00
$ 8.00
$ 3.00
Standard Kg for Output
250
250
250
750
Standard Cost
$2,500.00
2,000.00
750.00
$5,250.00
Due to several natural disasters around the world, the price for each input increased on January 1. The
actual material prices and the actual usage for April were as follows:
Corn
Wheat
Rice
Actual Price/Kg
$ 12.00
$ 8.50
$ 5.50
Actual Usage
375
200
325
900
Actual Cost
$4,500.00
1,700.00
1,787.50
$7,987.50
The following variances and variance components will be calculated:
1)
Total variance
2)
Materials price variance
3)
Materials quantity variance
4)
Weighted average standard price of the standard mix (waspSM)
5)
Weighted average standard price of the actual mix (waspAM)
6)
Mix variance
7)
Yield variance
1) Total Materials Variance
The total materials variance is the difference between the actual cost and the standard cost allowed
for the actual output. The actual cost for April was $7,987.50. The standard cost for April was
$5,250.00 The total materials variance was an unfavorable variance of $2,737.50, which is broken
down into the price and the quantity variances as follows.
2) Materials Price Variance
The materials price variance is calculated by determining the price variance for each of the three inputs
individually and summing them. The formula is (AP − SP) × AQ and the 3 calculations are:
Corn
Wheat
Rice
($12.00 – $10.00)
($8.50 – $8)
($5.50 – $3)
× 375 = $
× 200 =
× 325 =
Total materials price variance
750.00
100.00
812.50
$ 1,662.50
Unfavorable
3) Materials Quantity Variance
The total materials quantity variance is calculated by using the usage formula (AQ − SQ) × SP for each
of the classes individually and then summing them:
Corn
(375 – 250)
Wheat (200 – 250)
Rice
(325 – 250)
×
×
×
$ 10.00
$ 8.00
$ 3.00
Total materials quantity variance
=
=
=
$ 1,250.00
(400.00)
225.00
$ 1,075.00
Unfavorable
At this point, a simple reconciliation should be done to test the two main variances. The price variance
plus the quantity variance should equal the total variance, and it does: $1,662.50 + $1,075.00 =
$2,737.50.
(Continued)
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Section C
Manufacturing Input Variances
Calculation of Mix and Yield Variances
After the materials quantity variance has been calculated, the next step is to calculate the mix variance
and the yield variance. When those two variances are summed they must equal $1,075, the total material
quantity variance.
The first step in calculating the mix variance and yield variance is to calculate waspAM and waspSM. The
information about the actual and standard prices and quantities is repeated below with the addition of
some labels to clarify the information. The unused information has been made lighter and the boxes
have been clearly labeled.
Corn
Wheat
Rice
Standard Price SP
Standard Price/Kg
$10.00
$ 8.00
$ 3.00
Standard Quantity SM
Standard Kg for Output
250
250
250
750
Standard Cost
$2,500.00
2,000.00
750.00
$5,250.00
Actual Quantity AM
Corn
Wheat
Rice
Actual Price
$12.00
$ 8.50
$ 5.50
Actual Usage
375
200
325
900
Actual Cost
$4,500.00
1,700.00
1,787.50
$7,987.50
The first step in calculating the mix and yield variances is to calculate waspAM and waspSM. Since the
mix and yield variances are subdivisions of the total quantity variance, the actual price is not used. The
actual price is used in calculating the price variance, but it is not used for quantity variances such as are
being calculated here.
Note that arrows have been added to show the sources of the values used in the calculations of waspAM
and waspSM.
4) The weighted average standard price of the standard mix (waspSM) is calculated as follows:
Total Standard Cost ÷ Total Standard Kgs
The total standard quantity in kilograms is 750 and the total standard cost is calculated as follows:
Corn
Wheat
Rice
$10.00 × 250 kg =
$ 8.00 × 250 kg =
$ 3.00 × 250 kg =
Total Standard Cost
750 kg
$ 2,500.00
2,000.00
750.00
$5,250.00
The waspSM is $7.00 per kg ($5,250 ÷ 750).
5) The weighted average standard price of the actual mix (waspAM) is calculated as follows:
Total Cost using Actual Kg and Standard Price ÷ Total Actual Kg
The total actual kg was 900 and the total standard cost of the actual mix is calculated as follows:
Corn
Wheat
Rice
$10.00 × 375 kg =
$ 8.00 × 200 kg =
$ 3.00 × 325 kg =
Total Cost at Standard Price
900 kg
$ 3,750.00
1,600.00
975.00
$6,325.00
The waspAM is $7.0277 per kg ($6,325 ÷ 900).
(Continued)
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Because the mix was wrong, the weighted average standard price of each kilogram of actual input used
was $0.0277 more than it should have been.
6) Mix Variance
The mix variance is the portion of the total material quantity variance that was caused by the actual mix
having been different from the standard mix. The mix variance is the difference between the weighted
average standard prices of the actual and the standard mix multiplied by the actual total quantity used
of all inputs. The formula is:
Mix Variance = (waspAM – waspSM) × AQ
Putting the calculated amounts into the formula (waspAM – waspSM) × AQ results in the following:
Mix Variance = ($7.0277 – $7.00) × 900 = $25.00 Unfavorable
Therefore, $25.00 of the $1,075.00 unfavorable quantity variance arose because the actual mix of grains
was not the same as the standard mix of grains.
7) Yield Variance
The yield variance is the portion of the quantity variance that occurred as a result of having used more
or fewer total inputs than the standard total inputs. The mix of the inputs is not needed to calculate the
yield variance—only the total quantity of inputs used is needed. The formula is:
Yield Variance = (AQ – SQ) × waspSM
The waspSM was $7.00 per kilogram as calculated in the previous calculations, the Actual Quantity was
900 kilograms, and the Standard Quantity was 750 kilograms.
Putting all of the variables into the formula results in the following:
Yield Variance = (900 – 750) × $7.00 = $1,050.00 Unfavorable
Therefore, $1,050.00 of the $1,075.00 unfavorable quantity variance occurred because the company
used more material input than it should have for the amount of output.
Summary, Reconciliation, and Interpretation
The variance in the mix was not a material cause of the $1,075.00 Unfavorable quantity variance, since
it was responsible for only $25.00 of the unfavorable variance. Rather, the unfavorable quantity variance
was primarily caused by a general inefficiency in the use of the material inputs.
To prove all of the calculations, the sum of the two sub-variances should be reconciled to the total
quantity variance:
Materials mix variance
+
Materials yield variance
=
Total materials quantity variance
$
25.00 U
1,050.00 U
$1,075.00 U
Manufacturing Input Variances Graphic
The graphic on the following page was created by a CMA who used these study materials to prepare for his
CMA exams and graciously offered it for the assistance of other students. Many thanks to Aamir Mohamed.
322
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Section C
Manufacturing Input Variances
MANUFACTURING DIRECT INPUT
VARIANCES (MATERIALS AND
LABOR)
DIRECT MATERIALS VARIANCE
Actual DM Costs Incurred
– Std. DM Cost Allowed for
the Actual Output
DIRECT LABOR VARIANCE
Actual DL Costs Incurred
- Std. DL Cost Allowed for
the Actual Output
PRICE VARIANCE
QTY/EFFICIENCY
VARIANCE
EFFICIENCY VARIANCE
RATE VARIANCE
(AP – SP) × AQ
OR
∑(AP – SP) × AQ
(mult. inputs)
(AQ – SQ) × SP
OR
∑(AQ – SQ) × SP
(mult. inputs)
(AQ – SQ) × SP
OR
∑(AQ – SQ) × SP
(mult. inputs)
(AP – SP) × AQ
OR
∑(AP – SP) × AQ
(mult. inputs)
MIX VARIANCE
YIELD VARIANCE
(waspAM –
waspSM) × AQ
(AQ – SQ) ×
waspSM
Graphic created by Aamir Mohamed, PMP, CMA. Used by permission.
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The following information is for the next two questions: Azat Corporation produces ketchup. Azat
mixes two varieties of tomatoes: a locally grown variety to provide excellent taste and an imported
variety to provide a richer color. The standard costs and inputs for a 200-kg batch of ketchup are as
follows:
Tomato Type
Local
Imported
Total
Standard Quantity in Kg.
200
100
300
Standard Cost per Kg
$0.75
$0.90
Total Cost
$150
90
$240
A total of 110 batches were produced during the current period. The quantities actually purchased and
used during the current period as well as the prices paid are shown below:
Tomato Type
Local
Imported
Total
Quantity in Kg.
21,000
14,000
35,000
Actual Cost per Kg
$0.65
$0.95
Total Cost
$13,650
13,300
$26,950
Question 92: What is the materials mix variance for the current period?
a)
$1,050 favorable
b)
$350 favorable.
c)
$1,050 unfavorable.
d)
$350 unfavorable.
Question 93: What is the materials yield variance for the current period?
a)
$1,600 favorable.
b)
$1,600 unfavorable.
c)
$1,620 unfavorable.
d)
$1,620 favorable.
(HOCK)
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Section C
Manufacturing Input Variances
Factory Overhead Variances
Overhead costs are production and operation costs that a company cannot trace to any specific product or
unit of a product. Because these costs are incurred and paid for by the company and are necessary for the
production process, the company needs to know what the costs are and needs to allocate them to the
various products that are produced. This allocation must occur so that the full costs of production and
operation are known in order to set the selling prices for the different products. If a company does not take
overhead costs into account when it determines the selling price for a product, significant risk exists that
the company will price the product so that it covers the direct costs of production but not all of the indirect
costs of production. As a result, the company may sell the product at a loss.
Furthermore, generally accepted accounting principles require the use of absorption costing for external
financial reporting. In absorption costing, all overhead costs associated with manufacturing a product become a part of the product’s cost basis along with the direct costs. Along with the direct costs, the overhead
costs flow to the income statement as cost of goods sold when the units they are attached to are sold.
Therefore, all manufacturing overhead costs must be allocated to the units produced.
Factory overhead costs are segregated into variable overheads that increase or decrease in total with
increased or decreased production and fixed overheads that ordinarily do not change in total as a result
of changes in the production level.118 Thus, factory overhead variances are also segregated into variable
overhead variances and fixed overhead variances.
Factory overhead costs are incurred as production takes place, and an estimated amount is applied to each
unit as manufacturing takes place. The amount of overhead costs to be applied to each unit produced is
usually based on the standard usage allowed per unit of a cost allocation base119. The standard usage
allowed for a reporting period is the usage of the allocation base allowed for the actual production level
achieved120 during the period.
The overhead allocation rate is predetermined121 at the beginning of the period by dividing the
total budgeted overhead cost by the budgeted usage of the allocation base or by the budgeted
production level in units. As with other manufacturing costs, overhead costs are applied to production
as production takes place using the predetermined or standard rate instead of an actual incurred rate,
because the actual rate is not known until after the end of the period.
Common cost allocation bases used to allocate overhead to products are direct labor hours and machine
hours allowed for the actual production of one unit of product.
Example: Budgeted variable overhead for the year is $10,000,000, and 800,000 units are budgeted to
be produced. Variable overhead is applied on the basis of direct labor hours, and the direct labor standard
is that 1.25 hours of direct labor are allowed for each unit produced. Therefore, the variable overhead
application rate (called the predetermined rate) is $10,000,000 budgeted costs ÷ (800,000 budgeted
units × 1.25 DL per unit), or $10 per direct labor hour allowed for the actual production. Since 1.25
direct labor hours are allowed for each unit, the amount of variable overhead applied to each unit actually
produced will be $10 × 1.25, or $12.50. The difference between the actual variable overhead incurred
and the amount of variable overhead applied is a variance.
118
Fixed factory overhead costs are fixed as long as production activity remains within a given range, called the relevant
range. If production drops below the relevant range or increases above the relevant range, fixed overhead will change,
and then it will again be fixed as long as production remains within the new relevant range.
119
A cost allocation base is a measure of activity that is used to assign costs to cost objects. Direct labor hours and
machine hours are commonly used as cost allocation bases for factory overhead. A cost object is anything for which cost
information is desired.
120
This discussion assumes that standard costing and flexible budgeting are being used.
121
Determination of the predetermined overhead allocation rate is explained in Section B of this text, in the topic Setting
Standard Costs.
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Thus, the incurring of factory overhead costs is separate from the application of those costs to the products
manufactured. Differences between the overhead costs incurred and the overhead costs applied account
for the majority of factory overhead variances.
This discussion will begin with the total overhead variance, move on to variable overhead variances, and
conclude with the fixed overhead variances. Both the total variable overhead variance and the total fixed
overhead variance can be broken down into two sub-variances, similar to the way the direct material and
direct labor variances were broken down. Therefore, candidates need to know four individual variances that
are calculated for factory overhead.
The four individual overhead variances are:
1)
Variable overhead spending variance.
2)
Variable overhead efficiency variance.
3)
Fixed overhead spending variance.
4)
Fixed overhead production-volume variance.
The four overhead variances can be combined in various ways, such as four-way, three-way, and two-way
analyses. The different methods are simply different combinations of the same four variances. The four
variances will each be explained individually first, and then the various possible combinations of the individual variances will be presented.
Overview of Total Manufacturing Overhead Variances
The total overhead variance is the most general overhead variance. It includes both the variable and the
fixed overhead variances:
Actual total variable and fixed overhead incurred (money actually spent on these items)
–
Total variable and fixed overhead applied to production using predetermined rates
=
Total overhead variance
As with all cost variances, a positive variance is unfavorable and a negative variance is favorable.
The total overhead variance is the same as the amount of over- or under-applied factory overhead. Overand under-applied overhead is calculated as actual overhead incurred minus applied overhead. The formula
above is the same formula as the formula for over- and under-applied overhead.
The total overhead variance is not the difference between actual overhead incurred and budgeted overhead. Rather, it is the difference between the actual overhead incurred and the overhead applied to
production. (This subject will be covered in more detail later.)
The total overhead variance is divided into the total variable overhead variance and the total fixed overhead
variance. The total variable and total fixed overhead variances are calculated the same way as the total
overhead variance: actual overhead incurred minus overhead applied to production. (The calculation is
explained below.)
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Section C
Manufacturing Input Variances
The total variable and total fixed overhead variances are both subdivided into two other sub-variances:
Variable overhead spending variance
Fixed overhead spending variance
+ Variable overhead efficiency variance
+ Fixed overhead production-volume variance
= Total variable overhead variance
= Total fixed overhead variance
Variable Overhead (VOH) Variances
Variable overheads are overhead costs that change in total as the level of production changes. Examples
of variable overheads are plant electricity, equipment maintenance, other utilities, and so forth. Overhead
costs are called overhead costs because they cannot be traced to specific units manufactured. However,
since they do increase when production increases and decrease when production decreases, they are variable costs.
Total Variable Overhead Variance (or Variable Overhead Flexible Budget Variance)
The total variable overhead variance is equal to the difference between the actual variable overhead incurred and the standard variable overhead applied. The standard variable overhead applied is based on the
standard usage allowed of the overhead allocation base (machine hours, direct labor hours, and so forth)
for the actual output.
Actual total variable overhead incurred (money spent on these items)
(AP x AQ)
*
(SP x SQ)
–
Variable overhead applied to production using predetermined rate
=
Total variable overhead variance
*Overhead is applied to individual products produced, usually on a basis such as direct labor hours or machine
hours. Materials costs, units of production, and other similar measures are sometimes used, as well. Overhead
is covered in depth in Section D, Cost Management. The “variable overhead applied to production” is calculated
as Standard Overhead Rate × Standard Quantity of the Application Base Allowed for the Actual Production Level.
The interpretation of the variable overhead variance is the same as for other cost variances:
•
A positive variance is an unfavorable variance because actual costs were greater than costs
applied, and
•
A negative variance is a favorable variance because actual costs were less than the amount of
cost applied.
Note: The difference between the actual total variable overhead incurred and the variable overhead
applied to production using a predetermined rate is also referred to as the amount of variable overhead
that was over- or under-applied.
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Note: In a standard cost system, the following three items are all exactly the same—they are just called
by different names:
1) Variable overhead allowed for production.
2) Variable overhead applied to production.
3) Variable overhead flexible budget.
In a standard cost system, the amount of variable overhead allowed for the actual production is the
amount of variable overhead that is applied to the production. It is also the variable overhead flexible
budget amount.
All of the three items are calculated by multiplying the predetermined overhead rate (the rate per unit
allowed of whatever is used as the overhead allocation base) by the number of units of the allocation
base allowed for the actual output.
The predetermined overhead rate is total budgeted variable overhead divided by the number of units of
the allocation base allowed for the budgeted output.
Example: ABC Industries uses a standard cost system and allocates (applies) variable overhead to
production on the basis of machine hours. ABC’s budget for 20X8 included production of 250,000 units,
and 2 machine hours were allowed per unit. Thus 500,000 total machine hours were allowed for the
20X8 budgeted output. ABC Industries also budgeted total variable overhead of $180,000 for the period.
The predetermined variable overhead rate for 20X8 is $180,000 ÷ 500,000 machine hours, or $0.36 per
machine hour.
ABC Industries actually produced 270,000 units during 20X8 using 567,000 actual machine hours.
The standard variable overhead allowed for production, which is also the variable overhead applied to
production and the variable overhead flexible budget amount, is calculated as follows.
$0.36 × (270,000 × 2) = $194,400
Note that the actual amount of machine hours used in producing the 270,000 units (567,000) is not a
part of the calculation of the variable overhead allowed and applied to production and the variable overhead flexible budget amounts. Instead, the standard number of machine hours allowed for the actual
production (270,000 × 2) is used. The 567,000 actual machine hours used will be used to break down
the total variable overhead variance into the variable overhead spending and the variable overhead
efficiency variances, however (see the following topics).
ABC actually incurred $198,450 in variable overhead during 20X8. ABC’s total variable overhead variance is
$198,450 − $194,400 = $4,050 Unfavorable
The total variable overhead variance is broken